Answer to Question #9608 in Macroeconomics for Kris Tully
Explain the role of China's administered exchange rate in contributing to its trade surpluses and therefore growth in the global supply of goods relative to demand.
A pegged exchange rate regime has been pivotal to China’s еxport-led development strategy.. A combination of huge trade surpluses, managed exchange rate and highly regulated capital inflows and outflows has prompted assertions that China’s development strategy is best termed ‘neo-Mercantilist’ insofar as large trade surpluses are seen as an appropriate end-goal of economic policy. At the same time, large trade deficits experienced by China’s major trading partners have been a source of major policy concern in those countries. Pegging the yuan maximizes China’s exports as it prevents any loss of competitiveness stemming from nominal appreciation. To achieve this, the central bank purchases foreign currency and invests it in foreign currency denominated securities, mainly G7 treasury bonds held as international reserves. While the purchase of foreign currency reduces foreign money supplies, the acquisition of foreign currency denominated bonds leaves foreign money supplies unchanged. Consequently, capital inflow from China to purchase foreign securities satisfies the excess foreign demand for yuan arising from imports exceeding exports. Exchange rate management becomes a crucial instrument for achieving higher short run growth. At the same time, with less imports of foreign consumer goods and services than otherwise, China’s living standards, as measured by absolute consumption levels, are lower than they could be. Meanwhile the reverse is true in trading partners. Short run output and presumably employment in the tradable sector is lower and household consumption higher.