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This paper investigates whether China, with unemployed resources, can benefit from a trade surplus in one period and a deficit in the next by manipulating the yuan's peg. A country may be tempted to stimulate its economy temporarily by devaluation, but any surplus so generated subsequently must be expended with inescapable reverse output effect. It is shown that under reasonable conditions, nonintervention is the optimal policy and the optimal exchange rates are the equilibrium rates that yield a trade balance in each period. Numerical examples using the Cobb–Douglas utility function illustrate the main proposition.
5. Concluding remarks
China has been criticized for maintaining a large amount of foreign exchange reserve to take unfair advantage of its trading partners. This paper investigated whether a country can benefit from generating a trade deficit or surplus by arbitrarily changing the yuandollar peg. In a two-period framework, a Keynesian open economy with high unemployment may devalue its currency below the equilibrium rate in order to stimulate output, but the accumulated trade surplus must be spent later, which reverses the output effect. Alternatively, the country may incur a trade deficit in one period, and the principal plus interest subsequently must be paid off. It is shown that under reasonable conditions, the optimal exchange rate yields a trade balance over both periods. Therefore, there are no gains from temporarily stimulating output as the output effect is reversed when the trade surplus subsequently is spent. China's acquisition of a large foreign exchange reserve suggests that the current exchange rate policy may be harmful to consumer welfare, contrary to the prevailing view that China pursues its own self-interest by taking unfair advantage in the global market.