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08/03/2010: "Global Influence of the Renminbi and Chinese Monetary Policy"
Several articles have appeared in various news services over the summer of 2010 that deal with the value of the Chinese yuan relative to the US dollar and China's monetary policy. China employs a pegged exchange rate system and the current peg is below the equilibrium value. One reason for adopting such a policy is to stimulate economic growth through exports. A deflated currency makes a country's products relatively less expensive to foreigners and foreign made products more expensive to domestic residents. Exports rise and imports fall. Aggregate demand increases and so does equilibrium GDP.
There is a problem with an undervalued currency that was understood as early as the 1760's by the likes of Richard Cantillon, David Hume and Adam Smith. Market forces will cause prices to converge in open economies whether the government wants them to or not.
One possible cause of price adjustments is retaliation by trading partners. This is the basis of a Globe and Mail article dated June 10, 2010. (click here for article) While not all economists agree that buying relatively inexpensive products from foreign countries is a bad thing, a growing number of politicians believe that imports cause domestic jobs to be lost. The American government is drafting policies that would impose duties on Chinese goods if they do not revalue the yuan. In late June, China announced a suspension of its exchange rate peg and the yuan rose by 0.7% against the US dollar. Another article that appeared in the Economist on July 1, 2010 offers further insight into the problems facing both the U.S. and China in this matter. (click here for article).
A second cause of price adjustment is related to what David Hume called the price-specie flow mechanism. In the 18th century, when a country ran a trade deficit, they made up the difference by paying in gold. For example, suppose that the value of France's imports from England were greater than the value of France's exports to England due to lower prices in England. France would have to pay for the difference by shipping gold to England. Since the money system was backed by gold, an increase in a country's gold reserves meant an increase in the amount of money in circulation. An increase in the money supply in excess of the growth rate of the economy resulted in inflation in England. France's imports would fall and their exports rise reducing the size of the trade deficit. A similar thing happens in the 21st century with fixed exchange rates. A fixed exchange rate, below the equilibrium price, has the same effect as a price ceiling. There will be an excess demand. In the case of China, this means an excess demand for yuan. To maintain a peg below equilibrium, the People's Bank of China, China's central bank, must sell yuan in exchange for dollars. This increases the money supply in China and, if the rate of increase exceeds the growth rate of the economy, China suffers inflation. This phenomenon is illustrated in a May 26, 2010 article from the New York Times. (click here for article)
There is yet a third possibility for market corrections. When a country has lower production costs, other countries will import from them. This is the current situation in China. However, as demand for Chinese made goods rises, so too does the demand for labour. If wage rates don't rise, there will be a shortage of workers and unrest among those that are still working. If wage rates rise, production costs rise and the competitive advantage falls. This is shown in a New York Times article dated July 5, 2010 (click here for article) that exposes the increased production costs of the iPhone and the labour unrest at the Foxconn Technology factory where the iPhone is assembled. In addition to the increase in demand for labour, there may be a decrease in the supply of labour. When nominal wage rates are held constant and other prices rise, the purchasing power of wages, or real wage, falls. When the real wage falls, people are less willing to give up their leisure and the supply of labour falls. An increase in demand and a decrease in supply puts upward pressure on the nominal wage rate. A Globe and Mail article dated June 29, 2010 (click here for article 5) illustrates this problem.
Canada does not escape the problems associated with the US trade deficit and Chinese monetary policy. During the recession, shipping companies took ships and containers out of service. This is a decrease in supply. Now that consumer spending is starting to recover and China is shipping more goods, the price of container traffic across the Pacific has increased. This is affecting the goods that Canada imports and exports. A Globe and Mail article dated July 28, 2010 (click here for article) states that the cost of shipping a container has tripled since 2009.
There is growing pressure from the international community for China to revalue the yuan to alleviate some of the problems illustrated in this case study. It may not matter if the markets work faster than the politicians to rectify the imbalance.
Relevant Learning Objectives
Chapter 5
LO#2 How a market works in the presence of legislated price floors.
Chapter 13
LO#2 What determines a profit-maximizing firm's demand for a factor
Chapter 34
LO#3 The effects of a tariff or quota on imported goods.
Chapter 35
LO#5 The theory of purchasing power parity (PPP) and its limitations.
Sources
A History of Economic Theory; Classic Contributions 1720-1980, Jüng Niehans, Johns Hopkins University Press, Baltimore MD, 1990 Ch 6
Chinese trade numbers fuel angry U.S. response. Brian Milner, Globe and Mail, June 10, 2010. Accessed August 2, 2010
http://www.theglobeandmail.com/report-on-business/economy/strong-chinese-trade-numbers-fuel/article1599957/?cmpid=rss1
Yuanimpressed: China's adjustment of its currency is too small and slow for many. The Economist, July 1, 2010. Accessed August 2, 2010. http://www.economist.com/node/16486559?story_id=16486559
Trampled in a Land Rush, Chinese Resist. Michael Wines and Jonathan Ansfield, The New York Times, May 26, 2010. Accessed August 2, 2010.
http://www.nytimes.com/2010/05/27/world/asia/27china.html?_r=2
Supply Chain for iPHone Highlights Costs in China. David Barboza, The New York Times, July 5, 2010. Accessed August 3, 2010
http://www.nytimes.com/2010/07/06/technology/06iphone.html?_r=2&th&emc=th
China's changing labour landscape. Mark MacKinnon, Globe and Mail, June 29, 2010. Accessed Aug 3, 2010.
http://www.theglobeandmail.com/report-on-business/chinas-changing-labour-landscape/article1623478/
Shipping goods from Asia more costly. Brent Jang, Globe and Mail, July 28, 2010. Accessed Aug 3, 2010
http://www.theglobeandmail.com/report-on-business/shipping-goods-from-asia-more-costly/article1655161/
Questions
1. Suppose that the government imposed tariffs on Chinese imports. How would these tariffs affect the different sectors of the economy? Would the economy as a whole be better off?
2. In what way is a fixed exchange rate similar to a minimum wage or a rent control?
3. When the People's Bank of China (China's central bank) purchases yuan on the open market it creates new commercial bank deposits. As of February 2010, Chinese banks were required to hold 16.5% reserves against deposits. Assuming no cash drain, if China had a trade surplus of US$600 billion and an exchange rate of 6.7739 yuan per dollar, how much could the Chinese money supply increase?
4. In Chapter 13 of Ragan/Lipsey there is a discussion of monopsonistic buyers and in Chapter 10 there is a discussion of monopolistic sellers. If local governments in China control the market for land as suggested in Michael Wines' article, how would you explain the cause of the social unrest?
5. Will an increase in the demand for labour and a decrease in the supply of labour always lead to an increase in wages and an increase in employment?
Michael S. Leonard
Kwantlen Polytechnic University
Surrey, BC
