Exchange rate regime and optimal policy: The case of China

Abstract

This paper studies optimal financial taxes under alternative monetary regimes in a small open economy with Chinese characteristics. Entrepreneurs issue foreign currency-denominated debt but often encounter financial constraints. We focus on three types of external shocks: foreign interest rate shocks, foreign demand shocks, and exchange rate shocks. Foreign interest rate and exchange rate shocks affect the Chinese economy mainly through the financial channel, while foreign demand shocks primarily affect it through the trade channel. Either an optimal capital inflow tax or an optimal financial regulation tax, or an optimal joint policy leans against the wind due to pecuniary externalities caused by financial frictions. This, in turn, leads to more stable macroeconomic variables and higher welfare. In addition, a more flexible exchange rate regime can effectively mitigate the impact of external shocks on the Chinese economy and contribute to increased welfare.