China fixes the rate of its yuan to the dollar on a pegged float, where the float is minimal. This policy results in Chinese exports being underpriced, making them attractive in world markets (Dunaway, 2010). Two impacts of this policy are a strong export sector and a weak import sector, as foreign goods are very expensive in China. While Chinas economy is growing rapidly, the currency policy also facilitates high rates of inflation (Batson & Back, 2010). This causes its own problems in the internal market, in particular given that countrys high level of wealth disparity. In addition, this inflation will put pressure on the central government — the peg to the dollar becomes more expensive to maintain, assuming that China increases interest rates in order to address the inflation.
Monetary and exchange rate policies are used to address issues such as the current account and inflation, but they also have an impact over the level of employment in a country, and the level of domestic consumption as well. Even business investment is impacted, because higher interest rates lead to higher required rates of return, discouraging investment and innovation.
Nations need to find the right balance between these different outcomes in order to maintain employment, output and inflation at healthy, sustainable levels. Monetary and exchange rate policy, therefore, is central to finding this equilibrium point.
Dunaway, S. (2004). Chinas exchange rate policy: The heat is on. Council on Foreign Relations. Retrieved May 16, 2010 from http://www.cfr.org/publication/21455/chinas_exchange_rate_policy.html
Puget, T. (2007). International Economics. New York: McGraw Hill.
Velasco, a. (2000). Exchange rate policies for developing countries: What have we learned? What do we still not know? United Nations Conference on Trade and Development. Retrieved May 16, 2010 from http://www.unctad.org/en/docs/pogdsmdpbg24d5.en.pdf
Batson, a. & Back, a. (2010). Chinas inflation picks up. Wall Street Journal. Retrieved May 16, 2010 from http://online.wsj.com/article/SB10001424052748703880304575237151414962556.html.