The Chinese government manages the value of the Chinese yuan relative to the U.S. dollar. Between 1995 and 2005, the yuan was strictly pegged to the dollar at a rate of roughly 8.28 yuan per dollar with a slightly looser peg adopted in 2006. By early 2017, the yuan was trading at 6.90 per dollar. China’s central bank, the People’s Bank of China (PBC), is responsible for using monetary policy to defend the fixed exchange rate. As a result of government policy geared toward spurring capital investment, China experienced a significant increase in investment demand.

a. Using the IS‒LM diagram for Home (China) and Foreign (the United States), illustrate the impact of this policy, assuming that the PBC responds to maintain a fixed exchange rate.

b. How would this policy and central bank response affect the government budget, current account, domestic interest rates, and output?

c. How would China’s experience be different if the PBC allowed the yuan to float against the U.S. dollar? What would be the implications for China’s exports to the United States? For China’s imports from the United States?

d. In practice, China uses capital controls to fix its exchange rate. How does this affect the previous answers? In the case of capital controls, is the outcome more similar to the fixed case in (a) or the floating case in (c)?