1. Free Slides from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ How Chinese Inflation Policy Will Shape the Yuan- Dollar Exchange Rate Post prepared November 28, 2010 http://dolanecon.blogspot.com/ Terms of Use: These slides are made available under Creative Commons License Attribution Share Alike 3.0. You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishers.Attribution Share Alike 3.0 Introduction to Economics

2. Chinas Growth in the Global Recession By pulling out all the stops, China made it through the global recession with only a moderate slowdown in its rapid GDP growth To achieve this result, it used a combination of fiscal stimulus, easy money, and a freeze on the yuan-dollar exchange rate Posted Nov. 28, 2010 on Ed Dolans Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com

3. The Inflationary Consequences China is now facing the inflationary consequences of its pro-growth policies The rate of increase of the CPI has accelerated steadily all year In October 2010, CPI inflation reached an annual rate of 4.4 percent Posted Nov. 28, 2010 on Ed Dolans Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com

4. Inflation and the Yuan Chinas inflation, and the policies used to combat it, will be critical to understanding development of the yuan-dollar exchange rate over the coming months Since it was unfrozen in June, the yuan has already appreciated substantially against the dollar in nominal terms, and is expected to continue to do so Posted Nov. 28, 2010 on Ed Dolans Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com Notice: Because the vertical axis shows the exchange rate in yuan per dollar, a movement down on this graph indicates an appreciation of the yuan (The purchasing power of the yuan getting stronger relative to dollar)

5. Watch the real exchange rate, not the nominal rate! However, the nominal exchange rate does not by itself tell the whole story The competitive position of a countrys exports depends not only on the nominal exchange rate, but also on the rate of inflation When a country experiences inflation while its nominal exchange rate remains fixed, its exports lose competitiveness To correct for the effect of inflation, economists watch the real exchange rate, not the nominal rate Let H = nominal exchange rate in yuan per dollar h = the real exchange rate PUS = US price level PCN = Chinese price level Then h = H (PUS/PCN) This is the simplest of several ways to calculate the real exchange rate. For some other examples, see this post by Menzie Chin on Enconbrowser.com: http://www.econbrowser.com/archives/2010/09/th e_yuans_cours_1.html Posted Nov. 28, 2010 on Ed Dolans Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com

6. Real Appreciation is Faster than Nominal Appreciation To measure the real rate of appreciation of the yuan, we add the rate of nominal yuan appreciation to the difference between the Chinese inflation rate and the US inflation rate Because inflation in China is faster than in the US, the yuan has been appreciating faster in real terms than in nominal terms At its current rate of appreciation, the yuans estimated 20-40% undervaluation would be overcome in less than three years Posted Nov. 28, 2010 on Ed Dolans Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com

7. Nominal Appreciation as an Anti-Inflation Tool One way the Peoples Bank of China (PBoC) could slow inflation would be to allow the yuan to appreciate more rapidly in nominal terms However, doing so would not slow the real rate of appreciation, which is the sum of nominal appreciation and the inflation differential Faster nominal appreciation helps fight inflation in two ways It makes imported goods cheaper, holding down the cost of living It reduces the need to buy dollars, and thereby reduces the rate of growth of the yuan money supply Faster nominal appreciation plus less inflation would still mean rapid real appreciation Posted Nov. 28, 2010 on Ed Dolans Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com

8. Can the PBoC Have its Cake and Eat It Too? There are several tools that the PBoC could try to use to fight inflation without faster nominal appreciation of the yuan Sell more PBoC bills Raise interest rates or reserve requirements Use direct price controls However, each of these tools makes the economy operate less efficiently and threatens growth Posted Nov. 28, 2010 on Ed Dolans Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com Headquarters of the Peoples Bank of China Photo source: Yongxinge, http://commons.wikimedia.org/wiki/File:People%27s_Bank_of_China.jpg

9. The Bottom Line: Expect Continued Real Appreciation The most likely outcome in coming months will be a use of several anti-inflation policies in combination, including continued nominal appreciation These policies may slow inflation, but they will not fully erase the China-US inflation differential The resulting continued nominal appreciation of the yuan will provide gradual but welcome relief to some of the most acute imbalances in the global economy Posted Nov. 28, 2010 on Ed Dolans Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com