Economics Internal Assessment

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Since 1994, the Chinese Yuan has been pegged to the U. S. dollar (8. 28 Yuan/USD); this period has caused the Chinese economy to experience an average 8% annual increase in GDP. In order to sustain the undervaluation of the Yuan (by maintaining the peg), Chinese consumers have to keep their savings artificially high and the government has to intervene by buying out U. S. dollars from the United States daily. Lately, the U. S. has been pressuring China to revalue or float their currency while Chinese economists believe that such an action would cause disastrous effects to their economy.

Even though a fixed exchange rate does not violate WTO or IMF rules it disrupts WTO agreements or is used to gain a comparative advantage. It is arguable that China’s peg to the USD is somewhat bending the rules if not breaking them. By keeping their exchange rate lower than market equilibrium, China is able to increase the demand and consumption of their exports because all of the exports have to be bought in the producing country’s currency. In addition, the import prices rise (more Yuan exchanged for them).

In the letter to the editor entitled “Trading Blows”1, the reader compares the undervaluation of the Yuan to a tariff on imported goods. However, it is important note the different between these two concepts. When a tariff is established, there is not resulting benefit to consumers in the import-producing country whereas a peg has some benefits. One important benefit to the U. S. consumers from the Chinese peg, is that it provides economical trade-stability between the United states and China. In the table and graph above we can see benefits and disadvantages ceterus paribus if a government applies a tariff on a foreign import.

Even though in China’s case this tariff is not directly applied by the government, it is still present from the low exchange rate and is virtually the same concept. We can see that from this tariff, there is one goal, to improve the domestic rather than global economy. Perhaps a better parallel of a currency peg can be made by comparing it to a subsidy. A subsidy is the process in which the government pays the producers (usually domestic) to produce less and the loss of revenue from a decrease in production is paid by the government.

In this case, consumers who purchase the exports receive benefits but the domestic firms that have to compete against the low-priced import suffer. Having the potential negative effects of the undervalued Yuan in mind, many critics of the peg assume that the trade United States trade deficit with china is caused by the low exchange rate and harms the United States economy.

However there are several important things to note on this issue. Firstly, a large amount of foreign investment in China comes from international companies who take advantage of China’s cheap labor. Also, besides the fact that the U. S. deficit with China has been growing increasingly, it is also important to keep in mind that China has become one of the fastest growing markets for U. S. exports3.

Under pressure from U. S. officials, including Alan Greenspan, who is expressing his concern with this issue quite openly by stating that he believes that, “the system hurts China by encouraging the inefficient allocation of economic resources, and that changing it would boost China’s economy4,” it seems that China will sooner or later take action against the peg; whether this means letting the currency float or devaluating the Yuan.

The Chinese officials however, say that China’s economy and its banks are not ready for such a move- they believe that their economy needs time to prepare for the change in currency. If the Yuan is left to float freely, it’s value will rise in order to match the equilibrium. Thus, both of the methods of solution, devaluation and float will result in similar consequences. The J-Curve is a Marshall-Lerner concept that shows the effect of a devaluation on a country’s balance of payments; this curve is illustrated below.

This concept supports China’s concern about spontaneous currency devaluation and at the same time disproves this with the long-term surplus. The fact that the deficit eventually changes into a surplus, can be explained by the idea that consumers need time to adjust to different producers5. In order to maintain general economic stability, the Chinese government will have to find a way ot devaluate the currency in such a way that the rise in the exchange rate will not have totally drastic effect on the economy.

What seems most appropriate is floating the currency in order to provide automatic adjustment of the exchange rate to reach market equilibrium. In the long run, the both the U. S. and Chinese economies will benefit. 1 The Economist print edition, Nov. 17,2005 2 Because of the rise in certainty, ceterus paribus, there is an rise in trade patterns of trade in terms of capital and trade integration. Thus the statement, “[Schumers] proposal is justified based on the effective tariff China places on foreign goods via a forcibly undervalued currency” is false.

China’s Exchange Rate Peg: Economic Issues and Options for U. S. Trade Policy, may 10, 2005, Congressional Research Service-The Library of Congress 4 http://www. msnbc. msn. com/id/8129284/ 5 It is important to note that there is a crucial assumption that is made here. The assumption, and in this case it seems to be fairly true, is that the demand for exports is price elastic because if this is true, then the fall in the price of exports will lead to a proportionately greater increase in quantity of exports demanded.

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