Exchange Rate Regime and Optimal Policy : The Case of China

English Abstract: This study examines how financial friction in a situation with foreign currency- denominated debt could affect the Chinese economy and social welfare using a small open economy model with Chinese characteristics. We find that the financial channel, as well as the trade channel, operates well in response to various external shocks. In addition, macroeconomic variables are more stable and bring higher welfare under a floating exchange rate system than under a fixed exchange rate system. Finally, in an economy with macroprudential policies, such as a capital inflow tax and financial regulation, welfare is higher than in an economy without such policies under either exchange rate regime. This analysis has important policy implications for the choice of exchange rate regime and for foreign debt management in China