Currency war: US $ versus Chinese 元

Posted by: 11cresma on: December 8, 2010

• In: Section 4 - International Economics
• 2 Comments

Using information from your research and your knowledge of economics evaluate the US claim that China is manipulating its currency.

The US and China are the two greatest power in the world right now. They have been trading, so exchanging goods and services, with each other for a long time now, since China opened up to the world. Chinese products are known to be cheap almost everywhere else in the world; thus Americans consume much of it.

The Chinese export their products; hence they manufacture them in China and then sell them to the world. The US imports them into their country, since they are so affordable. The issue is that, in order to keep a balance in the economies, they need to find a balance in the number of imports and exports. Nevertheless, the US imports a lot more from China than it exports from it; and vice versa for China. As a result, the US is in deficit to China, while China is in deficit to the US.

In order to fully understand the causes and consequences of this, we need to look at currency exchange rates. The US believes in free market, thus it has a floating exchange system, which means that the value of the currency is decided only by the equilibrium point in the supply and demand diagram for the currency, as shown on the diagram below.

This diagram represents the floating system of the US since only the supply curve S and demand D determine the equilibrium point Ep, thus price P. This price P is the price of US dollars in terms of Yuan, in order words how much Yuan bills are needed to buy 1 US dollar. Since the market is floating it is responds highly to change either in demand or supply of dollars, thus fluctuates often.

On the contrary, China has a managed, which means that the value of its currency is set to a certain number of dollars by the government, and does not respond to changes in the market, as shown on the diagram below.

The diagram is a fixed exchange rate because it both managed and fixed, the price of Yuan in terms of Dollars depend on the government, and is set below the equilibrium point Ep for a price of P*. As a result, there is a shortage of Yuan of Q1-Q2.

So, why does this even matter? In order to answer this question fully, we need to first understand the balance of payments, which is a measure of a country’s trade’s performance. It is made of the current (visible and invisible trade, and net transfers) and capital (transfers of capital, investment and loans, and national reserve) account, which need to balance each other out so that the balance of payment is equal to 0.

The US have a balance of payment that is negative, and China has a positive one, and this is an issue for both of them because it creates international tensions, that may, in the long term, deterior the relationship between the two countries.