Q.62 exchange-rate-and-china

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  • 1. (a) Explain the fixed exchange rate system and the flexible exchange rate system. [10] (b) Discuss whether a revaluation of the yuan would hurt the Chinese economy. [15] (a) The exchange rate of a currency is the rate at which the currency can be exchanged for another currency. There are three main types of exchange rate system: the flexible exchange rate system, the fixed exchange rate system and the managed float exchange rate system. Under the flexible exchange rate system, also known as the floating exchange rate system, the exchange rate of domestic currency is determined by the market forces of demand and supply. Therefore, the flexible exchange rate system does not involve any central bank intervention in the foreign exchange market. Most of the large economies in the world operate under the flexible exchange rate system. Under the flexible exchange rate system, an increase in the demand for domestic currency will lead to a rise in the exchange rate. In the above diagram, an increase in the demand for domestic currency (D$) from D$0 to D$1 leads to a rise in the exchange rate (E) from E0 to E1. The demand for domestic currency may rise due to an increase in the foreign demand for domestic goods and services or assets. The converse is also true. Under the flexible exchange rate system, an increase in the supply of domestic currency will lead to a fall in the exchange rate. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  • 2. In the above diagram, an increase in the supply of domestic currency (S$) from S$0 to S$1 leads to a fall in the exchange rate (E) from E0 to E1. The supply of domestic currency may rise due to an increase in the domestic demand for foreign goods and services or assets. The converse is also true. Under the fixed exchange rate system, domestic currency is pegged to a foreign currency at a particular rate. Therefore, the fixed exchange rate system involves central bank intervention in the foreign exchange market. The fixed exchange rate system is not commonly used. Under the flexible exchange rate system, an increase in the demand for domestic currency will lead to a rise in the exchange rate. However, under the fixed exchange rate system, the central bank will intervene in the foreign exchange market by selling domestic currency and buying foreign currency to keep the exchange rate unchanged. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  • 3. In the above diagram, an increase in the demand for domestic currency (D$) from D$0 to DS$1 followed by an increase in the supply of domestic currency (S$) from S$0 to S$1 leaves the exchange rate (E) unchanged at E0. Under the flexible exchange rate system, an increase in the supply of domestic currency will lead to a fall in the exchange rate. However, under the fixed exchange rate system, the central bank will intervene in the foreign exchange market by buying domestic currency and selling foreign currency to keep the exchange rate unchanged. In the above diagram, an increase in the supply of domestic currency (S$) from S$0 to S$1 followed by an increase in the demand for domestic currency (D$) from D$0 to D$1 leaves the exchange rate (E) unchanged at E0. In conclusion, most large economies that typically depend more on the domestic sector operate under the flexible exchange rate system. On the other hand, most small economies that depend more on the domestic sector have adopted the managed float exchange rate system and to a lesser extent, the fixed exchange rate system. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  • 4. (b) The question on whether a revaluation of the yuan would hurt the Chinese economy can be discussed in terms of the effects on the balance of payments, national income, unemployment and the general price level. A revaluation of the yuan will lead to a deterioration in the balance of payments of China. The balance of payments is a record of all the transactions between the residents of the economy and the rest of the world over a time period and is made up of the current account and the capital and financial account. When the yuan revalues, China’s goods and services will become relatively more expensive than foreign goods and services which will lead to a decrease in the net exports resulting in a deterioration in the current account and hence the balance of payments, assuming the Marshall-Lerner condition holds. Further, a revaluation of the yuan will increase the costs of investing in China in foreign currency which will lead to a decrease in the inward foreign direct investments resulting in a deterioration in the capital and financial account and hence the balance of payments. When the yuan revalues, the aggregate demand in China and hence the national income will fall. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. The decrease in the net exports and inward foreign direct investments in China will lead to a decrease in the aggregate demand and hence the national income. In the above diagram, a decrease in aggregate demand (AD) from AD0 to AD1 leads to a decrease in national income (Y) from Y0 to Y1. When aggregate demand falls, firms will employ less factor inputs to produce less output and hence pay less factor income to households. Household income and hence consumption expenditure will fall. Due to the decrease in consumption expenditure, firms will employ even less factor inputs to produce even less output and hence pay even less factor income to households. Household income and hence consumption expenditure will fall further. Therefore, the © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  • 5. decrease in aggregate demand will lead to a larger decrease in national income and this is commonly known as the reverse multiplier effect. Since national income is equal to national output, the decrease in the national income of China due to the decrease in the aggregate demand will lead to a fall in the demand for labour resulting in a rise in unemployment, assuming the size of the labour force remains the same. The decrease in the aggregate demand in China will lead to a surplus of goods and services and hence a fall in the general price level. In the above diagram, a decrease in aggregate demand (AD) from AD0 to AD1 leads to a fall in the general price level (P) from P0 to P1. When the general price level in China falls, people may expect it to fall further. If this happens, the consumption expenditure in China will fall which will lead to a further decrease in the aggregate demand. Although a revaluation of the yuan will bring about detrimental effects to China, it will also bring about beneficial effects. A revaluation of the yuan may reduce inflationary pressures in China. The Chinese economy may be overheating due to a rapid rise in the aggregate demand. If this happens, a stronger yuan will lower demand-pull inflation in China. Further, a revaluation of the yuan will reduce the prices of imported intermediate goods in China. When this happens, the cost of production in China will fall and hence the aggregate supply will rise. Aggregate supply is the total supply of goods and services in the economy over a period of time. When this happens, cost-push inflation in China will be lower. When the yuan revalues, productivity in China may rise. A stronger yuan may induce Chinese exporters to increase productivity to maintain their competitiveness. Higher productivity in China will lead to higher aggregate supply resulting in higher economic growth, lower unemployment and lower inflation. A revaluation of the yuan may increase foreign direct investments in China. A stronger yuan is more likely to lead to a fall in foreign direct investments in China if the revaluation is substantial and rapid. However, a modest and gradual revaluation of the yuan is unlikely to do so. Indeed, a modest and gradual revaluation of the yuan may instill foreign investors’ confidence in the currency resulting in an increase in foreign direct investments in China. In the final analysis, a revaluation of the yuan is beneficial to China. China is currently experiencing both high demand-pull inflation and high cost-push inflation due largely to a rapid rise in the exports and the prices of imported intermediate goods. The savings rate in China is very high. Therefore, a stronger yuan which will reduce inflation in China is needed to preserve the real value of the high savings of the people. As China becomes more domestically-driven over time, it will need to give up control over the exchange rate to control interest rates. When this happens, if the yuan is still grossly © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  • 6. undervalued, the resultant sharp appreciation of the currency will have adverse consequences for the Chinese economy. To avoid this, China should begin revaluing the yuan modestly and gradually. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek