In fixing the exchange rates, central bank trades domestic and foreign exchange reserves to adjust the money supply such that the domestic interest rate equals the foreign interest rate. Since the Chinese’s foreign exchange reserves mainly compose only of US government and institutional bond, most of our analysis will relate more on the impact of the U.S. economy. The central bank would have a choice to use the monetary policy or fiscal policy to alter the money supply.
In both policies, when the domestic currency (suppose the dollar) appreciates higher than its fixed level, the central bank will enter the foreign exchange market and purchase foreign assets. This causes an increase in domestic money supply, leading to a fall in dollar interest rate in the short run. A fall in domestic exchange rate makes return on dollar deposits lower than foreign currency deposits. In turn, investors will exchange their dollars for foreign currency, depreciating the dollar to its fixed level. The reverse happens when the dollar depreciates lower than desired.
Policy makers from US and all over the world have argued that the Yuan is highly undervalued by around 40% (Morrison and Labonte 2008, p.2). This statement is further supported by China’s foreign reserves exceeding $3 Trillion, which indicates the government’s intervention in keeping th...
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... Currency: A summary of the Economic Issues Federation of American Scientists
‘World-record China Reserves Pass $3 Trillion in Policy Challenge for G-20’, Bloomberg News, 14 April 2011, Internet.
Lau, Lawrence J., Xikang Chen, Leonard K. Cheng, K. C. Fung, Yun-Wing Sung, Cuihong Yang, Kunfu Zhu, Zhipeng Tang and Jiansuo Pei, 2006b, The Estimation of Domestic Value-Added and Employment Generated by U.S.-China Trade, Working Paper no 2, The Institute of Economics, Chinese University of Hong Kong.
US-China business Council, US-China Trade Statistics and China's World Trade Statistics 2011, Annual Report 2001-2010, Beijing.
Midas Letter 2010, China Reserves Threatened by Devaluation Thanks to U.S. Dollars, Bowen Island.
Morrison, W 2011, China-US Trade Issues, Congressional Research Service
Joseph, G 2008, China’s Volatile Stock market, Dresdener Bank
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