Economic development under currency intervention

In the past two decades, the rapid goods market globalization and persistent currency intervention (CI) within key emerging economies, especially China, have posed great challenge to the applications of traditional macroeconomic models with slow goods market adjustment or monetary neutrality assumptions to study international economic issues. This paper fills this gap by developing a new dynamic stochastic general equilibrium (DSGE) model to investigate the implications of CI policies on economic development in emerging markets. Considering the strict foreign exchange and capital account controls under CI, we loosen the standard price rigidity and Fisher effect assumptions in traditional models and treat exchange rate and interest rate as exogenous or predetermined. We also introduce several factors to measure the degree of economies of scale, short-run and long-run price elasticities, and inflation rate misperceptions. Results show that monetary neutrality does not hold from both international and local currency perspectives. Currency devaluation and sterilization policies have significant positive effects on output or output growth rate and financial stability under both stable steady state (“middle income trap” and stationary inflation rate expectation) and unstable steady state (“catch up” and nonstationary inflation rate expectation) scenarios. Results also reveal that fiscal policy and monetary policy have opposite implications, though with different magnitudes, on economic development: The CI economy can enjoy long run low price or inflation but high output or output growth simultaneously through expansionary fiscal policy and/or contractionary monetary policy. We further conduct a case study on China from the China Premium Database in CEIC Data to illustrate the applicability of the model.

Key words: DSGE modelling, currency intervention, economic development, China