Question

1. Throughout the 2000s, China’s exchange rate was considered to be consistently below the free-market equilibrium.
   1. Without intervention by the central bank, this would lead to excess (demand/ supply) of the yuan.

2. How would the central bank in China have maintained the desired exchange rate?

3. Sustained increases in domestic money supply lead to higher inflation in the long run. Explain how undervaluation of the yuan during this period is tied to rising inflation in China.

Answer 1

During the 2000s China's exchange rate was considered to be consistently below the free-market equilibrium. This is because during this period, China has been a large net exporter of goods earning huge amount of foreign currency (esp. USD). The importers (of Chinese goods) in, say, the US would need Yuan to pay for their imports and it would lead to an appreciation in the value of Yuan if market forces were in play. The central bank of China bought the USD (and other foreign currencies) available in China and sold it in the international market at a fixed price (keeping the price of Yuan low)

a) Without intervention by the Chinese central bank, this would lead to excess demand for the Yuan

b) As explained above, the Chinese central bank maintained the desired exchange rate by buying all the USD (and other foreign currencies) available in China and selling them at a fixed rate in the international market

c) As the Chinese central bank bought foreign currencies available in the China market, it would end up selling (supplying) Yuan leading to increase in local money supply. Higher money supply leads to inflation, since there is more money chasing the (domestic) supply of goods and services. Hence we can say that undervaluation (maintaining the desired exchange rate as per b above) of the Yuan during this period is tied to the rising inflation in China.