Chinese Currency

From 1995 to 2005 the Chinese Yuan was pegged to the U.S. dollar at the fixed exchange rate of 8.28 Yuan per U.S. dollar. The Chinese central bank bought and sold Chinese currency at the rate in order to ensure the exchange rate would remain fixed. The exchange rate was fixed to promote a stable environment for foreign trade and investment in China. The fixed exchange rate was accompanied by a policy of restricting capital flows in that Chinese citizens were not allowed to invest abroad. By 2000 it was clear to many people that the Yuan was undervalued, and would appreciate if the Yuan were allowed to float. Many economists sited the growing reserves of American dollars that China was accumulating as evidence of their undervalued currency. The Chinese central bank had to supply Yuan and demand dollars in foreign exchange markets in order to keep the Yuan fixed at the same exchange rate.

The undervalued Yuan became a growing political issue in the United States. As the Yuan continued to become more undervalued, Chinese imports became cheaper in comparison to goods produced in the U.S. Some political figures went as far as to say that the undervalued Chinese currency is the cause of the large U.S. trade deficit.

In 2005 China announced that it would move toward a floating exchange rate, but the central bank would intervene to prevent large-scale shifts in rates. From 2005 to 2008, the Yuan was allowed to appreciate. However, once the effects of the economic crisis were too big to ignore, the appreciation of the Yuan was stopped, and the exchange rate was held constant at 6.83 Yuan per dollar.

In order to fully understand the Chinese currency controversy, it is important to understand the differences between a floating exchange rate economy and a fixed exchange rate economy, the consequences of appreciating the Yuan, and potential outcomes of this controversy.

Monetary and fiscal policies have very different effects on a small open economy depending on whether the economy has a floating exchange rate or a fixed exchange rate. For a country with a floating exchange rate, change in fiscal policy will cause a change in the exchange rate. An increase in government purchases or a decrease in taxes shifts the IS* curve in the Mundell-Fleming Model to the right increasing the foreign exchange rate, e, but leaving income, Y, unchanged. The level of income does not change because an increase in government purchases is offset by an appreciation of currency and a decrease in net exports caused by the increase in planned expenditure.

In a country with a fixed exchange rate a change in the fiscal policy has no effect on the exchange rate. An expansionary fiscal policy shifts the IS* curve to the right, putting upward pressure on the market exchange rate. With a fixed exchange rate the central bank is ready to trade currencies at the fixed rate, so the shift in the IS* curve to the right causes investors to sell foreign