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Determination of the foreign exchange rate of the Chinese currency

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  1. Environmental taxes: Definition, inventory
    1. Context
    2. Goals
    3. Existing environmental taxes
    4. Implementation
  2. Environmental taxes: An effective tool?
    1. An effective tool under certain conditions
    2. Barriers
    3. Recommendations for future action

The recent debate in the United States on the alleged guilt of the undervaluation of the Chinese renminbi in the persistent deficit in the US current account is interesting for two reasons. Firstly, because economists opine that the optimal method should be used to measure the equilibrium exchange rate of a country, and secondly because it shows how two subjects are intertwined and associated in the public debate so that nothing indicates that a cooperative solution can be found.

A presentation and critical review of the article by Cecile Virginia Couhert Couharde entitled 'Real Exchange Rate Equilibrium in China' (CEPII Working Paper No. 2005-01) will provide an opportunity for us to take stock of what we really know about these global imbalance issues, and it is regrettable that the article Couhert Couharde fell into this trap of the Chinese and American domestic conditions.

China radically changed its exchange rate policy in 1994 when it decided to anchor the nominal exchange rate to the US exchange rate, leading to a situation of de facto of fixed exchange rate. This policy lasted until July 21, 2005, when the Chinese authorities, responding to the US pressure, agreed to revalue the renminbi by 2.1% and this time to secure a basket of currencies including the dollar, the yen, the euro and many others.

Although US officials denounced the undervaluation of the renminbi, the economists found different results for the undervaluation of the renminbi that can go from 0 to more than 50% (El-Kadhi Carlotti, 2005).

These differences are attributable to the models chosen, the assumptions underlying them, the windows of estimation and the data used. What then are these methods? Are the methods used by the authors questionable? Is there a greater contextualization and highlighting of the issues underlying the determination of the equilibrium exchange rate?

The choice of method for estimating the exchange rate in China is the first point of controversy in the debate about the possible undervaluation of the renminbi. Several methods exist and we will now review them.

The most classic is the so-called Purchasing Power Parity (PPP) absolute. It was initiated among others by Rogoff (1996) and applied more recently by Frankel (2005).This approach implies that a property where it is produced, must have the same price once fixed the standard of living of the country where it is produced. This method aims to estimate, using a large sample of countries, Rogoff and 100 to 118 to Frankel, the magnitude of the correlation between the real exchange rate and real income of selected countries.

This average is then applied in countries of interest to the economist and which we know the real income to arrive at the real exchange rate. For China, Frankel (2005) is thus an underestimation of 36% of the renminbi. Although the choice of absolute PPP is justified by the lack of relevance of the PPP on (because of the necessarily arbitrary choice of the beginning of the period it is estimated that the exchange rate is in equilibrium), it presents several disadvantages.

The first is that it is based on panel data and does not at all have the characteristics and the economic environment in its own country, which we wish to calculate the exchange rate. We know that the countries included in the large sample of Frankel have large discrepancies in their economic structures (liberalization of capital and labor against foreign exchange controls and limiting labor mobility, trade openness against import substitution) and their economic performance (inflation against uncontrolled price stability, sustainable growth against soft growth, rapid catch-up against slow in catching the accumulation of capital and technology).

These data therefore warrant a classification in order to be grouped together within more homogeneous and therefore more comparable. The second problem relates to the Balassa-Samuelson (1964). This can be presented as a spillover effect on wages of non-tradable sector resulting from increased productivity in the tradable goods.

Tags: China; currency; renminbi; yen; foreign exchange rate

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