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The Choice between Adjustment under a Fixed Exchange Rate and Adjustment under a Flexible Rate



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A3B2 Ver 8 07r W 28 4 06 First Proofs CESIFO OUP FPP cesifo ifj004 3d ifj004 Page 1 30 OUP CESifo Economic Studies 2006 doi 10 1093 cesifo ifl004 On the Yuan The Choice between Adjustment under a Fixed Exchange Rate and Adjustment under a Flexible Rate Jeffrey Frankel Abstract Fixed and flexible exchange rates each have advantages and a country has the right to choose the regime suited to its circumstances Nevertheless several arguments support the view that the de facto dollar peg may now have outlived its usefulness for China i Although foreign exchange reserves are a useful shield against currency crises by now China s current level is fully adequate and US treasury securities do not pay a high return ii It may become increasingly difficult to sterilize the inflow over time iii Although external balance could be achieved by expenditure reduction e g by raising interest rates the existence of two policy goals external balance and internal balance in general requires the use of two independent policy instruments e g the real exchange rate and the interest rate iv A large economy like China can achieve adjustment in the real exchange rate via flexibility in the nominal exchange rate more easily than via price flexibility v The experience of other emerging markets points toward exiting from a peg when times are good and the currency is strong rather than waiting until times are bad and the currency is under attack vi From a longer run perspective prices of goods and services in China are low not just low relative to the US 0 23 but also low by the standards of a Balassa Samuelson relationship estimated across countries which predicts 0 36 In this specific sense the yuan was undervalued by 35 percent in 2000 and is by at least as much as it is today The study finds that typically across countries such gaps are corrected halfway on average over the subsequent decade These six arguments for increased exchange rate flexibility need not imply a free float China is a good



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