Tuesday, July 25, 2006

A Tale of Two Dragons: China's Trade Surplus and Inflation

In Chinese mythology, dragons can bring prosperity or destruction to villages and empires. China currently faces two dragons: the trade surplus that brings prosperity to Chinese manufacturers and urban workers, and inflation, which threatens China's price stability. Bloomberg reports that China's trade surplus might be fueling China's inflation problems.

One possible explanation is that the increase in the trade surplus outpaces the increase in potential output. Net exports are one component of aggregate demand in China. An increase in net exports pushes the aggregate demand curve to the right. Potential output increases as China utilizes more of its work-force (labor-intensive growth) and increases its capital stock (capital-intensive growth). The graph below shows that the increase in potential output (LRAS1 to LRAS2) is less than the increase in aggregate demand (AD1 to AD2). Whenever the increase in aggregate demand exceeds the increase in potential output, inflation is sure to follow (for example, from SRAS1 to SRAS2).
1. China maintains a relatively fixed nominal exchange rate between the yuan and the U.S. dollar (nominal exchange rate = 8 yuan per U.S. dollar). The real exchange rate is the nominal exchange rate times the ratio between the U.S. price level and the Chinese price level. The real exchange rate also represents the cost of U.S. goods and services relative to Chinese goods and services. How does an increase in China's inflation rate affect the real exchange rate?

2. How does an increase in China's inflation rate affect the trade balance between the United States and China?

3. The People's Bank of China often keeps its nominal interest rate equal to the United States' nominal interest rate in order to maintain the fixed nominal exchange rate (interest rate parity). Can the Bank of China choose to fight inflation and keep the nominal exchange rate fixed?

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  • At 7:03 AM, July 31, 2006, Blogger moming said…

    A minor correction. The central bank of china is people's bank of china, not bank of china, which is a state-owned commercial bank... don't want this tiny error ruin the great blog..

  • At 9:25 AM, July 31, 2006, Blogger William Chiu said…

    Thanks. Corrected.

  • At 2:27 AM, August 02, 2006, Blogger Street Walker Economist said…

    China's economics are too complex to be analyzed through some simple graphs based on static economic analysis. The fact of the matter is that despite super-fast growth, there are no signs of inflation; rather sign of deflation being readily found. Anyone interested may browse my weblog http://chinastreeteconomist.squarespace.com - for fun and casual browsing.

  • At 11:53 PM, August 21, 2006, Blogger William Chiu said…

    An alternative approach that explains China's increasing inflation rate is the quantity theory of money.

    Money Supply x Velocity of Money = Price Level x Potential Output

    MV = PY

    Or, in percent change form,

    % change in M + % change in V = % change in P + % change in Y

    m + v = inflation + y

    inflation = m + v - y

    Hence there are two sources of inflation--money growth and velocity growth. And there is one source of deflation--output growth.

    If the change in (m + v) exceeds the change in y, then the inflation rate will increase.

  • At 11:34 PM, April 30, 2008, Blogger nitin said…

    Oil prices ease ahead of U.S. Federal Reserve rate decision


    The most debatable topic from last few years is the rising oil prices. since 9/11
    and war on Iraq world oil prices rose tremendously. the rising inflation and the
    weakening of dollar is causing the prices of commodities to go up. this article is
    taken from thomson financial on April 30 2008.

    Oil fell on Wednesday, extending crude's sharp sell-off as the dollar strengthens
    ahead of the Federal Reserve interest rate decision later today .The Fed is widely
    expected to cut rates by 25 basis points to 2.0 percent , which would typically
    weaken the dollar and boost commodities. However, rate setters in the world's
    largest economy are expected to signal a desire to hold rates there for the time
    being. That anticipation is lending the dollar support and reducing the appeal of
    commodities priced in the greenback.' A dollar rally could likely derail the short
    dollar/long commodities play that has been working so well for much of the
    year,' said MF Global analyst Ed Meir. New York-traded West Texas Intermediate
    crude for June delivery dropped to an intraday low of $114.86 before firming to
    $115.40 by 12:20 p.m., a 23-cent decline from T uesday's close. Meanwhile,
    London Brent crude for June delivery fell 18 cents to $113.25. Supply concerns,
    which boosted oil prices to within a few cents of $120 a barrel earlier this

    week, have also eased. Falling demand in the United States has dealt a further
    blow to prices, with revised figures released by the Energy Information
    Administration (EIA) yesterday showing gasoline demand in February was 7
    percent lower than the year before.

    Some of the drop in demand may have been due to the weather, some may be
    due to the price level, and some may be due to the slowing economy. Analysts
    polled by Thomson Financial News expect to see a rise in crude inventories of
    1.1 million barrels, while distillate stocks are expected to be up by 830,000
    barrels. While this could further weigh on prices, expectations for a 625,000-barrel
    drop in gasoline inventories could lend support. according to my reading the oil
    prices will come down to $80 a barrel and thats what we all want it to be.


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