Chinese Exchange Rates and Reserves from a Basic Monetary Approach Perspective

101 As China exercises greater influence over global economics commensurate with the size of its economy, political discussions of the correct exchange rate for China will demand center stage. Questions about whether China should float the yuan, what the ‘competitive’ exchange rate might be, and so forth, will take a great deal of political time and energy of policymakers. Most discussions by U.S. and European political officials and central bankers heretofore have centered on unfair trade advantages accruing to China due to an ‘under-valued’ yuan, as if this is an absolute fact. Some focus on im- balances in bilateral trade accounts. Others focus on imbalances in current accounts, with accusations back and forth. Our belief is that most of these discussions miss the point, seeing only the trees and misunderstanding the size and complexity of the forest. That is, the exchange rate regime, exchange rate level, and the accompanying accumulation of foreign reserves by the Chinese government are a natural result of a set of carefully chosen domestic monetary policy decisions. Using a basic version of the monetary approach to the balance of payments model, one can develop a frame- work in which the Chinese monetary policy decisions can be better understood and interpreted. This type of analysis, we believe, provides a superior context for discussing the value of the yuan compared to the misguided focus on competitiveness and fair value. It also provides insight as to where problems may occur as well as what factors driving policy may be important in defining adjustments in either policy or economic outcomes involving exchange rates, inflation, wage demands, and equity prices.