Question

There have been increasing political tensions between the U.S. and China as the two countries negotiate a new trade agreement. Suppose China decides to sell its holding of U.S. treasury securities as a means of punishing the U.S.

a. Assume that China is the home country.   Draw a graph showing the supply and demand for dollars. The vertical axis should have the cost of a dollar in terms of the Chinese currency, the RMB, E_RMB/$, (Hint:China is selling U.S. treasury securities, a dollar denominated asset).

b. Now draw a graph showing the supply and demand from the U.S. perspective. The graph should show the supply and demand for RMB. The vertical axis is E_$/RMB.

c. Explain what effect the asset sale will have on the U.S. current account.

Answer 1

China selling its foreign exchange reserves in the form of dollars will make sure that the supply of dollars increases. This will depreciate dollar and it will make it weaker. Terms of trade for USA will deteriorate but export competitiveness of US goods will increase and as its exports will increase and current account balance will improve.

a. As shown in figure a below, as supply of dollars increases, the dollar depreciates and each dollar which used to buy A1 amount of ERMB will buy less amount of ERMB A2.

b. shown in figure b below, as demand of ERMB increases, the ERMB apppreciates and each ERMB which used to buy B1 amount of $ will buy B2 amounts of dollar in each ERMB.

c. Terms of trade for USA will deteriorate but export competitiveness of US goods will increase and as its exports will increase and current account balance will improve.