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Can you please explain if this following is True or False? If the inflation rate rises...

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lilylee | Student, College Freshman | Salutatorian

Posted June 18, 2013 at 3:00 PM via web

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Can you please explain if this following is True or False?

If the inflation rate rises in China so that it exceeds that of the US, then net exports from the US (to China) should increase, all else held constant.

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted June 18, 2013 at 3:22 PM (Answer #1)

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This statement is false.  If the inflation rate in China is higher than that in the United States, the Chinese currency will weaken.  When the Chinese currency weakens relative to the US dollar, the US will have a harder time exporting to China.  Therefore, net US exports will fall.

When there is more inflation in one country than in another, the value of the first country’s currency falls.  It has lost more value than the currency of the second country.  This makes it harder for the first country to import from the second country.  Thus, if China has a higher rate of inflation than the US, China will import less than it previously did.

When the Chinese currency loses value, it will be harder for Chinese companies to buy from US companies.  When Chinese companies buy American dollars, they will have to spend more Chinese yuan to buy them.  This will mean that American goods will cost more for the Chinese companies.  When the American goods cost more, the Chinese will import fewer of them.  This will cause America’s net exports to decline.  Therefore, the statement is false.

Strong dollar = Weak foreign currency:
Disadvantages: U.S. exports are expensive, including tourism in U.S.  Hurts the export sector, companies that sell abroad, makes them less competitive. Hurts the import-competing sector.

Weak dollar  = Strong foreign currency:
Advantages: Helps the U.S. export sector.  Our goods and services are cheap overseas, including tourism in US.  Helps the import-competing sector like GM, domestic goods are more competitive  (Professor M.J. Perry, University of Michigan)

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lilylee | Student , College Freshman | Salutatorian

Posted June 18, 2013 at 5:00 PM (Answer #3)

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I am confused now between these two answers! I thought that China would be cheaper than the US. PLEASE HELP ME to understand this!

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K.P.L. Hardison | College Teacher | eNotes Employee

Posted June 21, 2013 at 2:15 AM (Reply #1)

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In an attempt to abate your confusion, I'll say that world currencies are exchanged (bought and sold) on a currency market. The prices, or rates, of world currencies "float" in value based upon demand and supply. The prices of world currencies can on occasion be so volatile they change daily or even hourly.

In contrast, the China yuan does not have an international currency exchange rate that floats according to demand and supply. China has a "fixed" price, or fixed exchange rate, that is set, or fixed, by The People's Bank of China. The People's Bank sets the yuan at a fixed price against the value of the US dollar. At the present moment, the price, or exchange rate, is 1 USD to 6.1286 Yuan.

Recently, in response to international demands for a market liberalization of the yuan (pressure to allow it to float freely with market pressure), China has fixed the yuan's exchange rate more frequently, though perhaps not more liberally: in April 2013 the People's Bank adjusted the yuan to 6.2506 yuan per US dollar while today in June 2013 it is 6.1286 per US dollar.

This relates to international import and export because, while inflation affects the currency exchange rate and the import/export rate of countries with market pressure effected floating currencies, inflation does not similarly affect the currency exchange rate and the import/export rate of China with its fixed currency value: i.e., 6.1286 per US dollar. This explains how one question about the increase or decrease of U.S. exports to China can have two answers: each answer looks at the inflation-import/export relationship from a different perspective since China's fixed rate creates two different perspectives, the theoretical one and the actual one.

In 2003, then President George W. Bush complained of China's fixed rate in relation to U.S. import/export by saying that "we expect the markets to reflect the true value of [a] currency" and that "countries need to be mindful that we expect fair trade." He was complaining of the limitations to a free import/export market that a fixed exchange rate creates. On a similar theme, South China Morning News reported (13 April, 2013) that the People's Bank readjustment to the yuan in April was in response to international pressure:

China often allows the yuan to appreciate faster before visits by officials from Western countries, who usually push for exchange rate liberalisation.

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted June 21, 2013 at 2:28 AM (Answer #4)

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If this is a question from basic economics, it probably is using China as a generic country. It is not trying to take into account the degree to which China lets its currency float. In that case, my answer is correct and so is the first half of chaseguinn's answer. If, however, this is a much more advanced economics class, the professor might expect you to take into account the fact that China's exchange rate is not completely floating nor completely pegged either. In that case, the second half of chaseguinn's answer is correctly directed to a fixed, not floating, exchange rate.

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chaseguinn | (Level 1) Adjunct Educator

Posted June 18, 2013 at 4:09 PM (Answer #2)

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Using the monetary approach, which is a long-term model of future currency exchange rates, we can infer a USD appreciation from the relative change due to inflation in the price levels from China's Yuan because of purchasing power parity (PPP).

Inflation in China's yuan is defined as an increase, or rise, in price levels for the same goods: the same goods cost more than before inflation. Because of PPP, this affects the currency exchange rate for import/export as explained below.

Since the United States Price = Exchange Rate (E) x China Price, a rise in China's price--while holding the US price at a constant--yields a lower Exchange Rate E ratio of USD to Yuan. This means it takes fewer US dollars to buy the same goods in yuan: the US dollar has appreciated relative to the yuan, which has risen in an increase.

So, this theory shows that the answer to your question is FALSE and that US goods should be more expensive and exports from the US to China should slow.

However, there is a critical factor of currency exchange rates relative to the US and China that must be considered when asking specifically about US exports to China.

The above analysis applies to a floating currency exchange rate, which is not the case with the China Yuan relative to the USD.

China's foreign currency exchange market policy interventions maintain the Yuan currency exchange rate in relation to the USD at a fixed rate that is unaffected by inflation, which means that Chinese goods become overvalued. PPP does not hold in a fixed currency regime. This means that as Chinese goods become relatively more expensive through inflation, US goods are relatively cheaper, yielding an increase in US net exports to China.

Example:

Call E (Exchange Rate) 5:1 USD to Yuan (the E was fixed at 6.2506 yuan per US dollar in April, 2013). An apple costs 1 yuan or 5 dollars. The yuan inflates. Now an apple costs 2 yuan but is still only worth 5 dollars in international markets. China's fixed currency exchange rate of 5:1 prices the apple at 10 dollars, making the US importer lose the extra 5 dollars. The apple is overvalued and China's exports are relatively more expensive after the inflation.

China's fixed regime reverses the expected effect of inflation theory and cause Chinese exports to become less expensive, which is analogous to US exports more expensive. US net exports will increase.

The People's Bank of China set the midpoint at 6.2506 yuan per US dollar - up from the fixing of 6.2578 on Thursday - ahead of a visit by US Secretary of State John Kerry to Asia. ... China often allows the yuan to appreciate faster before visits by officials from Western countries, who usually push for exchange rate liberalisation (Jane Cai in Beijing and Kwong Man-ki, South China Morning Post).

The answer to your question is TRUE because inflation theory does not apply to a fixed, or pegged, currency rate.

U.S. manufacturers have strongly criticized China for maintaining an artificial exchange rate with the dollar. Groups such as the National Association of Manufacturers argue that China's currency, the Yuan, is [artificially valued] because the Chinese government has fixed its value in dollars. (Marc Benitah, Ph.D., American Society of International Law).

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