Identifying the Interdependence Between Monetary Policy and Financial Stress: Evidence from China

• DOI: http://doi.org/10.1111/1468-0106.12174
• Published date: 01 August 2018
• Date: 01 August 2018
• Author: Xiaohui Tian,Rong Li

Pacific Economic Review,••:•• (2016) pp. 1-29

doi: 10.1111/1468-0106.12135

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IDENTIFYING THE INTERDEPENDENCE BETWEEN

MONETARY POLICY AND FINANCIAL STRESS:

EVIDENCE FROM CHINA

RONG LI*Renmin University of China

XIAOHUI TIAN Renmin University of China

Abstract. We estimatethe interdependence betweenChinese monetary policyand financial stress using

structural vector autoregression. To solve the simultaneity problem, we employ a strategy including

both short-run and long-run restrictions that maintains the qualitative properties of monetary policy

shocks derived from the literature. This method is applied to Chinese monthly data, together with a

newly constructed index of financial stress in this paper. Our findings suggest there exists strong

interdependence between monetary policy and financial stress. The financial stress index increases

immediately by0.4 of its standard deviation aftera monetary policy shock that raisesthe M2 growth

rate by 1percentage point. An increaseof financial stress by one standarddeviation leads to a declinein

the M2 growth rate by 2percentage points.

1. INTRODUCTION

Monetary policy affects private-sector decision-making and financial markets.

The stress of the financial market also influences the macroeconomy and is,

therefore, likely to be a critical factor in the determination of monetary policy,

resulting in interdependence between monetary policy and financial stress.

This interaction is important for several reasons. First, financial shocks have

been shown to lead to a significant decline in the real economy. Hence, from

the perspective of monetary authorities, accurate estimates of the response of

financial stress to the policy instrument are crucial in making correct policy

decisions. Second, investors are also interested in this topic, because having

reliable estimates of this interdependence is a critical step in formulating effective

investment and risk management decisions.

However, little is known about the magnitude of this interdependence, in part

because of the simultaneous responses of one party to the other (Rigobon and

Sack, 2003; Rigobon and Sack, 2004 and Bjørnland and Leitemo, 2009). The

present paper aims to estimate the magnitude of this interdependence for China,

using an identification strategy based on short-run and long-run restrictions such

that the contemporaneous responses between monetary policy and financial

stress are left intact.

We investigate this interdependence in two steps. In the first step, we construct

a measure of financial stress. There exist multiple ways to measure financial

stress. One common method is to calculate an interest rate spread to gauge

default risks, for example the yield spread between a risky asset and a risk-free

*Address for Correspondence: School of Finance, Renmin University of China, 59 Zhongguancun St,

Beijing 100872, China. E-mail: lirong.sf@ruc.edu.cn. Source of Funding: the Fundamental Research

Funds for the Central Universities, and the Research Funds of Renmin University of China

(16XNB001).

Pacific Economic Review,••:•• (2016)

doi: 10.1111/1468-0106.12174

© 2016 John Wiley & Sons Australia, Ltd

© 2016 John Wiley & Sons Australia, Ltd

Pacific Economic Review

, 23: 3 (2018) pp. 411–425

doi:10.1111/1468-0106.12174