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Using IS-LM model for open economy, explain what happens to the Chinese currency (will it appreciate...

Using IS-LM model for open economy, explain what happens to the Chinese currency (will it appreciate or depreciate) if China continues selling U.S. Treasuries. What will be a possible effect on the net export of China? Support your answer with a properly labeled graph.

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Answer #1

Currently Chinese exchange rate system has evolved from being to fixed one or pegged one to a managed float one where now the central monetary authority has limited interference to maintain the exchange rate.

In case China continues selling U.S. Treasuries, it will decrease its money supply so that domestic rate of interest in Chinese deposits will increase. This will increase capital inflows and reduce net capital outflows. As a result of increased demand for Chinese yuan, Chinese currency, it is highly certain that it will appreciate over time.

This happens as LM shifts left. Appreciated currency will reduce exports and raise imports so net exports would decline.

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