A financial CGE model analysis: Oil price shocks and monetary policy responses in China

a r t i c l e i n f o Most CGE models are real and cannot be easily used to study monetary policies. This paper develops a financial CGE model with interaction between real and financial side of the Chinese economy and applies the model to study oil price shocks and monetary policy responses. Unlike macro models in the current literature, the financial CGE model can be implemented to look into industrial details of effects of oil shocks, the responding interest rate and reserve ratio policy. We then identify the optimal monetary policies aiming at each inflation target. We found that when tolerance for inflation is high, it is best to implement interest rate policy alone. On the other hand, when tolerance for inflation is low and the government is more focused on social stability and household welfare, reserve ratio policy should also be implemented in addition to interest rate policy. In a scenario where world oil price increases by 100% and the inflation rate is to be targeted at below 2%, the monetary authority should raise the interest rate and reserve ratio by 2.5 percentage points and 3.0 percentage points, respectively. Most CGE models are real and cannot be easily used to study monetary policies. This paper develops a financial CGE model with financial flows, interest rates, monetary aggregates and other financial variables. We apply the model to study oil price shocks and monetary policy responses. Crude oil is the essential energy to most economic activities. Both the production of goods and the provision of services involve a substantial use of oil in their day-today operations. Consequently, shocks resulting from a sudden rise in oil prices or an unexpected shortage of oil supply will bring significant negative effects to the economy. In fact, a large number of studies have reported that most sudden and lasting oil price increases have been accompanied by economic recessions and high inflation (e.g., Brown and Yücel, 2002). The most recent oil price shock occurred in 2007–2008, where it reached a record high of over $140 per barrel. Countries all over the world suffered from such a sharp price increase. Despite being a fast-growing economy, China is not immune to this shock. During this period , its economic growth rate declined and inflation increased. This drew the attention of the Chinese government. A sequence of policy actions followed, including its immediate monetary actions …