China is the world’s second largest economy; however, China’s economic growth is

Question

China is the world’s second largest economy; however, China’s economic growth is slowing down. Companies are shifting capital intensive manufacturing jobs out of China to other countries like Vietnam with lower wages as China's wages are rising. In addition, investment is down and the real estate bubble has burst, decreasing fortunes and wealth. These trends imply consumers in China will be cutting back on their demand for both domestic goods and foreign imports, in addition to the structural changes in China’s economy, e.g., loss of jobs and a shift from manufacturing. Suppose these events have impact on Chinese economy at national level that reduces the real income.

1. Given fixed money supply, what would be its effect on aggregate real money demand and interest rate in Chinese economy?

2. Now suppose, in response to above situation amid the fears of recession, Chinese central bank increases the money supply in its own economy. What would happen to Dollar/Yuan Exchange rate in short run? (Note: Yuan is the Chinese currency). Please explain which currency would appreciate/depreciate.

3. Extending the same situation and considering only money supply has permanently increased with no change in labor and capital in Chinese economy, then what would be its effect on Chinese exchange rate and output in the long run?

Bonus: What suggestion would you offer to Chinese government in this scenario. Please provide suitable explanation.

Explanation / Answer

1. Aggregate demand for money will fall this has been due to decline in demand for both domestic goods as well as foreign goods .Since the demand for money is less people are holding excess money which they will save. Savings will increase this means the interest rate will fall.

2. Increase in money supply means people have greater money balance they require and hence they will save more. Increased savings will reduce the interest rate in China . Fall in interest rate will lead to outflow of foreign capital from China. Demand for foreign currency will increase and supply of domestic currency will increase thus Chinese yuan will depreciate and thus US $/yuan will fall.

3. Permanent increase in money supply has no effect on output and no change in exchange rate. Permanent increase in money supply means people has anticipated for the change in money supply thus negating the effect of increase in money supply.

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