Suppose that the Bank of China wishes to maintain the value of its currency when

Question

Suppose that the Bank of China wishes to maintain the value of its currency when measured against the US dollar. Consider the situations (a), (b) and (c) below. For each situation, describe if the yuan will appreciate or depreciate vs. the US dollar, and what action the Bank of China must take to maintain the value of the yuan. As an example, if the yuan is depreciating compared to the dollar, the Bank of China might uses its foreign currency reserves to buy the yuan, shifting its demand outward, and increasing its value relative to the dollar.

a) US parents begin buying fewer Chinese made toys for their children.

b) US interest rates rise relative to interest rates in China, so Chinese residents seek to purchase additional US financial assets.

c) Chinese furniture manufacturers produce high quality early American furniture and successfully export large quantities.

Explanation / Answer

a) US parents begin buying fewer Chinese made toys means that importers will need less yuan to buy these goods for import. The demand for yuan will decrease, and this will cause a depreciation against the dollar. In response, the Bank of China might uses its foreign currency reserves to buy the yuan, shifting its demand outward, and increasing its value relative to the dollar. b) Chinese residents will need more US dollars, so the demand for the dollar will increase, causing the yuan to depreciate against the dollar. Again, the Bank of China might uses its foreign currency reserves to buy the yuan, shifting its demand outward, and increasing its value relative to the dollar. c) The importers buying this furniture will need more yuan, increasing the demand, causing the value relative to the dollar to appreciate. The Bank of China could sell its reserves of yuan for dollars, shifting the supply and decreasing its value relative to the dollar.

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