Abstract: Through establishing a medium-scale open economy DSGE model with currency substitution, financial accelerator, and liability dollarization, this paper conducts a Bayesian estimation with China’s quarterly macroeconomic data. The results show that China’s monetary policy and exchange rate regime can be empirically described by a monetary policy rule in the form of a managed floating exchange rate regime. The transmission of monetary policy is under the influence of financial frictions and the characteristics of emerging economics. In turn, financial frictions and the characteristics of emerging economics would result in more active monetary policy intervention, which will weaken the role of monetary policy in stabilizing the economy, thus more welfare losses will be caused. Therefore, we should explore a series of more flexible foreign exchange policies, speed up the market-oriented exchange rate reform, and open up the domestic financial market step by step.

Key words: financial accelerator; currency substitution; liability dollarization; optimal monetary policy