China ’ s domestic consumption under interest rate pegs - analysis based on simulation

Under the standard Taylor rule, the demand shocks (such as positive government spending shock or positive export shock) actually ‘crowd out’ private consumption by lowering household disposable income. However, under interest rate peg policy, this kind of demand shocks could actually ‘crowd in’ private consumption. What we mean by ‘crowd in’ effect of the positive demand shocks are that these shocks actually help improve the private consumption. This can be verified from the output/consumption multiplier and also the IRFs of consumption. So the policy implication here is that under the economic environment where prime interest rates have remained unchanged or relatively stable for few years, demand shocks could actually improve domestic consumption. The PBoC has enacted an interest rate peg policy for more than two years since 2012M7 for its prime policy rates, and nowadays, since China’s economy is experiencing downward pressures, we believe that Chinese government should use stimulative fiscal policies such as to increase the government spending or to offer more preferential policy for export, and in turn these policies will improve domestic consumption and hence GDP.