Transcript Free Slides from Ed Dolan’s Econ Blog http://dolanecon

Free Slides from
Ed Dolan’s Econ Blog
http://dolanecon.blogspot.com/
How Chinese Inflation
Policy Will Shape the YuanDollar Exchange Rate
Post prepared November 28, 2010
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look at my textbook, Introduction to Economics, from BVT Publishers.
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
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
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
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/th
e_yuans_cours_1.html
Posted Nov. 28, 2010 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
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
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
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
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