Suppose the People\'s Bank of China wishes to peg the rate of exchange of its cu

Question

Suppose the People's Bank of China wishes to peg the rate of exchange of its currency, the Yuan, in terms of the U.S. dollar. In each of the following situations, should it add to or subtract from its dollar foreign exchange reserves? Why?

1. U.S. parents worrying about safety begin buying fewer Chinese-made toys for their children.
2. U.S. interest rates rise relative to the interest rates in China; therefore, the Chinese residents seek to purchase additional U.S. financial assets.
3. The Chinese furniture manufacturers produce high-quality early American furniture and successfully export large quantities of the furniture to the United States.

Explanation / Answer

1.) Add to its dollar foreign exchange reserves because reduced buying of Chinese goods by US customers will reduce its foreign exchange reserves of China as there will be lesser inflow of US dollars for consumption of Chinese goods...

2.) Add to its dollar foreign exchange reserves because additional buying of US financial assets will lead to greter outflow of the Chinese yuan and lead to an imbalance in the foreign exchange market...

3.) Subtract from its dollar foreign exchange reserves because increased sales of Chinese goods to US consumers will increase the inflow of US dollar and will lead to an increase in the foreign exchange reserves relative to the value of Chinese yuan and in order to correct the balance, subtraction shall be done...

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