Sunday, September 12, 2010

Inflation in China

Inflation is rising in China. Why do we care about Chinese inflation?

As you probably realize the economies of China and the United States are more intertwined than ever. Over the last two decades China focused their domestic policies toward export lead growth. This was primarily achieved through a pegged exchange rate. The lower the value of the yuan the cheaper it was for Americans to covert dollars into yuan and buy more Chinese goods. Foreign investors began flocking for Chinese firms. As foreign money flowed into China normally the yuan would appreciate. An appreciation would make exports more expensive and slow down manufacturing in the export sectors. To offset the added demand China would increase their money supply and use the money to buy U.S. denominated assets. These policies allowed China to have a large trade surplus with the United States, conversely a large deficit for the United States.

There are costs to maintaining a pegged exchange rate. During the financial crisis the United States increased the money supply, i.e. lower interest rates, to stave off a financial panic. As more dollars enter the economy the value declines relative to foreign currencies. This would cause the yuan to appreciate unless the Chinese government undertook the same policies (by pegging the yuan to the dollar China is effectively adopting U.S. monetary policy). Here's the concern for China, their economy is starting to grow relative to the United States, but they cannot maintain their pegged exchange rate without risking double digit inflation rates. They are faced with an appreciation of the yuan or higher inflation both will increase the cost of Chinese goods on the global market. Unfortunately, I don't see this being overly beneficial to the United States. Our manufacturing does not complete directly with China, it won't immediately cause jobs to return to the U.S., and it will result in higher prices to households.

1 comment:

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