Toward the end of the Using the Theory section, you learned that higher inflation in China than in the U.S. has reduced the yuan’s undervaluation in recent years. To see how this works, draw a graph similar to that in Figure 12. To keep the problem simple, suppose the price level in the U.S. does not change and the price level in China rises, while China continues to fix the exchange rate at $0.15 per yuan.
a. What impact does the rise in China’s price level have on the supply of yuan curve?
b. What impact does the rise in China’s price level have on the demand for yuan curve?
c. What is the combined effect of the changes you found in (a) and (b) above on the equilibrium price of the yuan?
d. After the changes you found above, is the yuan (fixed at $0.15 per yuan) more or less undervalued than initially? Explain briefly.