Chapter 5: The Cause and Cure: Simple Numerical Illustrations
INTRODUCTION In this chapter simple numerical illustrations are used to validate the proposition that, unlike what China bashers believe, revaluation of the yuan will not eliminate or even reduce the US trade deficit with China. This is because a number of inhibiting factors and unsatisfied conditions disturb or prevent the effect of exchange rate adjustment from being transmitted to the trade balance (for example, Moosa, 2011a). In these illustrations, revaluation of the yuan necessarily means devaluation (or depreciation) of the dollar, and the US trade deficit with China is equivalent to China’s surplus with the US. The illustrations can be presented from either a Chinese or a US perspective, but we will predominantly consider the situation from a Chinese perspective (not that it matters, anyway). In this case we consider the question regarding whether or not a revaluation of the Chinese currency against the dollar eliminates or reduces the Chinese surplus with the US, which is equivalent to the question of whether or not depreciation of the dollar will eliminate or reduce the US deficit with China. The starting point in this exercise is to explain how the trade balance (or current account) is related to the foreign exchange market where the exchange rate is determined. For the purpose of the following discussion, the term “exchange rate adjustment” is used to refer to both revaluation and devaluation (or both appreciation and depreciation), while the term “foreign exchange” is used to refer to either currencies, depending on which perspective we use...
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