Question one: It is 2020 and there are three large economies in the world, China

Question

Question one: It is 2020 and there are three large economies in the world, China, the US and Europe. The following table gives expected growth rates of income (G) and money (M) for these economies. Assume that prices are flexible and ignore interest rates. In each case, state your assumptions and show your calculations. China 0.05 US Europe G 0.01 -0.02 M 0.04 0.02 a. Suppose that the Chinese central bank wants to keep its exchange rate roughly constant with the Euro. What target should they have for their money supply growth? b. Suppose that China wants to keep its exchange rate roughly constant with the US. What money supply growth rate should they set? c. Can China achieve a stable exchange rate against the Euro and the dollar simultaneously? Explain your answer Question Two: Assume that the following parity conditions hold covered and uncovered interest rate parityalong with absolute PPP. Answer in each case what happens to the value of the dollar against the Euro. Note: parts (a)-(d) are independent of each other a) The U.S. annual nominal interest rate is 3% and that in Europe is 5% b) The U.S. inflation rate expected over the coming year is 1 percentage point higher than irn Europe c) The forward exchange rate ($/euro) is 3% higher than the current spot exchange rate d) The basket of identical goods costs S100 dollars in the US and 150 Euros in Europe. The current exchange rate is 1.0

Explanation / Answer

Question 1

a) China has a strictly controlled currency policy where it regulates trading activity and tries to control daily movements of the yuan on the forex market. China has maintained strict rules for individuals and banks holding foreign currency, and thus the currency is not yet considered to be fully convertible. Investors who exchange dollars or other foreign currency for yuan must sell them directly to China’s central bank, which incorporates them into the country’s foreign reserves. By easing the fixed rate and managing the currency can aid money supply growth.

b)

c) The Chinese yuan has gained 10 percent against the dollar. Experts say Beijing is allowing the move so it will not appear to be manipulating its currency downward. Against a trade-weighted basket of currencies, the Chinese yuan is still mostly stable. in an effort to make the yuan more market determined (or, if you are cynical, in an effort to make a depreciation against the dollar stem from market pressure rather than from a conscious decision to guide the yuan down through a set of weaker fixes) the PBOC reduced the utility of one of its standard tools of exchange rate management (the signal from the setting of the fix) and in the process increased its reliance on direct intervention in the market (e.g. selling reserves to limit the pace of depreciation).

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