Question

5. How does China’s trade surplus with America put pressure on its currency (the Yuan or RMB) to rise. How does its central bank prevent the Yuan (RMB) from appreciating? Describe the actions and illustrate on a graph. The y-axis should be labelled $ per Yuan. Assume the supply curve of Yuan is perfectly inelastic (vertical)

Answer 1

Answer:-- Trade surplus is the excess of Export over Import. Here China has trade surplus with USA. It implies that USA is importing more commodities from China than it imports. In order to pay excess import, more Chinese currency is needed in exchange of dolllar. So supply of dollar will move up in the international market and demand of Chinese Currency will increase. It will appreciate the value of Chinese currency.
Appreciation of currency will make Chinese goods costly. Suppose before appreciation one dollar was equal to 10 Chinese currency. After appreciation it is equal to 8 Chinese currency. So goods of one dollar is now required to pay. Thus Export is more costly now. It will reduce export from China and will increase import of China from USA. So surplus will decrease and trade balance may get reversed.
In order to overcome it Chinese goverment has to increase availability of Chinese currency in the international market. It can be done by purchasing dollar by paying Chinese currency to the extent required.
In the diagram, blue line is demand of dollar and orange currve S1 is iitial supply curve of $. So at poit e1 they are equal. Therefore, initial equilirium rate (X doller per RMB) is obsrved. (in horizontal axis).
Now due to surplus trade balance, dollar supply has increased. Supply curve has shifted to S2. It will reduce dollar value. New equilibrium has shifted at point e2. In order to remove it, Chinese Government should uy dollar against RMB, until created gap is removed.
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