The Effectiveness of Monetary Policy in Responding to Oil Shocks in China

Oil shocks have demonstrated to have major effects on a nation’s economic activities over the past decades, as rising oil prices have preceded almost all of the post-WWII recessions. Monetary authority might tend to tighten the liquidity in response to the current oil shock because of the potential inflation. When an oil price shock occurs, will and by how much will tight monetary policies aggravate the output reduction? A financial computable general equilibrium (CGE) model for China is constructed to answer these questions. The CGE model incorporates a financial side, which depicts the role of financial intermediates (commercial bank), the monetary authority (central bank), and financial markets (loanable fund market, enterprise bond market, government bond market, foreign borrowing market) in the economy. The linkages between the real and financial sides of the model are price index, interest rates of deposit, loan and other financial assets. Financial flows are distributed and allocated according to relative interest rates or to the monetary policies in the model. The benchmark data of the financial CGE model are obtained from a Chinese social accounting matrix of 2007 for the real side, and the flow of fund table and balance sheet of 2007 from the Central Bank of China for the financial side, along with a balance of payment table. Results show that tightening policies might contribute much less to the output reduction than the oil shock itself does.