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Published on Feb 15, 2016

Abstract

We model provincial inflation in China during the reform period. In particular, we are interested in the ability of the hybrid New Keynesian Phillips Curve (NKPC) to capture the inflation process at the provincial level.

The study highlights differences in inflation formation and shows that the NKPC provides a reasonable description of the inflation process only for the coastal provinces. A probit analysis suggests that the forward-looking inflation component and the output gap are important inflation drivers in provinces that have advanced most in marketisation of the economy and have most likely experienced excess demand pressures. These results have implications for the relative effectiveness of monetary policy across the Chinese provinces.

China's rapid growth and ever-increasing economic importance imply a need to understand its inflation developments. While some papers have recorded the ability of the New Keynesian Phillips Curve (NKPC) to capture the inflation process in the Mainland, less attention has been paid to differences across China's provinces. This is important, as aggregate figures mask significant differences in economic performance and different degrees of market development across regions, and institutional differences between provinces may impact the link between output growth and inflation. Table 1 in the Appendix presents some key economic statistics for China and its provinces for 2005.1 Moreover, the effectiveness of monetary policy depends on the role of inflation expectations in determining inflation, which is of importance for conducting policy in a major economy with regional differences such as China.

One of the stated aims of China’s gradual transition towards a more flexible exchange rate regime is to develop and implement an independent monetary policy framework effectively, which could in the future also evolve towards adoption of some form of price stability objective. In this regard, differences in the inflation formation process across Chinese provinces matter because they will directly hinge on the effectiveness of monetary policy. Furthermore, inflation differentials between provinces may reflect price adjustment processes between regions which are necessary and desirable from a regional convergence perspective.

However, if differences in inflation formation processes are persistent, this might be a reflection of persistent structural rigidities that reduce some region’s capacity, relative to others, to adjust to shocks. Previous literature has reported evidence of substantial trade barriers between the different provinces in China in the past (see Young, 2000). Such measures may prevent price arbitrage between the provinces. Moreover, if regional inflation developments are unrelated to the output gap and marginal costs, then there is little room for monetary policies to anchor inflationary expectations and provide a favourable environment for inter-regional economic growth convergence. Structural policies that target regions where the inflationary process is less responsive to variables that respond to monetary policy might then be called for.

About the data

In our analysis, we use data for 29 Chinese provinces provided by the National Bureau of Statistics (NBS) in their Compendium of Statistics. Chongqing and Tibet are omitted due to data availability. The periodicity of the data is annual, starting in 1978. Chinese economic reforms were initiated at that time in the rural areas, when price and output decisions were liberalised in agricultural markets. Foreign trade and investment were also allowed by the new "open door" policy in 1978 although these were strongly encouraged only in the 1990s, when current account transactions were made fully convertible and tariffs on imported inputs were reduced.

We acknowledge the fact that there have been structural changes in the economy during the reform period, which may pose a problem for the parameter stability of an aggregate supply relation. Nevertheless, including observations from 1978 onwards is imperative in order to have adequate observations for empirical analysis, and high-frequency price data for Chinese provinces is either non-existent or notably volatile. Finally, we tackle the stability issue by examining recursive estimates of coefficients for the output gap and inflation rate.

Author: Aaron Mehrotra, Tuomas Peltonen and Alvaro Santos Rivera , Bank of Finland, BOFIT

Source: http://ssrn.com/abstract_id=1010629