Reforms in China’s Monetary Policy Reforms in China’s Monetary

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Reforms in China’s Monetary Policy
The deposit liabilities (D) in the assets and liabilities of banks are equal 
to the assets in the following forms: (1) loans (or claims, including lending, 
overdraft, and banks’ purchase of commercial bills) to the nonbank private 
sector ( Δ LP); and (2) loans (or claims, including short-term governmental 
financial assets, for example, treasury bonds, deposits in the central bank, 
stock cash, and the long-term governmental bonds held by banks and loans 
of other forms) to the public sector ( Δ Lg).
Δ D = Δ Lp + Δ Lg
“ Δ Ms” is defined as “ Δ D + Δ Cp,” and therefore the change of “Ms” can be 
expressed with the corresponding items as follows:
Δ Ms = Δ Lp + Δ Lg + Δ Cp 
(1.3)
The public sector borrowing requirement (PSBR) must be met by fund 
financing via issuance of paper money and coins ( Δ Cp) to the nonbank pri-
vate sector, sales of governmental bonds ( Δ Gp) (treasury bonds and public 
debt), and exchange of foreign currency for local currency ( Δ Ext). The bank-
ing sector is the last source of government financing.
PSBR = Δ Gp + Δ Lp − Δ Ext + Δ Lg
(1.4)
Consolidate (1.3) and (1.4), an important identity for flow of fund will be 
obtained as follows:
Δ Ms = PSBR − Δ Gp + Δ Ext + Δ Cp
(1.5)
This identity emphasizes the package of methods to control “Ms.” “Ms” 
is influenced by changes in fiscal revenue and expenditure, sales of bonds 
to the nonbank private sector, trading volume in foreign exchange mar-
ket and changes in commercial banks’ lending to the private sector due to 
the adjustment of interest rates by the central bank. Generally speaking, 
the decision of fiscal policies will not be affected by the monetary policy, 
and the PSBR cannot be used as a monetary policy instrument. The sales 
of bonds to the nonbank public may affect “ Δ Ms,” which, however, is 
determined by the Ministry of Finance on the basis of its own borrow-
ing structure and thus beyond the control of the central bank. And this 
is particularly true in China. Under the fixed exchange rate system, the 
central bank only passively absorbs surplus foreign exchange or provides 
insufficient foreign exchange in the foreign exchange market at a fixed 

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price. Under the floating exchange rate system, the target of central banks’ 
intervention is usually the exchange rate, instead of trading volume. Such 
intervention will affect the exchange rate and therefore the money sup-
ply, but this is different from controlling money supply through foreign 
exchange market intervention. 
In addition to the above methods, central banks may affect the money 
supply via influencing the commercial banks’ lending to individuals. For 
example, some developing countries implement the credit limit control. In 
countries with a advanced market economy, the monetary authority may 
change the short-term interest rate via open market operations and accord-
ingly change banks’ lending interest rates and borrowing demand of the 
nonbank private sector so as to change the deposits and money supply. This 
mechanism actually assumes that banks only manage assets, which means 
that if there is any reserve shortage, banks will adjust their nonreserve assets 
instead of borrowing reserves in the interbank borrowing market. In this way, 
when the monetary authority takes measures (e.g., selling treasury bonds to 
the nonbank private sector) to reduce banks’ deposits and banks’ deposits in 
the central bank to obtain reserves, banks will sell out short-term financial 
assets to the nonbank private sector, leading to a drop of assets prices and 
an increase of interest rates. Or banks will borrow from the central bank at 
a penalty rate. These two practices may lead to the increase of lending rates 
by banks. This increase of lending rates will reduce the lending demand and 
money stock. This mechanism functions eventually via the change in lend-
ing. Therefore, it is usually called “credit market method.” 
3. Comparison and Analysis of the MB Model and the FOF Model 
It is commonly believed that the fiscal policy and interest rate policy affect 
the equilibrium of money supply and demand via influencing the money 
demand, and the MB model is deemed as an alternative method. The former 
is similar to changing the income of potential buyers and controlling the 
prices of train tickets or air tickets to control the production of automobiles, 
while the latter is similar to controlling the capital manufacturers’ steel supply 
(Friedman, 1980). 
Apparently, the MB method seems to be more effective for the central 
bank to accurately control the money supply than the FOF method. Because 
it assumes that the output (i.e., deposits) of the banking sector can be eas-
ily predicted and controlled by managing their input (the monetary base) 
and analyzing a few ratios. However, in reality, the monetary base cannot be 
completely controlled by the monetary authority just as it is very difficult 
to determine the actual steel supply to automobile manufacturers without 
considering the demand. And those assets ratios actually are balanced results 
of many assets demand functions and supply functions of the central bank, 

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banks and the nonbank private sector. As a group of data obtained from ex 
post facto observation, the “m” and “B” in the “Ms=mB” are impossible to 
be accurately predicted in advance. In fact, this identity hides the complex 
behavioral relationships among the central bank, banks and the nonbank 
private sector. For example, if the central bank increases the reserve’s money 
supply, and we assume that it causes increase of the actual supply of the 
monetary base, then under the circumstances where banks do not intend to 
increase loans, the reserves-to-deposits ratio in the “m” will correspondingly 
rise, reducing the multiplier, which will exactly offset the change in the mon-
etary base and therefore keep the money quantity unchanged. Clearly, the 
monetary base and the multiplier are not completely “separable.” Likewise, 
those assets ratios in the multiplier are not mutually independent but inter-
related with one another. So this model is incomplete, and to some extent, it 
is merely an identity without any behavioral meaning. 
The reason why such a model was widely promoted in developed coun-
tries lies in that: (1) in developed countries, the nonbank private sector sel-
dom used cash, which contributed to a relatively low and stable cash ratio; 
and (2) central banks set up the required reserves ratios slightly lower than 
the daily reserves of commercial banks, which led to a very low excess reserves 
ratio (the excess reserves ratio of commercial banks in United States in 1970s 
stabilized at around 1–2%). This left little room for commercial banks to 
accommodate in front of the buffer stock monetary base (especially the nega-
tive value). They could only adjust the scale and structure of their assets and 
liabilities. In addition, a sound and effective monetary market met the daily 
liquidity management demand of commercial banks, and hence the demands 
of banks and the nonbank private sector might be neglected. Therefore, this 
method was of certain value in the practice of money control. 
However, since 1970s, the activities of banks and the nonbank private 
sector in Western countries have become more complicated, causing fluctua-
tions in the multiplier. In China, the demand elements are becoming more 
complex, especially the excess reserves demand function of commercial banks 
being very unstable, making the multiplier analysis invalid. 
Similarly, the FOF method is merely an accounting equation obtained 
from mathematical conversion of several accounting identities. We cannot 
get more information from this equation. Because despite several significant 
variables for money supply presented in this equation (PSBR, Δ Gp, Δ Ext, 
and Δ Lp), it does not illustrate relationship among these variables and simply 
divides the accounting item of “Ms.” Cleary, these two models cannot be 
used to study the monetary policy transmission mechanism. 
In fact, a useful money supply theory that the monetary authority can 
refer to for decision-making should not only include all major factors but 

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also illustrate the causal relations of such factors rather than, for instance, 
simply analyze the exogenous factors of each ratio in the money multiplier. 
The significance of the above two models lies in that they point out the major 
factors determining the money quantity. Although these two identities do 
not describe interacted behavioral relationships (monetary policy transmis-
sion mechanism involves the study of behavioral relationships), they could 
help clarify the direction of thinking. The MB model is especially useful, 
since it focuses on the monetary base in the balance sheet of the central bank 
and is consistent with the direction of monetary policy transmission from the 
central bank to the real economy. The FOF model is more meaningful for 
researches on the direct monetary policy operation framework (i.e., the direct 
control of commercial banks’ balance sheets by the central bank), since it 
focuses on banks’ credit in the assets and liabilities of commercial banks.

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