What Is the Relationship Between Money Supply and Interest Rate?

Under the conditions of a market economy, interest rates and exchange rates are highly correlated, and their changes are mutually constrained. In particular, the impact of interest rates on the exchange rate is very obvious, and jointly affects a country's money supply and internal and external equilibrium. At present, China's regulatory interest rate and non-market-based exchange rate constitute the two pillars of the current financial system. Under this institutional arrangement, after the marketization of interest rates, if China s economic growth slows down and international interest rates rise, China s central bank will face a dilemma: reducing interest rates to stimulate the domestic economy will cause an imbalance in international payments; and letting domestic interest rates The accompanying market will exacerbate domestic imbalances. According to the Mundell-Fleming model, if a floating exchange rate system is implemented at this time, China can maintain a low interest rate policy alone, because low interest rates cause capital outflows to devalue the local currency, and the devaluation of the local currency can stimulate exports and improve the balance of payments; It can also stimulate the export industry to expand investment, increase effective demand, and stimulate domestic economic growth. It can be seen that in order to achieve the coordination of domestic and foreign economic policies, while the marketization of interest rates, the marketization of the exchange rate formation mechanism must be promoted in time to form an interest rate and exchange rate linkage mechanism.

Interest rate and exchange rate linkage mechanism

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(1) Transmission mechanism of interest rate to exchange rate [1]
(1) The impact of the dynamic openness of financial markets on the interest rate-exchange rate linkage mechanism [2]
According to the empirical results above, one is that there is a block in the transmission channel of the impact of interest rates and exchange rates in China. It is necessary to clear the internal and external channels of interest rate exchange rates. On the one hand, it shows that the reform of interest rate marketization in China has achieved initial results, and that interest rate prices are more sensitive to market reflections. On the other hand, it also shows that the lag in marketization of China's exchange rate has seriously affected the transmission of interest rates on exchange rates. According to the traditional thinking, the path of interest rate liberalization-> capital account liberalization-> exchange rate liberalization should be followed. However, in the current situation, we should advance the construction of exchange rate liberalization in order to break through the bottleneck of the reform process. To give full play to the synergies brought about by various financial reforms, this requires arranging the order in the financial reform process. [2]
Today, China's interest rate and exchange rate have not yet formed a good linkage effect. The main reasons are that the RMB cannot be freely exchanged under capital accounts, interest rates have not been marketized, and a flexible exchange rate mechanism has not yet been formed. [3]
1. Mundell-Krugman's impossible triangle theory [3]
1. Comparative analysis of the results of the joint test of interest rates and exchange rates between China and the United States [1]
(1) There is a long-term equilibrium relationship between the exchange rates of China and the United States. From the results of the cointegration test, there is a situation in both countries where the impact of interest rates on the exchange rate exceeds the impact of exchange rates on Role, and there is a negative correlation between Chinese interest rates and exchange rates. Although from the cointegration formula, there is a negative correlation between the US interest rate and the exchange rate, but because of the difference in the pricing method, in fact, there is a long-term positive correlation between the US interest rate and the exchange rate.
(2) The impact of GDP on the exchange rate is greater than the impact of interest rates on the exchange rate. From this we can see that the relationship between the interest rate and the exchange rate or the interaction between the interest rate and the exchange rate is subject to other economic variables. Rising GDP and economic growth will cause the national currency to appreciate.
(3) Granger causality test results show that there is no Granger causality between the two independent variables of interest rate and exchange rate in China, but there is a more obvious two-way Granger causality relationship between US interest rate and exchange rate.
2. Reasons for the differences between the China-US interest rate and exchange rate linkage mechanism
(1) Previous studies have suggested that there is no long-term equilibrium relationship between interest rates and exchange rates in China. That is because the interest rates and exchange rates were not completely determined by the market, but were determined by relevant government departments based on planned economic goals. There is no strong relationship between these financial instruments. China introduced interest rate liberalization in 1996 to exchange rate reform in 2005. The linkage relationship between interest rate and exchange rate has been strengthened compared to the past. limit.
(2) China and the US have different economic regulation goals.
(3) Selection of indicators.
(4) Occasional small probability factors.

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