The yuan is the currency of the People’s Republic of China (PRC). The yuan has been pegged by the PRC government to the U.S. dollar for the past 10 years at a fixed rate of 8.28 yuan to the dollar. If the May 2005 undervalued yuan were allowed to rise to its true value, Chinese imports would become more expensive compared to U.S.-made products. One scenario is to allow the yuan to float in value against the U.S. dollar. Assume the yuan increases in value 25% against the dollar so that the dollar is worth 0.75(8.28 yuan) = 6.21 yuan. If an American firm buys a lot of Chinese-made textile products for 10 yuan apiece, it would cost 10 yuan ($1 U.S./6.21 yuan) = $1.6103 per item with the revalued yuan. The lot of 10,000 items would cost $16,103. Before the revaluing of the yuan, each item would have cost 10 yuan ($1 U.S./8.28 yuan) = $1.2077 per item, or $12,077 for the lot. Discuss the following with your classmates.
a. What happens to the cost of PRC goods in European countries when the dollar is strong (still 8.28 yuan per dollar)? What happens when the dollar weakens?
b. Will Americans buy the same amount of Chinese goods when $1 U.S. = 6.21 yuan? Will this fuel inflation in the United States?
c. What happens to the PRC–U.S. trade balance if more expensive Chinese goods are bought at the same level as with the $1 U.S. per 8.28 yuan policy?