Question

Suppose that the government of China is currently fixing the exchange rate between the US 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 want 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. They will increase.

b. They will decrease.

c. They will stay the same.

Short answer

The correct option is option (a): they will increase.

Step-by-step solution

Deterioration in FOREX reserves

The overall official reserves consist of various foreign currencies, collection of bonds issued by the government, gold reserves, and special reserves held at the IMF.The collection of only foreign currencies is called foreign-exchange reserves or FOREX reserves.

Any change in either of these constituents of the official reserve will change the amount of reserve held by the central bank.

Size of China’s official reserves

The fixed exchange rate between the US dollar and the Chinese yuan is $1=6. At this exchange rate, the number of dollars getting converted into yuan is $10 billion.

The amount of yuan the people want to convert into a dollar is 36 billion yuan.

The amount in dollars will be

36/6 = $6 billion

The outflow ($6) of foreign currency from the official reserve is less than the inflow ($10) of foreign currency into the official reserve.

Thus, the net effect on China’s official reserve will be that they will increase.