Capital controls and optimal Chinese monetary policy

China׳s external policies, including capital controls, managed exchange rates, and sterilized interventions, constrain its monetary policy options for maintaining macroeconomic stability following external shocks. We study optimal monetary policy in a dynamic stochastic general equilibrium (DSGE) model that incorporates these “Chinese characteristics”. The model highlights a monetary policy tradeoff between domestic price stability and costly sterilization. The same DSGE framework allows us to evaluate the welfare implications of alternative liberalization policies. Capital account and exchange rate liberalization would have allowed the Chinese central bank to better stabilize the external shocks experienced during the global financial crisis. •Present a DSGE model for China featuring capital controls and sterilized intervention.•Central bank faces a tradeoff between sterilization costs and price stability.•Declines in foreign interest rates relative to domestic rates raise costs of sterilization.•Optimal policy response includes less sterilization and expansionary monetary policy.•Easing capital controls or letting exchange rate float improves welfare.