The Impact of Government Intervention on Firms' Investment Decisions in China: An Extension in the IS-LM Model

Abstract

This essay examines how government interventions affect the firms in China, where political connections are valued as one of the essential factors in this fast-growing economy. This research aims to show that the Chinese government treats SOEs and non-SOEs differently by offering different interest rates. This paper contributes to allowing the policymakers to notice the difference in the responsiveness of SOE and non-SOEs investment. The government can plan its expansionary policy schemes by setting the interest rates according to the relative sensitivities of firms to overcome economic fluctuations. The primary methodology is an extension of the IS-LM model, which studies how the exogenous change in policies affects the equilibrium level of income. According to the correlation analysis, SOE investment has an intense negative relationship with interest rates. Still, the non-SOE investment is less responsive than the SOE investment, although it also has an opposite trend with the interest rates. This study modifies the IS-LM curve based on Chinese government intervention behavior and contributes to the further exploration of the investment behavior of firms under policy changes. The Chinese economy is currently rebounding from the aftermath of the pandemic, as the government abandoned its Zero-COVID regime. China’s policy-induced recovery will generate a considerable contribution to global growth according to the IMF’s forecasts, released on January 30th, 2023. This research topic is necessary to be developed as it studies the reaction of firms when the government applied its policy tools to spur the economy.