International liquidity, inflation and exchange rate: Evidence from China

This paper examines the effect of international liquidity and exchange rate on China's inflation through cointegration test and vector error correction model. We build the econometric model on the traditional quantity of money theory, while introducing international liquidity and its transmission channels. Empirical results show that impact of short-term external liquidity on China's inflation is not significant, but long-term external liquidity has a clear negative effect on China's inflation. We also find that after the reform of Renminbi exchange rate regime, this negative effect is strengthened. We should guard against China's inflationary pressure coming from the external liquidity crunch in the post-crisis era and take appropriate monetary measures.