Monetary Liquidity in China, Measurement and Implied Investment Strategy

Abstract

Monetary liquidity is an important yet complicated concept. This paper reviews various definitions of monetary liquidity in existing literature, and expands the discussion on comparison of measures of monetary liquidity. This paper uses time series of CPI and PPI to construct a new composite inflation index (CII), which is a comprehensive reflection of a nation’s inflation level. Based on this new composite inflation index and other three variables, namely M2, the industrial added value, and real interest rate, a new monetary liquidity indicator ML can be constructed, with demand for money taken into account. The results of Granger tests show that ML and the returns of stock market index are bidirectional Granger causes, and ML is the Granger cause of the volatility of stock market index. A strategic asset allocation model based on this new measure of monetary liquidity is proposed and it shows a good performance.