On 2010-10-12, at 8:28 AM, SA wrote:
> On 10/12/2010 7:34 AM, Marv Gandall wrote:
>
>> I'm not sure I understand Martin Wolf's reasoning in the October 5th Financial Times when he writes that "by sterilising the monetary effects, the Chinese government has also thwarted the mechanism of adjustment in a fixed-rate regime, which was explained by the great Scottish philosopher, David Hume, in the 18th century…" The effect of sterilization is to soak up excess yuan injected into the money supply when the Bank of China buys dollars. What "mechanism of adjustment" is being "thwarted" here? Failure to sterilize the dollar purchases would provoke inflation, requiring the BoC to hike interest rates, strengthening the yuan. This is what Wolf is driving at, yes?
>
> Hume's classical adjustment mechanism was that an increase in the domestic money supply, brought on by an export surplus, would cause the price level to rise, which would then eliminate the export surplus by making exports relatively more expensive and imports cheaper. In other words, even if the nominal exchange rate is fixed, an increase in the domestic price level causes the real exchange rate to appreciate.
>
> By sterilizing the increase in the domestic money supply caused by its export surplus, China prevents that mechanism from working.
Right. Thanks.