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? a. Increase. b. Decrease. c. Stay the same.

Short answer

b. Decrease.

Step-by-step solution

Understand Exchange Rate Situation

The exchange rate is fixed at \(1 \text{ USD} = 6 \text{ yuan}\). This means for every US dollar exchanged, 6 yuan are given in return. This exchange rate is maintained by the Chinese government.

Calculate the Demand to Exchange USD to Yuan

People want to convert \(10 \text{ billion USD}\) into yuan. At the fixed rate of \(1 \text{ USD} = 6 \text{ yuan}\), this amounts to a request to exchange \(10 \times 6 = 60 \text{ billion yuan}\).

Calculate the Demand to Exchange Yuan to USD

People want to convert \(36 \text{ billion yuan}\) into U.S. dollars. At the fixed rate, this amounts to a request to exchange \(36 \div 6 = 6 \text{ billion USD}\).

Analyze Net Effect on Demand for Yuan and USD

There is a higher demand to convert \(10 \text{ billion USD}\) to \(60 \text{ billion yuan}\) compared to the demand to exchange \(36 \text{ billion yuan}\) to \(6 \text{ billion USD}\). This means more dollars are being converted to yuan than yuan converted to dollars.

Determine Impact on Chinese Reserves

Since more USD is being converted to CNY than vice versa, China must use its dollar reserves to meet the excess demand for yuan conversion. Thus, China’s official reserves of dollars will decrease.

Key concepts

Chinese Yuan

The Chinese Yuan, denoted as CNY, is the official currency of China and plays a critical role in global trade. It's essential to understand how it functions within the global economy, especially in relation to currency conversion and exchange rates. The Chinese government sometimes sets a fixed exchange rate with the U.S. Dollar (USD), like in our exercise where \(1\text{ USD} = 6\text{ yuan}\). This means for every dollar exchanged, a fixed amount of yuan is given in return.

This fixed exchange rate method allows the Chinese government to control its currency's value against the USD, helping to stabilize their trade with the United States. A fixed yuan rate can protect China from rapid fluctuations in currency value that might affect import and export balances. However, maintaining this rate involves using China's foreign reserves to satisfy the demands of currency conversion, ensuring the fixed rate remains stable.

U.S. Dollar

The U.S. Dollar, commonly abbreviated as USD, is one of the most widely used currencies globally. It is often used as a benchmark for foreign exchange rates, partly because of its stability and the economic influence of the United States. The dollar's status as a "world's reserve currency" means it is widely used in international trade and finance. This leads countries like China to hold significant reserves of USD.When the Chinese government fixes the exchange rate at \(1\text{ USD} = 6\text{ yuan}\), they promise to exchange yuan for dollars at this rate. This has implications for how much USD they need to keep in reserve. If more USD is wanted for conversion into yuan, as in the exercise, China must dip into its reserves to meet the demand, potentially reducing its holdings of USD. This highlights the dollar's key role in international finance and as a strategic asset in foreign reserves.

Foreign Reserves

Foreign reserves refer to the assets a country holds in different foreign currencies. They are crucial for managing a country's exchange rate and accessing international markets. For China, holding adequate USD reserves is essential to maintain their fixed exchange rate against the dollar. In scenarios like our exercise, where there is a higher demand for exchanging USD to yuan, China must use its USD reserves to maintain the exchange rate of \(1\text{ USD} = 6\text{ yuan}\).Managing foreign reserves is a balancing act. On one hand, reserves ensure stability in foreign policy and economic interactions. On the other, they can be depleted quickly if conversion demands are not balanced by opposite currency flows.

• Foreign reserves help stabilize currency value against other major currencies like the USD.
• They enable countries to handle sudden economic shifts by providing a cushion against currency conversion mismatches.

Currency Conversion

Currency conversion involves exchanging one type of currency for another at a specific exchange rate. This process is critical in international trade as businesses and individuals need to operate across borders with different monetary systems. In our exercise, both USD and yuan are exchanged at a steady rate set by the Chinese government.Understanding the principles behind conversions can alleviate confusion during such transactions. The formula usually involves multiplying or dividing the amount by the exchange rate. For example, exchanging \(10\text{ billion USD}\) at a rate of \(1\text{ USD} = 6\text{ yuan}\) gives \(60\text{ billion yuan}\). If the demand to convert USD to yuan is higher than yuan to USD, this impacts the availability of reserves, as more of one currency is in demand. This kind of exchange keeps global trade fluid, ensuring companies and countries always have the currency they need to complete transactions.