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China’s Growth in the Global Recession

Free Slides from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ How Chinese Inflation Policy Will Shape the Yuan-Dollar Exchange Rate Post prepared November 28, 2010.

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China’s Growth in the Global Recession

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  1. Free Slides fromEd Dolan’s Econ Bloghttp://dolanecon.blogspot.com/How Chinese Inflation Policy Will Shape the Yuan-Dollar Exchange RatePost prepared November 28, 2010 Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishers.

  2. China’s Growth in the Global Recession • By pulling out all the stops, China made it through the global recession with only a moderate slowdown in its rapid GDP growth • To achieve this result, it used a combination of fiscal stimulus, easy money, and a freeze on the yuan-dollar exchange rate Posted Nov. 28, 2010 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

  3. The Inflationary Consequences • China is now facing the inflationary consequences of its pro-growth policies • The rate of increase of the CPI has accelerated steadily all year • In October 2010, CPI inflation reached an annual rate of 4.4 percent Posted Nov. 28, 2010 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

  4. Inflation and the Yuan • China’s inflation, and the policies used to combat it, will be critical to understanding development of the yuan-dollar exchange rate over the coming months • Since it was unfrozen in June, the yuan has already appreciated substantially against the dollar in nominal terms, and is expected to continue to do so Notice: Because the vertical axis shows the exchange rate in yuan per dollar, a movement down on this graph indicates an appreciation of the yuan (The purchasing power of the yuan getting stronger relative to dollar) Posted Nov. 28, 2010 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

  5. Watch the real exchange rate, not the nominal rate! • However, the nominal exchange rate does not by itself tell the whole story • The competitive position of a country’s exports depends not only on the nominal exchange rate, but also on the rate of inflation • When a country experiences inflation while its nominal exchange rate remains fixed, its exports lose competitiveness • To correct for the effect of inflation, economists watch the real exchange rate, not the nominal rate Let— H = nominal exchange rate in yuan per dollar h = the real exchange rate PUS = US price level PCN = Chinese price level Then h = H (PUS/PCN) This is the simplest of several ways to calculate the real exchange rate. For some other examples, see this post by Menzie Chin on Enconbrowser.com: http://www.econbrowser.com/archives/2010/09/the_yuans_cours_1.html Posted Nov. 28, 2010 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

  6. Real Appreciation is Faster than Nominal Appreciation • To measure the real rate of appreciation of the yuan, we add the rate of nominal yuan appreciation to the difference between the Chinese inflation rate and the US inflation rate • Because inflation in China is faster than in the US, the yuan has been appreciating faster in real terms than in nominal terms • At its current rate of appreciation, the yuan’s estimated 20-40% undervaluation would be overcome in less than three years Posted Nov. 28, 2010 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

  7. Nominal Appreciation as an Anti-Inflation Tool • One way the People’s Bank of China (PBoC) could slow inflation would be to allow the yuan to appreciate more rapidly in nominal terms • However, doing so would not slow the real rate of appreciation, which is the sum of nominal appreciation and the inflation differential • Faster nominal appreciation helps fight inflation in two ways • It makes imported goods cheaper, holding down the cost of living • It reduces the need to buy dollars, and thereby reduces the rate of growth of the yuan money supply • Faster nominal appreciation plus less inflation would still mean rapid real appreciation Posted Nov. 28, 2010 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

  8. Can the PBoC Have its Cake and Eat It Too? • There are several tools that the PBoC could try to use to fight inflation without faster nominal appreciation of the yuan • Sell more PBoC bills • Raise interest rates or reserve requirements • Use direct price controls • However, each of these tools makes the economy operate less efficiently and threatens growth Headquarters of the People’s Bank of China Photo source: Yongxinge, http://commons.wikimedia.org/wiki/File:People%27s_Bank_of_China.jpg Posted Nov. 28, 2010 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

  9. The Bottom Line: Expect Continued Real Appreciation • The most likely outcome in coming months will be a use of several anti-inflation policies in combination, including continued nominal appreciation • These policies may slow inflation, but they will not fully erase the China-US inflation differential • The resulting continued nominal appreciation of the yuan will provide gradual but welcome relief to some of the most acute imbalances in the global economy Posted Nov. 28, 2010 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

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