If a country like China tries to peg their nominal exchange rate against the dollar, they lose control over their own money supply. To see why, imagine that an exporter sells a flat panel TV to a US retailer. The US retailer pays in dollars, but the exporter's costs are in yuan, so he has to exchange dollars for yuan in order to pay for the TV.
If there is a net inflow of dollars to China (there are more Chinese exporters want to sell dollars to buy yuan than there are Chinese investors who want to sell yuan to buy dollars to invest in the US), then the Chinese central bank must "print" yuan to make up the difference. In turn, this causes Chinese inflation, which raises the price of Chinese goods. This means that a dollar, exchanged into yuan at the official (nominal) exchange rate can buy fewer Chinese goods.
In other words, the real value of the dollar has fallen, or the Chinese yuan has appreciated in real terms. This will make Chinese exports more expensive, and US imports to China less expensive, which should help correct the trade imbalance.
This has been going on for quite some time and hasn't really affected the trade balance between us and China. I think the problem is that the models assume that prices and wages within a country are far stickier than they are.
ReplyDeleteIf the trade balance is instead driven by the supply side, then the effect can be unaffected by what the currencies do. For example, say environmental regulation costs are too high in the US and capital markets regulatory costs are too high in China, then the US can have a near permanent trade imbalance with them even with zero stickiness.