Interest rate fixation, excessive fluctuations and exchange rate management in China

This article proves in a New Keynesian model that interest rate fixation can explain ChinaSs excessive business cycle fluctuations. The fixed nominal interest rate changes the propagation of external shocks, magnifies volatility of endogenous variables, and leads to economic instability. We then extend the model to a small open economy featuring capital controls, sterilized interventions and a managed exchange rate to capture the main characteristics of the Chinese economy. We prove that the magnifying effect of interest rate fixation holds in such an environment, but this effect diminishes with a more strictly managed exchange rate.