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Exchange Rate Stabilization: A Simple Interest-Subsidy Rule——Analysis on Dynamic Exchange Rate Model
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TitleExchange Rate Stabilization: A Simple Interest-Subsidy Rule——Analysis on Dynamic Exchange Rate Model  
AuthorLiu Yun,Xu Zhiwei and Wang Pengfei  
OrganizationThe Hong Kong University of Science and Technology; Shanghai Jiao Tong University;; 
Key WordsRMB depreciation; Dynamic exchange-rate model; Capital control; Exchange rate stabilization policy  
AbstractRenminbi has depreciated continuously since the end of 2015, and the situation is getting severe under the pressure of public’s pessimistic expectation. How to stabilize the exchange rate has become one of the biggest challenges faced by the Chinese government in this “new normal” economy. This paper constructs a dynamic exchange rate model incorporated with capital control, trying to dig out the reason and corresponding policy for the continuous depreciation of RMB. We prove that there exists multiple (high and low) equilibria for exchange rate. This explains the continuous depreciation even when the fundamentals are good because pessimistic expectation towards exchange rate or the real economy would make the exchange rate deviate from the high equilibrium to the low equilibrium. In this scenario, discretionary interest rate policy or capital control policy would not help stabilize but on the contrary fluctuate the exchange rate. To deal with this problem, we propose an endogenous interest-subsidy rule, which is theoretically effective in eliminating low equilibrium and stabilizing exchange rate. In the end, this paper brings out some operational applications of this interest-subsidy rule and potentially provides some suggestions on making exchange rate policy according to the characteristics of “new normal” economy.  
Serial NumberWP1289 
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