Expectation, excess liquidity and inflation dynamics in China

Abstract

By introducing the shocks from individual activities into the Hybrid New Keynesian Phillips curve (HNKPC), we investigate the inflation dynamics and the effect of excess liquidity in China. According to the estimation result, some soundly conclusions can be drawn. Firstly, the empirical results indicate that the HNKPC is consistent with the nature of inflation dynamics in China, which posits the inflation dynamics as the combination of backward looking adaptive expectations and forward looking rational expectations. Moreover, defining excess liquidity by M2, the elasticity of inflation defined by CPI to excess liquidity is approximately unit, which reveals that the quasi-money is the main force behind inflation. The nature of inflation expectation and the effect of excess liquidity all provide the evidences that tight monetary policy is effective to curbing inflation in China.

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