INFLATION IN CHINA: MODELLING A ROLLER COASTER RIDE

As a result of increased integration into the global economy and continuing domestic price liberalisation, prices in China are increasingly market determined. Therefore understanding the dynamics of inflation and its cyclical interaction with real aggregates is an important question in theory and in practice, especially for central banks vis-à-vis the conduct of monetary policy. The recent experience of high GDP growth rates coupled with low inflation observed in several countries casts doubt on the traditional Phillips curve as a model of inflation dynamics. Furthermore, standard specifications of backward looking expectations-augmented Phillips curves tend to overpredict inflation in the recent low inflation environment in many countries. This has been a major motivation for the development of a family of new forward-looking Phillips curves. A typical example is the New Keynesian Phillips Curve (NKPC),which has had success for both the USA and the euro area and has therefore become a new consensus theory of inflation in modern monetary economics and a true branch of research. The reason China makes for an interesting case study is that it is a developing country and has experienced mild deflation periods in the recent past. Another motivation is that inflation forecasting has become the dominant aspect of monetary policy in recent years. Explaining and forecasting inflation has thus never been more important. Economic reform in China since the late 1970s can be roughly divided into five phases. In the first phase (1978-1984), farming was decentralized and agricultural prices were raised. The success of the reforms encouraged the authorities to introduce further measures in the second phase (1984-1988), including some liberalisation of enterprise pricing and wage setting. Fourteen coastal cities were also opened up to foreign trade and investment. During the third (1988-1991) and fourth (1992-1998) phases, the Chinese reform process was characterized by a lack of effective macroeconomic policy instruments. As a result, inflation increased substantially after price liberalisation until finally the authorities introduced price controls and administered sharp contractionary policies to control double-digit inflation download.