China's Monetary Policy, From Fixed to Managed Exchange Rate Essay

China's Monetary Policy, From Fixed to Managed Exchange Rate - Essay Example As of the last quarter of 2010, the economy of China was reported to overheat when its gross domestic product (GDP) increased by 10.3% as compared to the previous year (Simpkins 2011). In response to the on-going global financial crisis, the Chinese government decided to implement a â€Å"moderately loose monetary policy† from the usual â€Å"prudent monetary policy† as a strategic move in stabilizing the overall economic condition in China (Pierson 2010; Yang 2010). Based on the standard economic practice, a tight monetary policy is normally implemented by the central bank in order to control the economic consequences associated with high inflation rate. To allow the readers have a better understanding about this particular research topic, the standard model of a fixed exchange rate economy will first be tackled followed by discussing the previous case of China. Upon examining China’s preferred monetary policy today, this report will focus on determining whether or not the Chinese economy behave in accordance with, or differently from what one would predict from a standard Model of a fixed exchange rate economy experiencing overall balance of payments surpluses. Standard Model of a Fixed Exchange Rate Economy Under the Bretton Woods System, monetary policy was focused on fixing the exchange rates in order to protect the balance of payments stability (Hagele 2006, p. 8). Right after the World War II, making exchange rates stable by pegging the currencies against the US dollar was considered as one of the best ways to promote growth on international trading and in making the employment rate high (Hagele 2006, p. 9). Even though the pegged exchange rates are adjustable when necessary, historical events revealed that implementing a fixed exchange rate system could create disequilibrium in the balance of payment and international trading system (Bordo and Eichengreen 1993, p. 5). Given that importation and exportation of products are considered inelastic, a lot of economists in the past disregarded the significance of exchange rates in the use of monetary policy. This is because most of them believe that developing countries will remain the principal exporters of goods. Given that the presence of industrialization reduces the need for importation of goods from other countries, devaluation of currencies were considered less advantageous for economic development. It was only during the 1997 Asian crisis wherein a lot of economists considered the significance of exchange rate in managing the internal economy in each country. In an economy wherein the exchange rate is fixed, the government tends to rely heavily over the use of its fiscal policy in order to control the economic situation in each country. To boost the economic growth in each country, the government can make use of its reserves or to borrow money from local or international sources to create more demand for products and services. However, Tornell and Velasco (20 00) explained that excessive use of fiscal authority could result to more economic consequences since misuse or excessive use of fiscal policies could result to the exhaustion of the government reserves. Since demand for goods and services is growing in China, the Chinese government is