Sunday, November 18, 2007

Article in Question: Chinese Prices Surged Again Despite Price Controls

The article, "Chinese Prices Surged Again Despite Price Controls" is published in the New York Times on November 14, 2007.

Statement from the article: Consumer prices unexpectedly surged again last month in China despite price controls on a wide range of industries, and this month holds the prospect of even higher inflation. For years, flat or falling prices for Chinese goods helped restrain inflation in the United States.

American companies buying from China face a double blow: not only are prices rising in terms of China’s currency but China has also quietly begun allowing the yuan to rise at a faster pace against the dollar. The annualized pace of appreciation of the yuan has climbed to 6 percent in the last week.

My Point of View: Why is this an economic problem?

Price controls keep the average price of goods and services at a level that is lower-than-optimal (optimal being the intersection of supply and demand). Currency controls keep the value of the Chinese currency lower-than-optimal. Both of these factors, along with the relative prices here in the U.S., affect the import demand of Chinese goods by U.S. consumers. As mentioned in a previous post, these elements make up the real exchange rate.

For a long time now, politicians, firms, and policy-makers have been accusing the Chinese central bank of setting the $/Yuan too low (the dollar is appreciated), which discourages consumption of domestic goods, and encourages consumption of foreign (Chinese) goods. Well, as I said in an earlier article, it is not the nominal exchange rate, but the real exchange rate that matters. Holding U.S. prices stable, as price controls in China fail, which allows prices to fluctuate upward, and the exchange rate appreciates, or the Yuan/USD price falls, the real exchange rate will rise. An increase in the real exchange rate, which is a depreciation of the U.S. real exchange rate with China, means that import demand by U.S. consumers will fall. Isn’t that the whole goal of policy makers? As import demand for Chinese goods falls, we will look to purchase these goods elsewhere (perhaps at home).

Inflation and rising prices in China is not bad – it is simply an economic correction caused by relative prices in China being too low, and the $/Yuan rate being pegged (fixed) at an appreciated level.

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