Thursday, January 31, 2008

Exchange Rate Appreciation and Inflation....

" China is reported to be accelerating the appreciation of the yuan to combat inflaton instead of increasing its interest rates, in part because of expectations of further cuts in US interest rates. How does appreciation combat inflation?" - Jane

That's an excellent question! There are a number of avenues available for the central bank to try to combat inflation. They've already tried price controls, that I've argued elsewhere will ultimately fail. They've also raised interest rates a number of times as well, an avenue that is more likely to be successful. But perhaps the most effective way to combat China's inflation rate is to allow the currency to appreciate more quickly.

How would that work? Well, as I wrote here, inflation ultimately results from demand exceeding supply within the Chinese economy. An increase in the value of the currency makes Chinese goods relatively more expensive and foreign-made goods relatively cheap. Thus demand for Chinese goods will fall, reducing demand and therefore inflation pressure in China.

There's a related effect as well. China is accumulating foreign reserves at a rapid rate, which means that it is buying foreign currency with domestic currency. To do this, it is expanding the domestic money supply. As Milton Friedman famously said, "Inflation is Always and Everywhere a Monetary Phenonemon." Increase the price of RMB and the demand for RMB will fall- reducing the need for Mainland authorities to increase the money supply.

8 comments:

EL said...

does that mean HK will feel:-

- imported inflation as most of HK's basic foodstuffs are imported from China... (can't be the 3.8% reported?)

- continuous pressure on the HKD to consider re-pegging at a different rate instead of 7.8...

- continuous increase on property prices due to devaluation of the dollar (both US / HK).....

Just a thought...should we all be buy hard assets (e.g., gold or foreign currency, property) with our $'s now as opposed to holding on to them for the future as they become more and more useless?

James Yetman said...

I think you missed my point. Higher inflation in China may be offset by an appreciating RMB. The former increases Hogn Kong's inflation rate; the latter decreases it.

On your points 2 and 3, I tend to agree, although I'm not sure I'd want to go and buy hard assets right now- they're already very expensive!

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