Volume 3, Number 2

This paper estimates a Markov switching IS Curve for China in an attempt to examine the relationship between monetary policy, the credit market and the real economy in China. It endeavours to solve two of the main problems encountered in studies of this kind in the past. Firstly, the Markov switching aspect will eliminate any non-linearities, structural breaks or asymmetries in the transmission process. Secondly, the IS Curve will be estimated using a monetary policy index (MPI) which has been calculated using a Kalman filter in a State-Space Model (SSM) form. This index will account for the various monetary policy tools, both quantitative and qualitative, that the People’s Bank of China (PBOC) have used over the time period of 1990 - 2010. The paper’s findings suggest that an IS Curve model can be used to analyse the effect of monetary policy on aggregate demand in China once the issues of structural breaks and monetary policy tool selection are properly accounted for.

Keywords: Monetary Policy in China; IS Curve; People’s Bank of China; Markov Switching; Kalman Filter.