Question

China has a trade surplus and the People’s Bank of China (PBC, China’s central bank) purchases all the excess foreign currency earning of the country’s exporters. This policy is equivalent to bond purchases by the PBC through open market operations.

1. What is the impact of the PBC’s policy of foreign currency purchase on the country's money supply?
2. If all foreign conditions are exogenous and the aggregate real income, the price level, and the future conditions of the Chinese economy (including the expected exchange rate) can be taken as given, what is the consequence of the policy for the current interest rate and the spot exchange rate in China?

Answer 1

China has a trade surplus and the People’s Bank of China (PBC, China’s central bank) purchases all the excess foreign currency earning of the country’s exporters.

a. The impact of this policy on the country's money supply will be an increase in the money supply. This is because if PBC purchases the foreign currencies from the traders, it will give them the local currency which the traders can spend in the home country only hence the money supply increases, this is also because it is equivalent to bond purchases by the PBC through open market operations which also leads to an increase in money supply.

b. If all foreign conditions are exogenous and the aggregate real income, the price level, and the future conditions of the Chinese economy (including the expected exchange rate) can be taken as given, the present policy of PBC will lead to a decrease in interest rate this is because since there is enough money in the economy and hence the demand will fall leading to a fall in the interest rate.

With increase in money supply, the demand for money will fall and hence its value will also fall in the foreign exchange market. So the spot exchange rate will go down i.e. we have to pay more of the local currency than before to get a particular amount of foreign currency.