Shadow Banking and China’s Monetary Puzzle

There are two monetary puzzles in post-2008 China—the money multiplier had risen considerably in magnitude and the rapidly expanding money supply, M2, has not led to a surge in consumer price index (CPI). To untangle the puzzles, the authors relaxed some of the assumptions in the conventional quantity theory of money (QTM) and introduced endogeneity into the money multiplier, taking into account the rapid expansion of shadow banking. This unveils a mechanism that links monetary authority and credit allocation among sectors. An important policy implication is that controlling the relative size of shadow banking can help improve the effectiveness of China’s monetary policies.