Question

Suppose that the government of China is currently fixing the exchange rate between the U.S. dollar and the Chinese yuan at a rate of \(\$ 1=6\) yuan. Also suppose that at this exchange rate, the people who want to convert dollars to yuan are asking to convert \(\$ 10\) billion per day of dollars into yuan, while the people who are wanting to convert yuan into dollars are asking to convert 36 billion yuan into dollars. What will happen to the size of China's official reserves of dollars? LO39.4 a. Increase. b. Decrease. c. Stay the same.

Short answer

China's reserves of dollars will decrease.

Step-by-step solution

Understanding Exchange Rate Balance

The exchange rate is fixed at 1 USD = 6 CNY, which means for every dollar converted to yuan, 6 yuan are given out. Conversely, converting 36 billion yuan into dollars requires 6 billion dollars.

Calculating Dollar Demand

People want to convert 10 billion USD into yuan every day. This demands 10 billion dollars.

Calculating Yuan Demand

People want to convert 36 billion yuan into dollars every day. This requires 6 billion dollars calculated as: \[ \text{Dollars required} = \frac{\text{Yuan to be converted}}{\text{Exchange rate}} = \frac{36 \text{ billion yuan}}{6} = 6 \text{ billion USD} \]

Determine Net Reserve Impact

Compare the dollar demand and supply: since 10 billion dollars are being converted to yuan but only 6 billion dollars worth of yuan is being converted to dollars, there's a net demand of 4 billion USD more than supply. China must supply the additional dollars from reserves.

Key concepts

Fixed Exchange Rate

A fixed exchange rate, as seen in the exercise, is when a country's government or central bank sets its currency's value relative to another currency. In our case, the yuan is pegged to the U.S. dollar at a fixed rate of 6 yuan per dollar. This means that the conversion rate does not fluctuate with market conditions, ensuring stability in international trade and investment.

This approach allows predictability in international transactions, but it requires the government to manage its currency actively. To maintain this fixed rate, China must intervene in the foreign exchange market, often by using reserve currencies like the dollar to manage supply and demand imbalances.

Such a system can be beneficial for countries heavily involved in international trade, but it also exposes them to challenges if supply and demand for their currency significantly diverge from the fixed rate.

Official Reserves

Official reserves are the assets held by a country's central bank to back its liabilities and manage the country's exchange rate policy. These reserves typically include foreign currencies, gold, and other assets. In the scenario, China's official reserves are crucial to maintaining the fixed exchange rate.

In the fixed exchange rate system, when there's a net demand for dollars exceeding the supply, such as here with more dollars being converted to yuan than the other way around, China must dip into its official reserves to fulfill the need for extra dollars. This results in a decrease in their official dollar reserves as they need to release more dollars into the market.

• Official reserves act as a buffer to stabilize the currency.
• They help in managing economic imbalances by ensuring enough foreign currency is available for trade.
• Maintaining adequate reserves is critical to protecting the country against financial crises.

Currency Conversion

Currency conversion is the process of exchanging one currency for another, facilitating international trade and investment. The exercise investigates this concept by analyzing how a fixed rate impacts daily conversions between dollars and yuan.

In our scenario, people wishing to convert their dollars into yuan create a demand for yuan, while those converting yuan to dollars create a demand for dollars. With a fixed exchange rate, the government or central bank must ensure that there's always sufficient supply to meet these demands.

The conversion rates and demands must be closely monitored and managed by the country's financial authorities to avoid potential imbalances that can affect monetary policy. This involves calculating how much of each currency is required to maintain equilibrium and support economic activities.

Foreign Exchange Market

The foreign exchange market, or forex market, is where currencies are traded globally. It is one of the largest and most liquid financial markets, crucial for currency conversion. In the context of a fixed exchange rate like China's, the market dynamics change significantly.

While in a floating rate system, exchange rates are determined by market forces, a fixed rate requires active participation by the government to stabilize the rate. This is seen through interventions, such as using foreign reserves to balance unequal currency demands.

• The forex market enables global economic interactions and currency stability when managed effectively.
• A fixed exchange rate might limit the market's natural fluctuations but provides predictability in pricing international transactions.
• Governments must continuously adapt their policies to respond to forex market pressures, ensuring that national economic objectives are met.