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purchasing power parity (PPP). The effects of this policy on the Chinese economy has been rising inflation as the central bankers have increased the currency supply. However, it has also kept Chinese exports cheap and imports to China expensive, increasing China’s trade surplus. This makes it much harder for other manufacturers to compete with Chinese products. By the end of 2006 China was beginning to allow its currency to appreciate (rise in value).In the News: The Fed’s Latest Rise (pages 474-475) In May of 2006 the U.S. dollar was depreciating against most other major currencies. This followed upon increases in the value of the U.S. dollar based on the strength of the U.S. economy. Therefore, what changed and caused the decrease? Some people blame the U.S. trade deficit and argue that Americans cannot continue importing more than they are exporting. But some of the change in the value of the dollar may be due to economic improvements in Japan and increases in Japanese interest rates. The European Central Bank was also expected to raise rates, and these rate increases attract foreign investment funds away from the United States. However, exporters to the United States are likely to feel the adverse effects of the relatively weaker dollar as they lose sales due to higher selling prices.Lessons of the Article: Monetary policy is one of several important determinants of the exchange rate. The current account is another. Large imbalances between imports and exports can place pressure on exchanger rates regardless of what central bankers may say or do. From 2002 to 2006 the U.S. dollar depreciated by roughly 20 percent against the currencies of America’s Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets15
Chapter 19 Exchange-Rate Policy and the Central Bank major trading partners; even as the FOMC increased the federal funds rate target from 1 percent to 5.5 percent, the dollar’s value continued to fall. So, while the exchange rates are tied to interest rates, there are times when the link is weak.Additional Teaching ToolsMark Landler, writing for The New York Times(“Fed’s Expected Rate Rise May Well Offer a Respite For Other Central Banks”, June 30, 2004) points out that the Fed’s (then) expected rate increase will ease the pressure on other central banks. The problem the other central banks have faced is that low U.S. rates (compared to those in other countries) have decreased the demand for the dollar against other currencies, lowering the dollar’s exchange rate and raising the price of goods exported to the United States. The increase in U.S. rates would help to stabilize the dollar. The article points out the likely reactions from a number of other central banks, including those in Europe and Asia. This is a good illustration of interest rate policy’s effect on the exchange rate.