China's Monetary Policy - Essay Example

? Does the Chinese Economy behave in Accordance with, or Differently from What One would Predict from a Standard Model of a Fixed Exchange Rate Economy Experiencing overall Balance of Payments Surpluses? Student’s Name Student Number Course Name and Number Name of Professor Date of Submission Number of Words: 1,759 Introduction To make cheap labor available in the global market, the Chinese government has been focused on manipulating its currency by pegging Yen against the US dollar for a long period of time (Reade and Volz 2001). Although pegging the Chinese Yuan against the US dollar could somehow protect the business people from exchange rate volatility, we cannot deny the fact that pegging the Chinese Yuan against the US dollar could trigger long-term economic consequences due to high inflation rate. As of the last quarter of 2010, the economy of China was reported to overheat when its gross domestic product (GDP) increased by 10.3% as compared to the previous year (Simpkins 2011). In response to the on-going global financial crisis, the Chinese government decided to implement a “moderately loose monetary policy” from the usual “prudent monetary policy” as a strategic move in stabilizing the overall economic condition in China (Pierson 2010; Yang 2010). Based on the standard economic practice, a tight monetary policy is normally implemented by the central bank in order to control the economic consequences associated with high inflation rate. To allow the readers have a better understanding about this particular research topic, the standard model of a fixed exchange rate economy will first be tackled followed by discussing the previous case of China. Upon examining China’s preferred monetary policy today, this report will focus on determining whether or not the Chinese economy behave in accordance with, or differently from what one would predict from a standard Model of a fixed exchange rate economy experiencing overall balance of payments surpluses. Standard Model of a Fixed Exchange Rate Economy Under the Bretton Woods System, monetary policy was focused on fixing the exchange rates in order to protect the balance of payments stability (Hagele 2006, p. 8). Right after the World War II, making exchange rates stable by pegging the currencies against the US dollar was considered as one of the best ways to promote growth on international trading and in making the employment rate high (Hagele 2006, p. 9). Even though the pegged exchange rates are adjustable when necessary, historical events revealed that implementing a fixed exchange rate system could create disequilibrium in the balance of payment and international trading system (Bordo and Eichengreen 1993, p. 5). Given that importation and exportation of products are considered inelastic, a lot of economists in the past disregarded the significance of exchange rates in the use of monetary policy. This is because most of them believe that developing countries will remain the principal exporters of goods. Given that the presence of industrialization reduces the need for importation of goods from other countries, devaluation of currencies were considered less advantageous for economic development. It was only during the 1997 Asian crisis wherein a lot of economists considered the significance of exchange rate in managing the internal economy in each country. In an economy wherein the exchange rate is fixed, the government tends to rely heavily over the use of its fiscal policy in order to control the economic situation in each country. To boost the economic growth in each country, the government can make use of its reserves or to borrow money from local or international sources to create more demand for products and services. However, Tornell and Velasco (2000) explained that excessive use of fiscal authority could result to more economic consequences since misuse or excessive use of fiscal policies could result to the exhaustion of the government reserves. Since demand for goods and services is growing in China, the Chinese government is only using its fiscal policy as a way to protect the socio-economic welfare of its local businessmen from the hands of foreign business owners. In line with this, fiscal policy is used to implement higher tariff rate for foreign-owned companies. Given that the value of exchange rate should be dictated by the supply and demand, it is clear that implementing a fixed exchange rate combined with an unsound fiscal policy can lead to the increase in the balance of trade deficits which could trigger the presence of global economic crisis caused by such disequilibrium (Hagele 2006, p. 18). Therefore, the price of money should be controlled to maintain monetary stability. The Case of China A fixed exchange rate at an artificially high level could result to either balance of payments deficit or balance of payments surplus. As defined by Baumol and Blinder (2010, p. 369), balance of payment deficit is referring to “the amount by which the quantity supplied of a country’s currency (per year) exceeds the quantity demanded” whereas balance of payment surplus is referring to “the amount by which the quantity demanded of a country’s currency (per year) exceeds the quantity supplied”. Therefore, it is a common mistake for most of the international financial analysts to pay more attention whether or not a country has balance of payments surplus or deficit without determining whether or not the exchange rate is either fixed or floating. Specifically the case of China is quite unique in the sense that the result of pegging the Chinese Yuan against the US dollar made its currency undervalued as a result of its growing economic condition. As a result of having a fixed exchange rate over the past decade, China was able to gain a huge amount of balance of payments surplus. It means that China is now holding to an excessively high amount of U.S. dollars as its reserves. According to Baumol and Blinder (2010, p. 370), the only way to correct disequilibrium in the case of China is to make its currency devalued by having balance of payments deficit or through an upward revaluation of China’s balance of payments surplus. Stated by Baumol and Blinder (2010, p. 370), “the balance of payments can be affected by the value of imports and exports of goods and services, the cross-border payments of interest and dividends, and the presence of cross-border gifts”. Since China’s total annual export is higher than the value of its total import, this country is able to gain balance of payments surplus. As a common knowledge, the economic growth and development of China is highly dependent on its export sales. For this reason, the Chinese government is decided on maintaining the undervaluation of its currency as a way of boosting its yearly export sales. Given that implementing an upward revaluation of China’s balance of payments surplus could make the market prices of Chinese made goods and services more expensive, this option is unlikely to be implemented in China’s monetary policy as this option will make them lose a large portion of the global market shares to its close competitors worldwide. Likewise, it is unlikely on the part of China to revalue its currency for the benefit of countries that are currently experiencing balance of payments deficit. Since China is currently experiencing high inflation rate, the central bank in China is more likely to control its interest rate combined with implementing a “moderately loose monetary policy” as a way to control its high inflation. Discussion China’s decided to shift from its usual “prudent monetary policy” to a “moderately loose monetary policy” means that it will be possible on the part of the Chinese policymakers to implement tighter or lenient lending controls whenever possible (Simpkins 2011). It is wrong to believe that moving away from a pegged currency could solve the high inflation rate that China is currently facing. On the contrary, Tornell and Velasco (2000) explained that having a more flexible exchange rate could also lead to the development of a new economic crisis since unsound fiscal policies could eventually be manifested in the movements of a more flexible exchange rate. Upon examining the monetary policy, fiscal policy and devaluations, Rush (1984) revealed that the use of fiscal policy and devaluations may not be neutral in the short- and long-runs. Depending on how China will make use of its fiscal and monetary policy, it is possible that making the exchange rate more flexible could result to either devaluation or overvaluation of currencies. Conclusion According to Baumol and Blinder (2010, p. 371), one of the best ways to correct problems related to balance of payments is to implement “a restrictive monetary policy that can pull down output and prices, which discouraged imports and encouraged exports”. Upon analyzing the current economic situation of China, this country is still experiencing balance of payments problem. The only difference in the case of China is that this country is going through the socio-economic consequences of balance of payments surplus rather than deficit. From a standard model of a fixed exchange rate wherein the economy is experiencing an overall balance of payments surpluses, a country that implements free floating exchange rate to solve balance of payments deficit due to depletion of its reserves are likely to go through the economic consequences of currency devaluation. On the contrary, a country that implement a free floating exchange rate policy to solve balance of payments surplus due to its excessive US dollar reserves are likely to go through the economic consequences of a strong currency. The case of China is unique as compared to other developing countries in the sense that this particular country is able to compete well in the global markets. Given that the export sales of China are so much higher than its total annual imports, this country is able to experience balance of payments surpluses. As part of maintaining China’s overall economic growth and sustainability, it is a challenge on the part of the Chinese government to maintain the devaluation of its currency. By allowing the Chinese Yuan to strengthen against the US dollar, China will automatically lose a large portion of its global markets to other developing countries that are capable of selling homogenous products and services at a relatively low market price. Specifically the use of either fixed exchange rate or floating exchange rate could cause serious harm in the economic development of China (Baumol and Blinder 2010, p. 372). For this reason, the policymakers in China are left with no other choice but to choose from the best available options that could trigger lesser harm in the Chinese market. Aiming to control the high inflation rate in China, China’s monetary policy focused on implementing a “moderately loose monetary policy” – a shift away from its usual “prudent monetary policy”. Coming from this point-of-view, it is safe to conclude that the Chinese economy is actually behaving in accordance with the standard model of a fixed exchange rate economy that is experiencing balance of payments surplus. *** End *** References Baumol, W., & Blinder, A. (2010). Macroeconomics: Principles and Policy. South-Western Cengage Learning. Bordo, M., & Eichengreen, B. (1993). A Retrospective on the Bretton Woods system: lessons for international Monetary reform. The University of Chicago Press. Hagele, K. (2006). The Bretton Woods System of Fixed Exchange Rates - Theoretical Background and its Development. Grin Verlag. Pierson, D. (2010, December 3). Los Angeles Times. Retrieved March 21, 2011, from China to tighten its monetary policy next year: http://articles.latimes.com/2010/dec/03/business/la-fi-china-monetary-policy-20101204 Reade, J., & Volz, U. (2001, February 18). Vox. Retrieved March 21, 2011, from Chinese inflation, monetary policy and the dollar peg: http://www.voxeu.org/index.php?q=node/6122 Rush, M. (1984). A classical model of a small fixed exchange rate economy. Journal of International Money and Finance , 3(1), pp. 31-49. Simpkins, J. (2011, January 21). Money Morning. Retrieved March 21, 2011, from China Monetary Policy: Inflation Won't Last – Growth Will: http://moneymorning.com/2011/01/21/china-monetary-policy-inflation-wont-last-growth-will/ Tornell, A., & Velasco, A. (2000). Fixed versus Flexible Exchange Rates: Which Provides More Fiscal Discipline? Journal of Monetary Economics , 45(2), pp. 399-436. Yang, F. (2010, December 3). Xin Hua Net. Retrieved March 21, 2011, from Shift in China's monetary policy stance aims to promote sustainable growth: http://news.xinhuanet.com/english2010/indepth/2010-12/03/c_13634086.htm Read More