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Newbie to Macroeconomics

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anuse10
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Hi folks, I am a first year MBA student taking an Economics course. My colleagues and I are having trouble learning by just poring over books, so instead I change my learning process by facilitating discussion online, incorporating business knowledge to my daily life.

China, in my preception, is experiencing a significant inflation as the government is maintaing an undervalued currency exchange rate. A low exchange rate results in a hefty trade surplus. What if there is an appreciation of RMB? My professor said such appreciation would push down inflation and according to Philip's curve, would spur a tepid output and heighten unemployment. Why would the appreciation of dollars push down inflation?

Canada, when compared to US, has a lower trade surplus as the loonie is firting greenback with parity. Despite a sign of recovery after the recession in 2010, locals are pessemistic about the outlook of the economy. Some analysts even note that there would be a double dip recession.Bank of Canada governor, Mark Carney, still carry out the monetary policy of increasing money demand by holding interest rate to as low as 1%.

My professor pointed out that Japan did a China a favor by purchasing European bonds. How did that happen?

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I can try to answer some of your questions. I'm a first year PhD student in Economics, and I took an international finance course last year, so I have some kind of understanding of international currencies.

China, in my preception, is experiencing a significant inflation as the government is maintaing an undervalued currency exchange rate. A low exchange rate results in a hefty trade surplus. What if there is an appreciation of RMB? My professor said such appreciation would push down inflation and according to Philip's curve, would spur a tepid output and heighten unemployment. Why would the appreciation of dollars push down inflation?

Well, first, if there is an appreciation of the RMB (relative to all other currencies), it will make Chinese-made goods more expensive for people in other nations, and make foreign goods (foreign to China) cheaper for Chinese consumers. This would lessen the trade surplus that they're currently running.

The reason that this would push down inflation is a little more involved. As per my understanding, one of the major ways China has been keeping the RMB undervalued is by buying dollars and dollar assets with RMB. Thus, they will (effectively) print some RMB and then go spend it on dollars. This decreases the amount of dollars floating around and increases the amount of RMB out there. This makes the dollar relatively more valuable and the RMB relatively less valuable. So this is what China has been doing for a little while now.

Now notice that this process continually puts more and more RMB out into the system. From the Quantity Theory of Money, we would expect that this will cause China's prices to rise. To understand this, imagine that we all woke up tomorrow and the amount of money in our bank accounts had doubled overnight. There is now (about) twice as much money in the system, but the same number of actual goods. Thus, shortly after this happened, prices would dramatically rise as well, as everyone has twice as much money to spend on the same amount of goods.

So when China keeps throwing more and more RMB out into the world, they are putting pressure on Chinese prices to rise. This is inflationary pressure. If they stopped doing this completely, the inflationary pressure would disappear and prices would stop rising (inflation would disappear).

However, there are also lots of other little policies that China has in place to try to control the exchange rate of their currency; buying dollars with RMB is not the only thing they do. Depending on which of these policies they relax and how much, different things may happen.

I don't know about the China/Japan/European bonds thing. I'd need more context to make a guess at that one.

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Thank you for your explanation.

From my understanding of your explanation, China has been keeping RMB undervalued by pushing up the RMB money supply. The price level has to rise in order to compensate the lowered value of RMB. As a result, inflation kicks in.

Another concern of the government is that the appreciation of RMB would also entice the flood in of hot money, as speculators expected to earn money through China securities. When the bubble pasts, hot money rush out and the economy of China would be hit harder than it would be. Correct me if I am wrong. :)

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China, in my preception, is experiencing a significant inflation as the government is maintaing an undervalued currency exchange rate.

The US is "exporting inflation" because of their massive increases in the money supply. Stupidly, many countries like China want to keep their currency at a certain ratio with the USD, thus making all of their citizens poorer and causing riots in the West of the country over rising food prices.

A low exchange rate results in a hefty trade surplus. What if there is an appreciation of RMB?

There certainly will be at some point, when the Chinese government wakes up.

My professor said such appreciation would push down inflation and according to Philip's curve, would spur a tepid output and heighten unemployment. Why would the appreciation of dollars push down inflation?

Inflation is an increase in the money supply. Reducing the rate at which one increases the money supply is reducing inflation.

The stuff about unemployment your professor said is Keynesian BS. There wouldn't be any long term unemployment, just some structural changes in the economy as the Chinese get to begin consuming the items they work all day creating rather than just giving them to Americans in exchange for IOU's.

My professor pointed out that Japan did a China a favor by purchasing European bonds. How did that happen?

Your guess is as good as mine. He sounds like an academic divorced from reality.
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Another concern of the government is that the appreciation of RMB would also entice the flood in of hot money, as speculators expected to earn money through China securities. When the bubble pasts, hot money rush out and the economy of China would be hit harder than it would be. Correct me if I am wrong. :)

What bubble? If the currency appreciates then investors will invest money in Chinese companies (that cater to their domestic market) based on solid macroeconomics. The real bubble in China is the government backed real estate bubble.

Check out the book How an Economy Grows and How it Crashes by Peter and Andrew Schiff for a great discussion of the US-China trade deficit and inflation.

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