# Random thoughts of an economist

## Containing the monster of inflation!

Posted in China, Economics, Exchange rate, Forecasting, Nguyen Phuong Thuy, Trade balance by kafuwong on February 17, 2011

[Written jointly with Nguyen Phuong Thuy]

Experiencing a global quick recovery, Chinese economy is beginning to over-heating (relatively high economic growth and inflation). It is reported that the country attempts to control inflation by increasing the interest rates and let their currencies appreciate. (http://www.bloomberg.com/news/2011-02-08/china-raises-benchmark-one-year-deposit-lending-rates-by-25-basis-points.html)

How do these tools help contain inflation?

To simplify the discussion, let’s imagine that China produces only widgets.  Then, inflation will simply be the percentage change in the price of widgets.  A rapid increase in the price (a high inflation, in other words) is driven by an increase in demand or decrease in supply.  To contain inflation, one must reduce the speed of increase in demand or the speed of decrease in supply.  Interest rate is a cost of consuming and investing today instead of tomorrow.  Thus, raising the benchmark interest rate encourages people to reduce their demand for consumption and investment today.  Thus, a higher interest rate will lower the demand or reduce the speed of increase in demand.  (Of course, since interest cost is a cost of production, a higher interest rate will also raise the cost of production and therefore reduce supply.  However, the impact of interest on supply curve is usually relatively negligible relative to its impact on demand.)

The higher interest rate or yield will also make domestic assets more attractive to foreign investors. IF China’s currency is perfectly convertible, we would expect a higher demand for RMB by foreigners, resulting in an appreciation of the RMB.  Consequently, Chinese exports become more expensive to foreigners and imports from foreign countries become cheaper to Chinese firms.  This reduction in foreign and domestic demand for Chinese products will further reduce the demand for widgets.

Of course, China’s currency is not freely convertible.  Consequently, to reduce the demand for widgets from the foreign trade sector, the government has to revalue (or appreicate) its currency.

China is not alone in dealing with its overheating economy.  Other economies in the region also raise their rates in order to keep inflation as targeted. The deposit rates first announced in Feb 2011 of the top bank deposit accounts in Asia can be found at http://asia.deposits.org/ .

How long it takes for these effects to work, on the other hand, depends on how the quick economic agents in the economy respond to the change in the interest rates, for example, how consumers change their decisions over spending and savings. Therefore, we should expect the size of timing to be different in different economies.  Nevertheless, full effect of monetary policy like this is expected to take about one to two years.

History tells us that rate hikes are usually higher serially correlated (a rate hike tomorrow is more likely if there is a rate hike today).  So, one would expect more rate hike to come.

Let’s wait and see.

Building a structural model?  Building a structural model of the Chinese economy can take enormous time and resources — not something you and I can afford.  An alternative but cheaper approach is to assume that a small set of macroeconomic variables (employment, real exchange rate, trade balance, consumer price index, etc.) approximately evolves over time as a close system.  This set of macroeconomic variables is known as a vector of variables.  This vector is assumed to evolve over time as an autoregressive process (i.e., $y_t=a_0+a_1 y_{t-1} +... +a_p y_{t-p}+e_t$, or in other words, current values of the vector depends on the past values of the vector and a shock).   We can then apply Ordinary Least Squares (OLS) to estimate the parameters equation by equation.  An impulse response function can be calculated.  The impulse can be a change in the real exchange rate (which is a ratio of domestic and foreign prices adjusted for exchange rate).  The response can be the trade balance, or the unemployment rate.