What Causes China's High Inflation? A Threshold Structural Vector Autoregression Analysis

• Author: Fang Guo
• Published date: 01 November 2013
• DOI: http://doi.org/10.1111/j.1749-124X.2013.12048.x
• Date: 01 November 2013

100 China & World Economy / 100–120, Vol. 21, No. 6, 2013

©2013 Institute of World Economics and Politics, Chinese Academy of Social Sciences

What Causes China’s High Inflation?

A Threshold Structural Vector Autoregression Analysis

Fang Guo*

Abstract

China’s astonishing economic growth implies a necessity to understand its inflation. The

present paper employs threshold nonrecursive structural vector autoregression analysis to

explore the asymmetric effects of macro-variables on inflation in low and high inflation

regimes. The empirical evidence demonstrates, first, that the reactions of inflation to various

shocks are inflation-regime-dependent and asymmetric. Second, monetary policy influences

China’s high inflation and adjusting the domestic interest rate in China may be an effective

way to control inflation in a high inflation regime, but not in a low inflation regime. In a high

inflation regime, a high inflation rate may cause the macro-policy authorities to increase the

domestic interest rate, in an attempt to stabilize high inflation. Third, contrary to expectations,

the world oil price is not a strong cost-push factor in a low inflation regime. Oil price

increases may increase inflation in a high inflation regime, but there is no such obvious

effect in a low inflation regime. Finally, China’s nominal effective exchange rate influences

inflation in both low and high inflation regimes. A nominal effective exchange rate appreciation

might be effective in controlling domestic inflation in both regimes.

Key words: China, inflation, threshold vector autoregression analysis

JEL codes: C01, C32, E31, E42

I. Introduction

China’s inflation oscillated greatly between 2001 and 2012, coinciding with several rounds

of inflationary and deflationary periods. China experienced a new round of high inflation

due to fiscal stimulus and expansionary monetary policy following the global financial

crisis in 2008. When the economy changes from an expansionary regime to a contractionary

regime, the dynamic adjustment of inflation to monetary policy is likely to change. As Shen et al.

(1999) demonstrate, the central bank will respond differently to changes in economic

*Fang Guo, PhD candidate, International Graduate School of Social Sciences, Yokohama National

University, Yokohama, Japan. Email: guofangynu@gmail.com. The author is grateful for useful comments

from anonymous referees, as well from Kiyotaka Sato, Yuichi Hasebe, Craig Parsons, Chan-Hyun Sohn

and Wei Li.

101

What Causes China’s High Inflation?

©2013 Institute of World Economics and Politics, Chinese Academy of Social Sciences

variables in high-inflationary and low-inflationary environments. Many regime-switching

models have been developed to analyze these types of regime changes, but the present

paper might be the first to employ threshold nonrecursive structural vector autoregression

(VAR) analysis, aiming at exploring asymmetric effects of macro-variables on inflation

between low and high inflation regimes in China. The present paper explores the following

questions. First, will China’s inflation respond asymmetrically to macroeconomic shocks in

low and high inflation regimes? Second, does monetary policy influence China’s high

inflation? If so, to what extent does monetary policy affect the inflation in low and high

inflation regimes? Third, is the world oil price a strong cost-push factor for China’s high

inflation in low and high inflation regimes? Finally, does China’s nominal effective exchange

rate influence inflation in low and high inflation regimes?

The published literature shows that monetary policy is widely affected by asymmetry.

Morgan (1993) finds that asymmetry exists in a number of widely accepted economic models.

Cover (1992) argues that positive and negative money-supply shocks have asymmetric

effects on output. Such asymmetric effects are also asserted by DeLong and Summers

(1988), who compare the effectiveness of different demand management policies in the

USA and other industrial nations before and after World War II. They find evidence of

asymmetry in business cycles. There was considerable improvement in the US economy

after World War II thanks to the more stable financial system and improved macroeconomic

policies. Beaudry and Koop (1993) find that allowing for the impulse response of gross

national product to be asymmetric, the effects of negative innovations on gross national

product are observed to be much less persistent than the effects of positive innovations.

Thoma (1994) shows that money–income causalities across sample periods are highly

correlated with the level of real activity. When real activity declines, money–income causality

becomes stronger, and when real activity increases, the relationship becomes weaker.

Kandil (1995) shows that asymmetric effects are expected to differentiate the cyclical impact

of positive and negative demand shocks on output growth.

In regards to asymmetric effects of macro-variables on inflation, the previous published

literature further reveals that the economic growth and inflation nexus might not necessarily

be linear and can be unstable. Friedman (1968) suggests the changes in the inflation rate

might induce regime switching and asymmetry. Threshold models provide an intuitive way

to capture the nonlinearity. Tong and Lim (1980) introduce a univariate threshold

autoregressive model to demonstrate that this model exhibits nonlinearity. Tong (1983)

also employs the threshold model, with inflation chosen as the threshold to separate the

whole sample into low and high inflation regimes. In this framework, the money supply is

assumed to be an exogenous variable. It is also assumed that the public and the central

bank can influence the money supply. The money supply movements are not only influenced