Time-Varying Coefficient Taylor Rule and Chinese Monetary Policy: Evidence from the Time-Varying Cointegration

No consensus has been reached about whether the Taylor rule performs well in China. Most studies have either ignored the nonstationarity of the variables in the Taylor rule model or assumed a constant cointegrating vector. China is a transition economy, undergoing gradual reform. Consequently, the fixed coefficient cointegration approach is unable to capture the long-run relationship among interest rate, inflation gap, and output gap. Therefore, this paper develops a time-varying coefficient Taylor rule and estimates it using a smooth time-varying cointegrating approach. The results show a time-varying long-run relationship among the variables in the Taylor rule. The coefficient on the inflation gap is significantly less than 1, indicating that the nominal interest ratei¯s response to inflation is inadequate. Moreover, the coefficient on the output gap is significantly greater than 0, implying that the response of the nominal interest rate to the output gap is sensitive. The Peoplei¯s Bank of China should adjust the short-term interest rate should be more flexible especially to changes in inflation.