From 2008 to 2010 the Chinese government pegged the exchange-rate value of the Chinese yuan to the U.S. dollar. Briefly explain the effects of the pegged rate and Chinese government intervention to defend the pegged rate on the Chinese economy. Then, starting in mid-2010, the Chinese government allowed the yuan to appreciate slowly relative to the U.S. dollar. Briefly explain the effects of the changed exchange rate policy on the Chinese economy.

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: The exchange rate is the price of one currency in terms of another. From 2008 to 2010 China intervened in foreign exchange markets to keep the value of its currency, the yuan, fixed at an artificially low rate. The artificially low value encouraged Chinese exports of goods and services and discouraged Chinese imports of other countries' goods and services. To keep the exchange rate value steady, the Chinese government intervened in foreign exchange markets by selling the yuan and buying U.S. dollars. Effectively, China's central bank was supplying yuan and demanding U.S. dollars. The increase in the yuan money supply encouraged Chinese domestic borrowing and spending. The increased domestic spending and borrowing created inflationary pressures in China. In mid-2010, the Chinese government began to allow the yuan to appreciate in the foreign exchange markets, which helped relieve inflationary pressures. As the yuan appreciated it effectively lowered the price of imports and slowed the growth of Chinese exports. This helped reduce the demand pressure on domestic resource prices and product prices. The appreciation in the yuan also reduced the amount of government intervention needed by the Chinese monetary authority, which reduced the pressure for growth of China's domestic money supply.