Question

U.S. Declines to Cite China as Currency Manipulator In \(2007,\) the U.S. trade deficit with China hit an alltime high of \(\$ 256.3\) billion, the largest deficit ever recorded with a single country. Chinese currency, the yuan, has risen in value by 18.4 percent against the U.S. dollar since the Chinese government loosened its currency system in July \(2005 .\) However, U.S. manufacturers contend the yuan is still undervalued by as much as 40 percent, making Chinese goods more competitive in this country and U.S. goods more expensive in China. China buys U.S. dollardenominated securities to maintain the value of the yuan in terms of the U.S. dollar. Source: MSN, May 15,2008. Explain how fixed and crawling peg exchange rates can be used to manipulate trade balances in the short run, but not the long run.

Short answer

Fixed and crawling peg exchange rates can manipulate trade balances short-term by making exports cheaper and imports costlier, but they're unsustainable long-term due to economic distortions and market forces.

Step-by-step solution

Understand Fixed Exchange Rates

Fixed exchange rates are when a country's currency value is tied or pegged to another major currency or basket of currencies. The central bank maintains the fixed rate by intervening in the foreign exchange market, buying and selling their own currency to ensure it stays at the pegged value.

Understand Crawling Peg Exchange Rates

Crawling peg exchange rates involve a currency being allowed to fluctuate, but only within a narrow band or gradually adjusting periodically. The central bank may also intervene to maintain the currency within the targeted range.

Trade Balance Manipulation in the Short Run

In the short run, fixed and crawling peg exchange rates can be used to manipulate trade balances by making a country's exports cheaper and imports more expensive, thereby encouraging exports and discouraging imports. For example, by keeping the yuan undervalued, China can make its goods cheaper in the U.S. market, increasing its trade surplus.

Long Run Limitations

In the long run, artificially maintaining a fixed or crawling peg exchange rate can be unsustainable. Market forces, such as differences in inflation rates and economic growth, may necessitate frequent interventions which could drain foreign reserves. Additionally, persistent imbalances can lead to economic distortions and eventual adjustments to the exchange rate.

Key concepts

Fixed Exchange Rates

Countries that use fixed exchange rates tie the value of their currency to another major currency or a basket of currencies. This way, the central bank ensures that their currency maintains a stable value. The central bank actively intervenes in the foreign exchange market by buying and selling its own currency to keep it at this fixed value.

For instance, if the pegged value is threatened by market forces, the central bank will step in. It might buy its own currency using foreign reserves to prop up its value or sell it to lower its value. This system provides stability for traders and investors because they know the currency value won't fluctuate wildly.

• **Advantages:** Predictability and stability for international trade.
• **Disadvantages:** Requires large foreign reserves and constant monitoring.

Crawling Peg Exchange Rates

A crawling peg exchange rate system allows a currency to fluctuate within a narrow band or adjust gradually over time. The central bank may intervene periodically to ensure the currency remains within the desired range.

This method provides more flexibility compared to strictly fixed rates and helps to adjust for differences in inflation rates or economic growth between countries. However, it still requires significant intervention from the central bank to maintain the targeted range.

• **Advantages:** More adaptability to economic conditions compared to a fixed system.
• **Disadvantages:** Ongoing need for active intervention and potential economic distortions.

Trade Balances

Trade balances refer to the difference between a country’s exports and imports. A positive trade balance (trade surplus) occurs when a country exports more than it imports, while a negative trade balance (trade deficit) happens when imports exceed exports.

Fixed and crawling peg exchange rate systems can temporarily manipulate trade balances. By undervaluing its currency, a country makes its exports cheaper and imports more expensive, fostering a trade surplus. This was observed in the U.S. trade relationship with China, where the undervalued yuan made Chinese goods more competitive in the U.S. market.

• **Advantages:** Boosts export industries and domestic job creation.
• **Disadvantages:** Could lead to trade tensions and retaliatory measures from trading partners.

Foreign Exchange Intervention

Foreign exchange intervention involves a central bank actively engaging in the currency market to influence the exchange rate. This can be done by buying or selling its own currency to adjust its value relative to another currency.

For example, if a central bank wants to weaken its currency to boost exports, it may sell its currency and buy foreign currency, increasing the supply of its currency and reducing its value.

• **Advantages:** Can help achieve specific economic goals, such as boosting exports.
• **Disadvantages:** Requires substantial foreign currency reserves and constant market monitoring.

Economic Distortions

Economic distortions occur when artificial interventions in currency markets lead to imbalances in the economy. These can include persistent trade imbalances, misallocation of resources, and inflationary or deflationary pressures.

Over time, maintaining an over or undervalued currency may become unsustainable. It can drain foreign reserves and require constant adjustments. Additionally, the distorted prices due to manipulated exchange rates do not reflect the true value of goods and services, potentially leading to inefficiencies.

• **Examples:** Artificially cheap exports or expensive imports.
• **Consequences:** Unsustainable economic practices and eventual market corrections.