Answer to Question #9608 in Macroeconomics for Kris Tully

Question #9608
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.
Expert's answer
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.

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