Marvin Goodfriend and Eswar Prasad INTRODUCTION AND OVERVIEW 8.1 As China’s economy develops and becomes more market oriented, and as its integration with the world economy continues, monetary policy will need to shoulder an increasingly large burden in ensuring stable, non-inflationary growth. Rising integration, for instance, implies greater vulnerability to external shocks, and monetary policy is typically the first line of defense against such shocks. Although deeper structural reforms may be the key determinants of long-term growth, monetary policy has an important role to play in creating a stable macroeconomic environment that is essential for those reforms to take root. Monetary policy in China has in recent years operated under difficult constraints, including a fixed exchange rate regime, an underdeveloped financial system and numerous institutional weaknesses. Having an independent monetary policy is an important policy priority. Maintenance of an exchange rate regime with limited de facto flexibility exposes the economy to significant risks of macroeconomic instability. While capital controls provide some room for maneuver for monetary policy even under such a regime, this room tends to be limited in practice and could result in inadequate control of investment growth and inflationary (or deflationary) pressures. Moreover, the effectiveness of capital controls inevitably erodes over time as domestic and international investors find channels, including rising trade, to evade them. These considerations have led the authorities to initiate a move towards a more flexible exchange rate regime. On 21 July 2005, the renminbi was revalued by 2.1 percent relative to the US dollar...
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