Increase in the Supply of Chinese Yuan - Assignment Example

International Economics Assessment– 2 Question 1 “China has reacted to U.S. QE in the past by expressing dismay, primarily given the overweight U.S. dollar position in their foreign currency reserves.” (Source: http://www.ibtimes.com/exnet/chinese-reaction-fed-qe3-not-happy-797141) Explain the dismay of Chinese government due to quantitative easing (QE) using the FOREX market model discussed in the class. Make sure that you consider the undervalued exchange rate of China while answering the question. Provide neat diagram (s) to explain your answer. (20 points) Quantitative easing refers to a type of monetary policy whereby the central bank creates new electronic money, in a bid to purchase government bonds or any other valuable financial assets (Godley, Papadimitriou, and Zezza 23). Purchasing these assets helps in stimulating the economy of a given county. Therefore, quantitative easing involves policies that help in enhancing the expansionary monetary policy. Chinese reacted to the U.S. QE by expressing total dismay. This is due to the overweight that the US solar had positioned in their foreign currency reserves. The US QE policy has a negative impact on the economy of Chinese, and this increased the level of complaints on the part of Chinese Government. In regards to China, most economist in the country believe that QE in the United States increased the rate of inflation in China. Firstly, the US QE increased the prices of international food and the energy prices as well in the market (Godley, Papadimitriou, and Zezza 27). Additionally, it also increased the interest rates, which greatly put appreciation pressure on the Chinese currency (Chinese Yuan). The appreciation of the Chinese Yuan will decrease the rate of exportation from China to the US, and increase the rate of importation from US to China. Resultantly, this scenario will raise the trade deficit that exists between China and the US. The main outcome of this situation is that there will be erosion of Chinese foreign reserve and China will greatly feel the weight of the US dollar. For this reason, the Chinese Government it is not pleased with the US QE policy, since it will only degrade the nation’s economic value. To reverse this situation, it is recommendable for the Chinese Government to purchase US currency from the foreign exchange market. By doing this, the supply of Chinese Yuan will increase, and this may cause depreciation of its value. A figure showing the existing relationship between the exchange rate and the dollar value Based on the figure above, it is evident that a reduction in exchange rate results in the supply curve shifting from S dollar 1 to S dollar 2. As a result, there is increase in the amount of currency that is available in the market. Moreover, the quantity level shifts from Q1 to Q2, which proves that the above demonstration is factual. Additionally, when there is increase in the quantity level of the Chinese Yuan, the exchange rate will decrease, and this will also reduce the quantity of money available in the existing foreign exchange market. The Chinese Government will feel these effects if it implements measure that will lead to positive growth of the economy. If the government does not implement effective measures or economic policies, the results will be the opposite of what is demonstrated above (Godley, Papadimitriou, and Zezza 31). On the other hand, the law of demand and supply in the foreign market could remain stagnant without any form of disturbance. Resultantly, there will be erosion of Chinese foreign reserve: hence, the nation will further feel the weight of the US dollar. By purchasing US dollars, there will be an increase in the supply of Chinese Yuan, making to reduce its economic value. Preferably, the Chinese Government should ensure that it can easily its national debt such that it is not forced to give out too much currency in from of Chinese Yuan in order to settle debts. Debts is one of the main factors that can hinder a country from prospering economically. Giving out the Chinese Yuan will also affect the strength of the nation’s currency in a negative manner. Another key factor that will affect the rate of economic growth in China is the interest rate. Interest rates tend to affect factors such as the level of savings and investments in a given country. When there is high interest rate in a country, the cost of capital within the nation increases. The impact of this increase is that investors will enjoy high returns from their various investments. Although there will be an increase in the rate of interest, the rate of economic growth will reduce since not all consumers will have the financial ability to obtain capital for spending or consumption. Therefore, when there is a high interest rate, the rate of consumption will slow down since there will be minimal chances of acquiring capital. Moreover, there will be an increase in the cost of capital, which will discourage consumers from borrowing in order to spend. On the other hand, when the rate of interest is decreased, consumers will manage to borrow capital from financial institutions. Although reducing the interest rate will increase the level of spending, it will also minimize the rate on investments due to low returns. Question 2 The main components of GDP are GDP: C+I+G+X-M. Consumer spending (C) =10000+0.6Y Investment (I) =2000 Government spending (G) =5000 Exports(X) =600 Imports (M) =400 Consumer spending (C) = 10000 + 0.6(2000 + 5000 + 600 + 400) = 17840 = I/ 1- MPC = 1/ 1-17840 Size of the multiplier=-0.000056 short run equilibrium output=12540 Question 3: The following news was issued in Bloomberg. “Thailand’s baht fell for a second week to reach the lowest level since 2010 and the benchmark stock index led losses in Southeast Asia on concern worsening political unrest will spur further capital outflows”. (http://www.bloomberg.com/news/2013-12-27/baht-falls-a-second-week-on-concern-protests-to-spur-outflows.html ) a. Why do you think that there is going to be capital outflow? When there is depreciation in the currency of a given nation, most of its products become cheaper, compared to those of other nations. As a result, most consumers purchase products from this country, and this increases the rate of capital flow of the foreign currency into the nation. Overall, an increase in money cause a reduction in the interest rate, and in the end, this may also decrease the rate of interest in the United States (Kristjansdottir 69). When interest rates reduce in other countries, the currency strength in the subject country depreciates: hence, there is flow of currency out of the nation. The main outcome of these economic changes is that the depreciation of other currencies will result in the appreciation of Thailand’s baht. On the other hand, when there is an increase in the rate of currency outflow, the supply of currencies in the foreign market will increase. Additionally, the appreciation of Thailand’s baht will reduce the level of exports to other nations: hence, causing an increase in trade deficit between Thailand and other nations. As a result, the erosion of Thailand’s foreign reserve will result in the nation feeling the extreme weight of the US dollar. To rectify this crisis, Thailand will have to purchase other currencies from the currency market, and this will depreciate the value of the nation’s currency. The outcome of this is that depending on policies implemented, there will be flow of capital between Thailand and other nations. b. If indeed there is going to be huge capital flight, what should be the policy taken up by Bank of Thailand to avoid a free fall of their exchange rate and how they can achieve it (explain at least one instrument)? In order for Thailand to experience economic recovery, the government must implement certain effective measures. Firstly, Thailand Government can minimize the level of government expenditure, which means reducing the supply arte of Thailand currency (Kristjansdottir 69). The government can reduce some of the unnecessary development projects in order to reduce the amount of money paid for importing machinery. Alternatively, Thailand government can also reduce the level of taxation on exports in the country, which will help to increase the amount of goods sold to other nations. It will also increase the level of foreign exchange in Thailand: hence, minimizing the pressure on the currency. Implementing these measures will prevent the currency from depreciating, thus boosting economic growth. Works Cited Godley, Wynne, Dimitri B. Papadimitriou, and Gennaro Zezza. Contributions to Stock-Flow Modeling: Essays in Honor of Wynne Godley. Basingstoke: Palgrave Macmillan, 2012. Web. Kristjansdottir, Helga. Sustainable Energy Resources and Economics in Iceland and Greenland, 2015. Web. Read More