Question

(Related to the Apply the Concept on page 1071) Graph the demand and supply of Chinese yuan for U.S. dollars and label each axis. Suppose the Chinese central bank were to decide to once again to peg the value of the yuan against the U.S. dollar. Indicate whether the Chinese central bank would typically be interested in pegging the exchange rate above or below the market equilibrium exchange rate. To maintain the peg, would the Chinese central bank typically be supplying yuan in exchange for dollars or selling dollars in exchange for yuan? Illustrate your answer on your graph.

Short answer

If Chinese central bank decides to peg the yuan above the market equilibrium exchange rate, it would be interested in supplying yuan in exchange for dollars to maintain the peg. This action is represented on the graph as a surplus of yuan due to the higher pegged rate, and the subsequent interaction of new supply and demand points.

Step-by-step solution

Draw the Initial Supply and Demand Curves

Begin by drawing an x-y graph, where y-axis represents the 'Price of yuan in dollars' and x-axis stands for 'Quantity of yuan'. Both supply and demand curves are usually plotted as downward and upward sloping lines, respectively, indicating the relationship between price and quantity demanded/supplied. Label the point where they intersect as the 'market equilibrium exchange rate'.

Discuss Exchange Rate Pegging

Once the graph is plotted, next thing to note is how currency pegging works. Pegging an exchange rate means fixing its price to a particular value. In this case, if the central bank of China decides to peg the yuan to the dollar, it fixes a specific exchange rate and commits to maintain it. Depending on whether the peg is set above or below the equilibrium exchange rate, the bank can either make the currency more expensive or cheaper than its natural market value.

Illustrate the Pegging on the Graph

To illustrate the pegging, suppose the central bank sets the peg above the equilibrium exchange rate. Draw a horizontal line at this price level to show the artificial exchange rate. Doing so makes yuan more expensive, therefore the quantity of yuan demanded decreases and the quantity supplied increases, leading to a surplus of yuan.

Explain Central Bank's Operations to Maintain the Peg

To maintain the peg, the central bank intervenes in the foreign exchange market. In this scenario, since there's a surplus of yuan, it would buy up the surplus yuan using its reserves of US dollars. Hence, it would essentially be supplying yuan in exchange for dollars. Mark the new point of supply and demand interaction on the graph to complete your answer.

Key concepts

Demand and Supply Curves

Understanding the fundamentals of demand and supply curves is crucial, especially when dealing with currency exchanges. Imagine you have two axes:
- The **y-axis** represents the "Price of yuan in dollars."
- The **x-axis** reflects the "Quantity of yuan."
To visualize, picture the demand curve as a line that slopes downwards from left to right. This indicates that as the price of the yuan increases, the demand for it decreases. Meanwhile, the supply curve, which typically slopes upwards, shows that as the price of the yuan rises, suppliers are willing to provide more of it.
When you plot these curves and find the point where they intersect, you've found the equilibrium point. Here, the quantity of yuan demanded equals the quantity_supplied, leading to the **market equilibrium exchange rate**. This point is crucial as it represents a balance, the natural point where the currency neither exerts upward nor downward pressure.

Market Equilibrium Exchange Rate

The market equilibrium exchange rate is a dynamic point of balance between currency demand and supply. When there is no intervention from a central authority like a government or a central bank, the exchange rate naturally settles at this equilibrium.
This rate ensures that:

• The amount of currency that people are willing to buy equals the amount they are willing to sell.
• As long as no external forces influence the market, this rate remains stable.

However, when a central bank, such as China's, decides to peg the rate, they set a fixed exchange rate that could either be above or below the natural equilibrium.
If the peg is set **above** the equilibrium, the currency is made more expensive than its market value, leading to decreased demand and increased supply. Conversely, if it's pegged **below**, the currency becomes cheaper, resulting in higher demand and reduced supply. Both scenarios can disrupt the market forces that typically regulate the exchange rate.

Central Bank Interventions

Central bank interventions are deliberate actions taken to control the exchange rate. When a central bank pegs a currency, it must actively manage its supply and demand.
Consider a scenario where the peg is set above the market equilibrium—here's what typically happens:

• A **surplus** of yuan arises as the high price reduces demand but increases supply.
• The central bank will need to purchase this excess yuan to maintain the peg, using its reserves of dollars.

This is essentially the bank supplying yuan in exchange for dollars. Without such intervention, market forces would push the exchange rate back to the equilibrium level.
Over time, constant interventions can strain a central bank's foreign exchange reserves. Therefore, maintaining a peg, especially when market forces are strong, can pose significant challenges to a country's financial stability.