The Effects of Energy Supply Shocks and Interest Rate Liberalization in China

Abstract

Based on a New Keynesian model with a transient interest rate peg and energy inputs in production, we examine the impact of China’s interest rate liberalization on the transmission of energy supply shocks. Theoretical analysis shows that in the face of negative supply shocks, output decreases less or even increases while inflation rises more under a fixed interest rate compared with a flexible interest rate. We construct the Divisia energy index based on Chinese data to test the model predictions. We identify energy supply shocks following the strategy of Kilian ( 2009 ) and obtain impulse responses using the local projection (LP) method proposed by Jordà ( 2005 ). The empirical results are generally consistent with our model predictions.