A nation’s balance of payments measures all economic transactions between that nation’s people and the people of all other nations. A country that spends more on imports than it earns from the sale of its exports is said to have a trade deficit. Such imbalances have become controversial topics of debate in political and economic circles, particularly over the last decade as the Chinese economy has emerged as the world’s largest exporter.
As goods and services flow from one country to another, the exchange rates of those countries’ currencies tend to fluctuate to promote balanced trade between the two nations. However, in some cases, most notably China, a country’s central bank will intervene in the market for its own currency to manage its exchange rate against that of a trading partner. When such interventions occur, the normal, moderating effect that rising and falling exchange rates has on trade flows is disrupted, and trade imbalances can become persistent.
This lesson will illustrate how trade flows should lead to appreciation and depreciation of currencies in a floating exchange rate system, and then explain how in the case of China, central bank policy aimed at buying large quantities of US government debt keeps the supply of Chinese currency high in the US and the demand for US dollars high in China. This means the dollar remains stronger than it otherwise might relative to the Chinese RMB, contributing to the persistent trade deficits the US exhibits in its trade with China.
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