Oil Price Shocks and China’s Economy: Reactions of the Monetary Policy to Oil Price Shocks

The paper empirically analyzes the effect of oil price shocks on China’s economy with special interest in the response of the Chinese interest rate to those shocks. Using different econometric models, i) a time-varying parameter structural vector autoregression (TVP SVAR) model with short-run identifying restrictions, ii) a structural VAR (SVAR) model with the short-run identifying restrictions, and iii) a VAR model with ordering-free generalized impulse response VAR (GIR VAR), we find the response of the Chinese interest rate to the oil shocks is not only time-varying but also showing quite different signs of responses. Specifically, in the earlier sample period (1992:4-2001:10), the interest rate shows a negative response to the oil shock, while in the latter period (2001:11-2014:5) it shows a positive response to the shock. Given the negative response of the world oil production to an oil price shock in the earlier period, the shock is identified as a negative supply shock or a precautionary demand shock, thereby the negative response the interest rate the oil shock is deemed as economy-boosting. The positive response of interest rate the oil shock in the later period, given that this shock is identified as a positive world oil demand shock, gives evidence that stabilization of inflation is one of the main objectives of China’s monetary authority, even though the current main objective of the monetary policy is characterized as “maintaining the stability of the value of the currency and thereby promoting economic growth.” Finally, the variance decomposition results reveal that the oil price shock becomes an increasingly important source in the volatility of China’s interest rate.