value quantity Yuan U.S. $ D – U.S. imports from China (China exports) S – China imports from U.S. (U.S. exports) S – U.S. imports from China (China exports) E1 E E2 D China imports from U.S. (U.S. exports) E E1 E2 1.) China imports from U.S. : Chinese businessmen must pay for goods with U.S. $. They sell Yuan and buy $. Creates supply of Yuan that will be used by U.S. importers. 2.) U.S. imports from China : U.S. businessmen must pay for goods with Yuan. They sell U.S. $ and buy Yuan. 3.) Since the U.S. imports more from China than China imports from U.S., the shifts in blue are greater than the shifts in red.

Effects on currencies resulting from trade deficit with China: Yuan appreciated U.S.$ depreciated Ceteris paribus, as a result of the above currency changes, U.S. would import less because imports become more expensive, and export more, causing the trade deficit to correct itself. Problem for China: They want to continue exporting a lot to the U.S. to promote economic growth in their country.

So the Central Bank of China intervenes in the FX markets to prevent the value of their currency from appreciating against the U.S. $, keeping it at a targeted value below E’. This also keeps the value of the U.S. $ at a targeted level above E’’. They sell Yuan and buy U.S $ by entering into FX transactions with U.S. Banks. D S D S E’ E’’ value Q Q Yuan Market U.S. $ Market target Buy $ Sell Yuan S1 D1

China uses their U.S. $ surpluses to buy U.S. government bonds. The effect of China keeping the value of their currency artificially low from : 1.) U.S. trade deficits soared from as we continued to buy cheap exports from China, financed by the Chinese who bought our government bonds.