China (To float or not to float) - Case Study Example

China Case (To float or not to float a) The exchange rate policy would result into essential appreciation in the valueof the Yuan because the policy aims at fixing the value of the Yuan against many currencies of other countries. Despite the increasing pressure from the United States, China strategy would have both economic and diplomatic development to the country. The strategy allowed commercial banks and monetary authorities to buy large amounts of dollar-denominated asset that would allow them to maintain the value of dollar high relative to the Yuan.

For this strategy to be effective, it would purchase a large amount of US treasury bonds and fixed income assets. Meanwhile, so that they would avoid the increase of price due to the exchange rate policy, PBOC would issue its own bonds to encounter the dollar-denominated assets (Musacchio 2). This was to be maintained because a raise in money supply would have brought severe effects on inflation in China. Thus, in order to achieve their development strategy, PBOC managed to maintain price increase as a result of exchange rate policy relatively low. (b) Delaying of the floating until the banking has been liberated and capital controls abolished was necessary because it allowed them to set strategies that would curtail the impact of the strategy.

Meanwhile, they could avoid inflation that was expensive to them a lot by trying to keep inflation low that was brought by the increase of money supply. (c) In order to keep the exchange rate undervalued, PBOC managed to maintain price increase comparatively low by sterilizing the monetary effect of the purchase of dollar asset where they encouraged open market operation. Meanwhile, PBOC adjusted its strategy in order to decline the rate of interest differential between its bond and that of the United States that would prevent the price from increasing.

According to Musacchio (2), PBOC managed to maintain the exchange rate undervalued by increasing the reserve requirement for banks up to 15% of bank deposits that pressured banks to keep balances with PBOC instead of lending them to citizens. The purpose of keeping the exchange rate devalued is to stabilize the macroeconomic variables like employment, investment and economic growth, and for the political purpose. (d) The move of using the undervalued exchange rate would create an adverse effect on the exporters because the strategy can cause a raise of tariffs on the Chinese products if the exchange rate policy is not adjusted.

Meanwhile, the devaluation of the exchange rate would increase the money supply in China’s economy that would cause inflation. According to Musacchio (2), the effect of inflation is that it will create social dissatisfaction and unrest because it would increase the cost of living of citizens and workers starts demanding for higher wages to meet their expenses. In case, the exchange rate was stable before the implementation of the policy, a raise in price would appreciate the real exchange rate in the floating market. (e) There are other factors that would cause the account surplus in China, like high saving rate (Garnaut 125).

However, the devaluation of the exchange rate has been the significant cause of the account surplus in China because affect the exports that are the significant source of income in China. The appreciation of the Yuan due to the devaluation of exchange rate caused the increase in the capital inflows in the economy, causing account surplus. (f) We would recommend China to revalue the exchange rate because devaluation has affected growth rate of the economy in the country. Bergsten (125) indicates that revaluation would help to depreciate the Yuan that will improve the situation of the macroeconomic variables like increase in the employment level.

Work Cited Bergsten, Fred. The United States and the world economy: foreign economic policy for the Next Decade. New York: Peterson Press, 2005. Print. Garnaut, Ross and Song, Ligang. China: Linking Markets for Growth. Australia: ANU E Press, 2007. Print. Musacchio, Aldo. China and Yuan-dollar exchange rate. Harvard Business School press, 2011. Print.