Inflation targeting in China based on a dynamic stochastic general equilibrium model

Xiaowen Hu, Bing Xu, Shangfeng

Abstract

Strict inflation or flexible inflation targeting, which is more suitable for China? By building, calibrating and estimating a new Keynesian DSGE model, we analyze and compare the effect of strict inflation and flexible inflation targeting. Through counterfactual simulation, analysis of impulse response and social welfare loss, we find, comparatively speaking, first, the strict inflation target will result to larger fluctuations of inflation and smaller fluctuations of output facing technology shocks; Second, the flexible inflation target will suppress the output expansion and inflation rising more largely in a relatively short period of time facing monetary policy shocks; final, the strict inflation targeting will result to fewer losses from the perspective of the central bank’s loss function. Thus, flexible inflation targeting is appropriate for managing the economy in Interest rate liberalization, but would cause larger the welfare loss.