1. value quantity Yuan U.S. $ D – U.S. imports from China S – U.S. exports to China S – Chinese exports to U.S. E1 E E2 D – Chinese imports from U.S. E E1 E2 1.) U.S. Exports To China: Chinese businessmen must pay for goods with U.S. $. They sell Yuan and buy $. 2.) China Exports To U.S. : U.S. businessmen must pay for goods with Yuan. They sell U.S. $ and buy yuan. 3.) Since the Chinese export more to the U.S. than we export to them, the shifts in blue are greater than the shifts in red. This means we have a U.S. trade deficit deficit with China.

2. 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.

3. 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 E2. This also keeps the value of the U.S. $ at a targeted level above E2. They sell Yuan and buy $ by entering into FX transactions with U.S. Banks. D S D S E2 value Q Q Yuan Market U.S. $ Market target Buy $ Sell Yuan

4. 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 2001-2006: 1.) U.S. trade deficits soared from 2001-2006 as we continued to buy cheap exports from China, financed by the Chinese who bought our government bonds.