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Chapter 30: Problem 18

(Related to the Apply the Concept on page 1071) Graph the demand and supply of Chinese yuan for U.S. dollars and label each axis. Suppose the Chinese central bank were to decide to once again to peg the value of the yuan against the U.S. dollar. Indicate whether the Chinese central bank would typically be interested in pegging the exchange rate above or below the market equilibrium exchange rate. To maintain the peg, would the Chinese central bank typically be supplying yuan in exchange for dollars or selling dollars in exchange for yuan? Illustrate your answer on your graph.

Short Answer

Expert verified
If Chinese central bank decides to peg the yuan above the market equilibrium exchange rate, it would be interested in supplying yuan in exchange for dollars to maintain the peg. This action is represented on the graph as a surplus of yuan due to the higher pegged rate, and the subsequent interaction of new supply and demand points.

Step by step solution

01

Draw the Initial Supply and Demand Curves

Begin by drawing an x-y graph, where y-axis represents the 'Price of yuan in dollars' and x-axis stands for 'Quantity of yuan'. Both supply and demand curves are usually plotted as downward and upward sloping lines, respectively, indicating the relationship between price and quantity demanded/supplied. Label the point where they intersect as the 'market equilibrium exchange rate'.
02

Discuss Exchange Rate Pegging

Once the graph is plotted, next thing to note is how currency pegging works. Pegging an exchange rate means fixing its price to a particular value. In this case, if the central bank of China decides to peg the yuan to the dollar, it fixes a specific exchange rate and commits to maintain it. Depending on whether the peg is set above or below the equilibrium exchange rate, the bank can either make the currency more expensive or cheaper than its natural market value.
03

Illustrate the Pegging on the Graph

To illustrate the pegging, suppose the central bank sets the peg above the equilibrium exchange rate. Draw a horizontal line at this price level to show the artificial exchange rate. Doing so makes yuan more expensive, therefore the quantity of yuan demanded decreases and the quantity supplied increases, leading to a surplus of yuan.
04

Explain Central Bank's Operations to Maintain the Peg

To maintain the peg, the central bank intervenes in the foreign exchange market. In this scenario, since there's a surplus of yuan, it would buy up the surplus yuan using its reserves of US dollars. Hence, it would essentially be supplying yuan in exchange for dollars. Mark the new point of supply and demand interaction on the graph to complete your answer.

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Most popular questions from this chapter

Although it is a member of the European Community, Denmark is not part of the euro zone; it has its own currency, the krone. Because the krone is pegged to the euro, Denmark's central bank is obliged to maintain the value of the krone within 2.25 percent either above or below the value of the euro. According to a 2017 article in the Wall Street Journal, the Danish central bank was forced to intervene in foreign currency markets "to keep the krone from strengthening too much." a. If the krone was strengthening, did it take more kroner to exchange for a euro or fewer kroner? Briefly explain. b. Given your answer to part (a), was the Danish central bank intervening by buying kroner in exchange for euros or selling kroner in exchange for euros? Briefly explain.

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