The Bank of Finland’s Institute for Economies in Transition (BOFIT) is currently developing a dynamic stochastic general equilibrium (DSGE) model for the Chinese economy. The purpose of the project is to create a model capable of replicating certain stylized facts of the Chinese economy. Such a model can be useful in evaluating issues of policy relevance and for deepening our general understanding of China’s economy and its dynamics.
The model under construction is close to the closed economy model formulated by Jordi Galí (2008, Chapter 3). The model is of the New-Keynesian variety, with three types of agents: households, firms and a policymaker. Each agent maximizes its utility (for firms, profits), subject to an intertemporal budget constraint. As in other similar models, all markets must clear, and equilibrium is reached after shocks to monetary policy and technology. Nominal rigidities stem from staggered price setting of firms, in line with the now-conventional Calvo-pricing (Calvo, 1983). The goods market is characterized by monopolistic competition, with each firm setting prices in accord with its objective function. The labour market is fully competitive, however, which is easily justifiable, especially in the export-oriented Chinese industrial sector. The equations characterizing equilibrium are a New-Keynesian Phillips Curve, a dynamic IS curve, and a monetary policy reaction function.
The monetary policy reaction function for China differs from the widely-used Taylor rule for advanced economies, in which nominal interest rates are the central bank’s policy instrument. In the Chinese model, the central bank uses base money as its instrument, and it supplies base money as a function of the output and inflation gaps. The difference in the rule specification versus advanced economies stems from China’s institutions: interest rates have not historically played a major role in its monetary transmission mechanism.
China’s level of development entails several challenges for modelling. Data problems set limits to the choice of parameters used to calibrate the model. It is partly the choice of these parameters that makes the model China-specific. The chosen parameters impact the economy’s responses to various shocks. On the other hand, the ongoing structural change in the Chinese economy may prevent the economy from reaching an equilibrium in the way described by the DSGE model.
Calvo, G., 1983. Staggered Prices in a Utility Maximizing Framework. Journal of Monetary Economics 12(3), 383-398.