Economic effects analysis of monetary shock on chinese financial markets

Required reserve ratio (RRR) is one of the important tools used by central bank to implement monetary policies. In order to solve the liquidity surplus and economic overheating problems in China, the central bank has increased the legal deposit reserve ratio continuously. This paper analyzes the reasons for continuous increasing of the RRR in recent period and explains the economic effects of such monetary shock on the changes of bank loans, exchange rate, consumer price index (CPI), and short-term interest rate. Monthly time series data ranging from 2002 to 2007 are collected for the computation. Granger causality test is made to find out the lead-lag relationship between economic variables. Vector Auto Regression (VAR) model is used to illustrate the impulse responses patterns between variables. The results show that the rise in reserve ratio has limited effect in tightening the bank lending activities and it will further lead to the appreciation of RMB against dollar. Government shall consider using other tools to slow down the economy.