Question

1. Throughout the 2000s, China’s exchange rate was considered to be consistently below the free-market equilibrium.
   1. Without intervention by the central bank, this would lead to excess (demand/ supply) of the yuan.

2. How would the central bank in China have maintained the desired exchange rate?

3. Sustained increases in domestic money supply lead to higher inflation in the long run. Explain how undervaluation of the yuan during this period is tied to rising inflation in China

Answer 1

During the 2000s China's exchange rate was thought about to be regularly listed below the free-market balance. This is because, during this duration, China has been a large net exporter of products making substantial quantities of foreign currency (esp. USD). The importers (of Chinese goods) in, state, the US would need Yuan to spend for their imports and it would result in gratitude in the value of Yuan if market forces remained in play. The reserve bank of China purchased the USD (and other foreign currencies) readily available in China and sold it in the global market at a fixed price (keeping the price of Yuan low).

1) Without intervention by the Chinese reserve bank, this would result in the excess need for the Yuan.

2) As explained above, the Chinese central bank maintained the preferred exchange rate by purchasing all the USD (and other foreign currencies) offered in China and offering them at a fixed rate in the global market.

3) As the Chinese reserve bank purchased foreign currencies offered in the Chinese market, it would end up selling (providing) Yuan resulting in an increase in the regional cash supply. Higher money supply leads to inflation because there is more money chasing after the (domestic) supply of products and services. We can say that undervaluation (preserving the desired exchange rate as per b above) of the Yuan during this period is connected to the increasing inflation in China.