Given the current volume of money supply, some analysts believe the government ought to tighten the monetary policy to drive up economic growth. Others think that the government should raise inter-bank interest rates to punish financial institutions and enterprises indulging in excessive arbitrage, and force capital to flow into the real economy by issuing more money. But neither argument appears effective. A prudent monetary policy is bound to backfire. For one, such a policy cannot boost the stock of money and thus will further reduce the circulation of money. So the central bank has to ultimately change its policy and issue more money to maintain economic growth.

A moderately loose monetary policy will boost banks' and businesses' confidence, and increase the circulation and supply of money. In contrast, a tight monetary policy will result in sluggish economic growth and reduce the circulation of money. In other words, the supply of money cannot be increased amid an economic slowdown.

A moderately loose monetary policy is needed to solve three major economic problems. These problems are: the downward trend of the real economy, the much lower growth of capital in the real economy than that suggested by the volume of social financing, and the floating of the producer price index in deflation territory and the consumer price index in a region just below the government's inflation target.

Perhaps China's policymakers could do with the suggestions that follow.

First, the central bank should make it clear that it is committed to stabilizing inter-bank interest rates in order to restore the confidence of banks and businesses. If commercial banks are convinced that the cash crunch is over, they will no longer hoard liquidity.

Second, interest rates have to be further liberalized by expanding the range of deposit and loan rates, and allowing banks to issue negotiable certificates of deposits.

Instead of focusing on the volume of social financing, China should increase the new credit, say, by 300-500 billion yuan ($49-81 billion) in new bank lending in the second half of the year. But it should refrain from increasing the effective exchange rate of the yuan during the rest of the year.

Instead of allowing signs of a deepening deflation and growth slowdown to become obvious, the authorities should adopt more relaxed credit policies to show their commitment to steady growth in order to boost banks' and businesses' confidence in the real economy.

They also need to differentiate between effects of structural reforms and trade cycles. Structural reforms, such as channeling social capital into various fields, are conducive to medium- and long-term economic growth. But they cannot produce tangible results in some areas, especially in boosting investors' confidence. So in the short term, the authorities should not expect to see steady growth by simply pinning their hopes on reforms while delaying the opportunity to issue macro regulations to counter the trade cycle.

The author is chief economist, Deutsche Bank, Greater China.