Interest Rate Pegging, Fluctuations, and Fiscal Policy in China

Abstract

This paper proves in a New Keynesian model that interest rate pegging can explain the unusual business cycle fluctuations in China. It is traditional wisdom that when the nominal interest rate is inflexible, there is no unique equilibrium in macroeconomic models. We prove that a unique equilibrium exists if the nominal rate is pegged for a limited period, after which it switches to a flexible rate regime. The peg alters the propagation of external shocks, magnifies volatility of endogenous variables, and leads to instability of the economy. Besides, the model becomes more unstable when the peg duration extends, and when the pegged rate deviates from steady state. At the same time, fiscal multiplier increases under the peg, indicating fiscal policy may be more effective in mitigating economic fluctuations when monetary policy is restricted by interest rate pegging.