Central Bank and Monetary Policy Comparison: US and China
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1. Introduction
Every economy in the world has a number of support systems that have a mandate to maintain control to ensure that the economic conditions are within optimal levels. One of the main pillars of a stable economy is a central bank system. According to McKinnon, Lee, and Wang (2010, 255), central banks are majorly tasked with conducting monetary policies that are aimed at achieving price stability and assist in the management of economic fluctuations. Policy frameworks that are the main operating structures of central banks have gone through major changes in recent years. Since the end of the 20th century, monetary policies have utilized inflation targeting as the leading framework. For example, the central banks in New Zealand, the United Kingdom, Canada and the euro economies have introduced explicit inflation targets to manage monetary policies. Similarly, a report by Taylor (2019, 107) has identified that a number of emerging economies are switching from monetary aggregate targeting to an inflation targeting structure. These activities provide evidence of the role that central banks play in ensuring that an economy is stable. They conduct monetary policies through an adjustment of money supply and other open market operations (Edge and Liang 2019). For example, the US Federal Reserve System may decide to reduce the supply of money in the economy through selling government bonds. The purpose of such operations in the open market would be to drive short-term interest rates to influence overall economic activity. In this report, the conduct of monetary policy by the US federal reserve will be pitted against the Chinese equivalent in terms of regulating the economy. The comparison is important in showing which system works well under what circumstances. Overall, the role of central banks in conducting monetary policies cannot be understated as seen in the way it helps economies to recover from slumps and to initiate economic activities that result in positive outcomes for an economy, and the different methods employed by the Federal Reserve in the US and the People’s Bank of China were uniquely suited to the two economies due to their different structures and economic systems.
2. Data and Methodology
This report will use empirical data from the US Federal Reserve and the Chinese Central Bank to show the conduct of these institutions with regard to monetary policies. Data from primary and secondary sources will be used for purposes of a comparative analysis on how the two nations use their central banks to formulate monetary policies. The report uses a qualitative comparative analysis to analyze the causal contribution of conditions used by the US federal reserve and the Chinese central bank. The report begins by first documenting different configurations of the conditions linked to the individual economies with every case of observable outcomes. The minimization procedure is preferred to identify the simplest sets of the conditions that account for observable outcomes. Equifinality is observed in each of the cases for the Chinese and US central banks where more than a singular way that results to outcomes on monetary policies can be observed (Correa et al. 2021, 89-91). In this report, monetary policy conduct following the 2007-2009 Great Recession for the US and China will be compared.
Data shows that the central banks, from a neutral point of view, often use policies that stimulate a given economy in anticipation of or during a recession (Williamson 2020, 199). In such instances, the expansion of money supply is done to bring about reduced borrowing costs and lower the interest rates, with the objective being to boost investment and consumption.
The Great Recession started towards the last quarter of 2007 and ended in mid-2009, making it the longest global recession since the Second World War. In the US, data from Menno and Oliviero (2020, 103568) assert that the real GDP dropped 4.3% from its peak in the last quarter of 2007 to the trough in mid-2009. In 2007, the unemployment rate in the US was only 5%, a phenomenon that changed in 2009 with a rate of more than 9% and at 10% in the last quarter of 2009 (Mian and Sufi 2010, 54). Similarly, the prices of homes fell roughly 30% from their peak in 2006, while the S&P 500 index reduced 57% from 2007 to 2009 (Mian and Sufi 2010, 54). The total net worth of US nonprofit organizations and households fell from $69 trillion to $55 trillion between 2007 and 2009 (Mian and Sufi 2010, 54). The 2009 American Recovery and Reinvestment Act and the 2008 Economic Stimulus Act were effective in reviving the US economic growth.
In China, from 1978 to 2010, GDP share in the global economy rose from 1.7% to 9.5% (Jiang 2015, 361). The negative effects of the Great Recession on the Chinese market were considerably stronger. However, the effects were largely unrealized because China, amidst the recession, continued to record high economic growth rates. In 2008, the country recorded a 9.6% growth rate and a 9.2% growth rate in 2009 (Dai 2006, 201). However, these figures, albeit impressive by global standards, were bad news for the Chinese economy which had previously recorded a 14% growth in 2007 (Cabestan, Meglio, and Richet 2012, 48). Table 1 below summarizes the annual GDP growth rate in China from 2005 to 2011, revealing the trends leading up to the Great Recession.
Year 2005 2006 2007 2008 2009 2010 2011
China’s GDP 11.30 12.70 14.20 9.60 9.22 10.33 9.47
Table 1: China’s Annual GDP growth rate
Source: IMF World Economic Outlook.
3. Analysis
3.1 Conduct of Monetary Policy by the Federal Reserve System of the US
The US federal reserve influences cost and availability of credit and money in an effort to ensure a healthy economy. The federal reserve is mandated with two coequal objectives of ensuring maximum employment and ensuring stable prices (Thorbecke 2002, 259-260). In simple terms, the US federal reserve has a mandate to ensure low and stable inflation. The dual obligation of the federal reserve spills over to include a third objective: provide moderate long term interest rates. The basic tool available for the Federal Reserve to use in conducting monetary policy include the funds rate. Funds rate are the rate that financial institutions such as banks are charged for overnight borrowing in the government (federal) funds market (Kuttner 2001, 530). Any changes in the funds rate would influence other forms of interest rates that also affect the borrowing costs for businesses and individuals and the entire financial conditions. For example, the federal reserve may lower interest rates, triggering several effects such as the ability of people to borrow more as households and business get credit facilities at cheaper rates. Similarly, businesses have more purchasing power to expand, are able to hire more, thus influencing employment. The improved demand for products would push wages and other costs upwards, influencing inflation.
As the US economy continues to change, the interpretation of stable prices and maximum employment objectives have shifted to accommodate changes. For example, the 2007-2009 global financial crisis aftermath led to a long expansion that did not trigger notable rises in inflation even after labor market conditions strengthened. Data shows that the federal reserve system de-emphasized previous concerns on employment thus going beyond the maximum levels, in order to focus instead on the shortfalls of employment under the minimum levels (Lane and Milesi-Ferretti 2017). These examples point to evidence that the US federal reserve system has the role of interpretating and redefining new parameters that apply to monetary policies that would ensure the health of the economy. Maximum or minimum employment are objectives that can be modified to suit the needs of the economy.
The US federal reserve views maximum employment as an inclusive and broad-based objective that cannot be directly measured and is influenced by shifts in the dynamics and structure of the US labor market. Therefore, the federal reserve does not automatically specify fixed objectives for employment (Gorton and Metrick 2013, 47). The assessment of the federal reserve on the shortfalls of US employment levels from maximum points are based on uncertain indicators. Instinctively, however, whenever the economy attains maximum employment, this means that a job is available to anyone who desires one. Policymakers in the Federal Reserve perceive a 2% inflation rate is most consistent in the long run in its mandate for stable prices measured through yearly changes in the prices index for the expenditures of personal consumption (Bundick and Smith 2021, 11). Therefore, whenever inflation persists below 2%, the federal reserve aims for inflation to be slightly above 2% for a short period. These adjustments in the rate of inflation are meant to maintain stable prices, not just in the short run, but overtime through sustained control of the interaction between employment, interest rates, and prices.
Following the Great Recession, the US federal reserve undertook expansionary monetary policies to boost investment and consumption. Figure 1 below shows an expansionary policy curve where a reduction of taxes and an increase in the government spending led to a shift in the aggregate demand curve to the right to increase output. The price level changes from P1 to P2 leading to an expansion of the aggregate demand.
Figure 1: Expansionary policy US Federal Reserve (Source: Bordo, Choudhri, and Schwartz 2002, 21)
Prior to the recession, the federal reserve had steadily increased interest rates to maintain stable inflation rates in the US economy. Market interest rates rose as a response, leading to a moderation of real estate prices. The rates on adjustable mortgages and exotic loans reset at higher rates than expected. The consequence was a bursting of the housing bubble. The interest rates were lowered to zero by the US federal reserve. As the housing prices started to reduce significantly in 2007, the economy slowed. To solve the issue, the US federal reserve cut its discount rate from 5% to 0% (Cuba-Borda 2014). The federal reserve also purchased government securities. This was in an effort to promote liquidity. The federal reserve further offered more than $7.7 trillion to banks as emergency loans in an quantitative easing move (Flemming 2012, 162).
3.2 Conduct of Monetary Policy by the Chinese Central Bank
As of 2020, China was the fastest growing economy in the world. The country uses a very unique open-market economy that also has aspects of a socialist system. The government retains significant control of the economy, yet operates a fairly free-market policy. Primarily, the nation is an export and manufacturing driven market that retains tremendous levels of forex capital due to exports (Jiang 2015, 361). The People’s Bank of China, its central bank, controls the money supply of the country with an aim of ensuring that the capital availability, price levels, economic cycle, and inflation in the country are stable. China’s money supply policy is different from other nations like the US due to its unique economic structure.
China operates with a trade surplus due to its export and manufacturing driven economy. It sells more than it buys from the rest of the world (Chan 2012, 199). Exporters get paid in US dollars for their products but use local yuan to pay for wages and expenses. Due to the population of the nation, the high consumption, the increased US dollar supply in China and the demand for the yuan causes the yuan to rise against the dollar. Such situations lead to exports from China being costlier and a loss of competitive advantage in pricing in the global export market. This would lead to lower sales of the manufactured products, high unemployment, and significant stagnation of the economy (Hodson and Quaglia 2009, 941). The central bank intervenes by keeping exchange rates lower using artificial measures.
The relationship between the yuan and the economy is strange partly because of the government actions on controlling the same and due to its dependence on exports and manufacturing. From the Great Recession in 2010 to 2020, major market reforms have raised the market orientation of China opening up the economy. China controls its money supply via control of the forex rates, sterilization actions, printing currency, discount rates, and the reserve ratio. Control of the forex rates allows the Chinese central bank to absorb large inflows resulting from foreign capital due to the trade surplus. The central bank purchases foreign currency from Chinese exporters and issues the same in yuan (Dai 2006, 201). It also practices publishing of currency and exchanges it for forex as a way of retaining a tight or fixed forex rate. Sterilization actions are also common as the central bank increases the supply of local currency to increase chances of inflation. Reserve ration and discount rates are used similar to the rest of the world to mitigate money supply in the economy.
28634785934500China’s high dependence on export was reflected in the Great Recession as it suffered immensely. Towards the end of 2007, export demand came crashing due to the financial crisis in China and the country suffered a shift from inflation to deflation as shown in figure 2 below.
Figure 2: Growth rate of exports and investment (Source: Vincelette et al. 2010)
In response, data shows that the government of China intended to mitigate its falling GDP growth through monetary expansion (Hodson and Quaglia 2009, 941). The country introduced a stimulus package through interest rate subsidies and direct grants. The Chinese central bank increased its expenditure, provided tax reductions, performed a VAT reform, cut back on business tax, increased the export rebate rates, and raised the individual income tax threshold. The differences between China and the US in terms of conduct and response during and after the 2008 financial crisis are evident. China’s banking system was relatively safe after non-performing loans were written off and capital injected into the economy (Cabestan, Meglio, and Richet 2012, 48). Consequently, China had no liquidity shortage, the monetary multiplier was not significantly affected, and there was no evidence of a credit crunch compared to the United States. As a result, the dramatic increase in the liquidity in the inter-bank system and market was translated into an increase in the broad money and bank credit.
4. Conclusion
In this discussion, the data and evidence presented has shown the conduct of monetary policy by the US federal reserve and the Chinese equivalent in terms of regulating the economy amidst the Great Recession. The comparison is important in showing which system works well under what circumstances. In the end, the discussion has established that the role of central banks in conducting monetary policies cannot be understated as seen in the way it helps economies to recover from slumps and to initiate economic activities that result in positive outcomes for an economy. China and the US used different monetary policies to stimulate growth after the Great Recession. While the objectives of the policies were relatively the same, the setup of the two economies made it impossible to employ the same strategies. The different methods employed by the Federal Reserve in the US and the People’s Bank of China were uniquely suited to the two economies due to their different structures and economic systems. The discussion establishes that none of the methods are superior to the other, as both nations were able to achieve economic growth shortly after the recession.
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