VIETNAM NATIONAL UNIVERSITY

VIETNAM JAPAN UNIVERSITY

MACROECONOMICS FOR PUBLIC POLICY

Final report
Essay question:
Explore the effects of a shock in exchange rate on export
Impacts of China devaluation currency the Yuan on China export
from 2015 - 2018

Student : Le Ha Phuong
ID : 19110026
Class : MPP - 04

Hanoi, 2020
1. Introduction
Exchange rate plays a vital role in managing macroeconomics. Many governments such as China
use this tool in order to achieve expected goals including stimulating export. Chinese
government controls the exchange rate by implementing fiscal policy, trade policy and managing
depreciation – a type of monetary policy. In this report, I would like to use the Mundell-Fleming
model to explain the effects of China devaluation currency on China export from 2015 to 2018.
This essay concentrates on two main parts. First, explaining key definition, the Mundell –
Fleming model and impossible trinity. The second part describes how this model illustrates the
reality of China.
2. Theoretical Basis
2.1. Definition
There are two kinds of exchange rate: the nominal exchange rate and the real exchange rate.
According to Mankiw, the nominal exchange rate is the relative price of domestic currency in
terms of foreign currency. The real exchange rate is the relative price of domestic goods in terms
of foreign goods. The real exchange rate can be calculated by the nominal exchange rate and
price levels as following:
P
ε =e x
P∗¿ ¿
where ε is the real exchange rate, e is the nominal exchange rate, P is domestic price level
(measured in domestic currency) and P* is foreign price level (measured in foreign currency).
If the real exchange rate is high, domestic goods become more expensive relative to foreign
goods. In this case, people want to purchase more imported goods; therefore, the country will
reduce export and increase import. Trade deficit happens when the amount of imported goods is
greater than the amount of exported goods and services. By contrast, if the real exchange rate is
low, foreign goods become more expensive relative to domestic goods, the countries will
stimulate export and contract import. Trade surplus happens when net export is greater than zero.
2.2. Models
2.2.1. The Mundell-Fleming model
The Mundell-Fleming model, also known as IS* - LM* model, is an economic model developing
in the early 1960s. It is an extension of the IS – LM model. However, while IS – LM focuses on
interest rate and outputs in a closed economy, the Mundell-Fleming model describes the
relationship between the nominal exchange rate, interest rate, and output in a small open
economy in short run. Key assumptions of this model are:
- Both domestic and foreign price level P and P* fixed. Therefore, the real exchange rate is
proportional to the nominal exchange rate and net export NX is also a function of
nominal exchange rate.
 - Small open economy with perfect capital mobility. This means that the nation can borrow
or lend as much as it wants. The world interest rate is given an is not affected by the
activities of this nation in financial market. The world interest rate r* determines the
domestic interest rate, r = r*.
With assumptions above, according to the Mundell–Fleming model, in short run, a small open
economy can be described by two equations:
Y = C(Y − T ) + I(r*) + G + NX(e) (IS*)
M/P = L(r*, Y ) (LM*)
IS* that describes equilibrium of goods market is a slopes downward curve since e and Y have an
inverse relationship. The higher e is, the lower NX is, which means the lower Y is. LM* that
describes equilibrium of money market is vertical curve because with the given r*, there is only
one value of Y regardless of e.
Figure 1: Equilibrium in the Mundell-Fleming model

The equilibrium for the economy is where the IS* curve and the LM* curve intersect (see figure
1). This figure is used to describe the effects of policies on export and NX under different type of
exchange rate mechanism.
Policy under floating exchange rate
Figure 2: Equilibrium in the Mundell-Fleming model, expansionary fiscal policy under
floating exchange rate

When the government applies the expansionary fiscal policy by increasing government
expenditure G or by cutting taxes T, IS* curve moves to the right. This raises e. IS – LM model
is used to explain the effect of this policy on NX. When G increases (or T decreases), IS curve
shifts to the right, as a result, r raises. The higher r makes inflow of capital to pull r back to r*,
increasing the value of domestic currency. The appreciation of the domestic currency makes
domestic goods expensive relative to foreign goods, reducing NX.
Figure 3: Equilibrium in the Mundell-Fleming model, expansionary monetary policy under
floating exchange rate

When expansionary monetary policy is implemented, an increase in money supply MS makes

LM* shifts right. e decreases. IS-LM model is used to explain these moving in more detail.
When M raises, LM shifts to the right, r falls. A lower r makes outflow of capital to push r back
to r*. This depreciates the value of domestic currency. As a result, domestic goods is inexpensive
relative to foreign goods, stimulating export.
 Figure 4: Equilibrium in the Mundell-Fleming model, import restriction policy under floating
exchange rate

The government uses a import quota or tariff in order to restrict import. This increases NX and
also the planned expentiture, hence shifts IS* curve to the right. e raises. The explaination for
this transition is similar to the case of expansionary fiscal policy. Import reduces; however, the
rise in the exchange rate also decreases export. NX is unchanged but the country will gain less
from trade.
Policy under fixed exchange rate
Under fixed exchange rate, the central bank buys or sells domestic currency for foreign currency
at a predetermined rate to control exchange rate.

Fiscal expansion moves the IS* curve to the right, thus increase exchange rate. In order to keep
exchange rate at announced level, central banks need to buy foreign currency to increase money
supply MS. This action shifts the LM* curve to the right. e moves back initial level and NX is
unchanged.
The central bank tries to increase money supply MS. This shifts the LM* curve to the right,
lowering e. However, with a fixed exchange rate, central bank needs to buy domestic currency to
decrease M, pulling LM* back to the left. e returns their initial points, NX remains.

The application of import restriction policy shifts IS* to the right, raising e. To pull e back to its
initial position, MS should be increased, moving LM* to the right. Overall, NX increases thanks
to the reduction of import.
The policy effects of Mundell-Fleming model can be seen in the following table:
 Table 1: Summary of policy effects

2.2.2. The Impossible Trinity

The argument about whether floating or fixed exchange rates is better leads to a conclusion is: A
nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate
simultaneously. This is called the impossible trinity. A nation must choose one side of this
triangle and giving up opposite corner. Figure 8 describes how three options work and examples
about a country with its option. For instance, China chooses the third option, decides to restrict
the international flow in and out of country to maintain independent monetary policy and fixed
exchange rate.
Figure 8: The Impossible Trinity (1)

3. Case study: Impact of China devaluation currency on China export from 2015 to 2018
3.1. Introduction
Since china is a large open economy which currently is the second-largest in the world by
nominal GDP (2), the influence of a shock in exchange rate on China export will be analyzed by
combining the IS–LM model for a closed economy and the Mundell–Fleming model for a small
open-economy. The final effect is the average of the two extreme cases.
In recent years, China is using a managed floating exchange rate regime. The Chinese yuan
tightly links to the USD but is allowed to fluctuate within a wide band establishing by the
People’s Bank of China’s (PBC) - the Central Bank of China.
Although monetary policy by managing money supply has no effect on net export under a fixed
exchange rate, a country with a fixed exchange rate can use other type of monetary policy by
changing the level of fixed exchange rate. The rise in the value of domestic currency by
intervention of central bank is called revaluation, in contrast, the fall of it is called devaluation.
In Mundell-Fleming model, a devaluated currency can act like an increase in money supply. It
moves the LM* curve to the right, expanding net export (Mankiw, 2010).
In August 2015, an analysis showed that China export slowed down when export fell by 8.3%
from June to July. The figure also revealed that while export to EU and Japan dramatically
decreased 12.3% and 13% respectively in June, export to US dropped at slower peace, 1.3%
(Inman, 2015). Furthermore, since CNY is pegged to the USD, a rise in the value of USD will
also rise the value of CNY, which worsen China export.
The slowdown of export along with an anticipation of the US raising interest rates (Inman ,
2015), on August 11, 2015, in order to boost export, the PBC decided to depreciate the CNY by
1.9% against the USD. On the next day, the CNY/USD rate devaluated by a further 1% (Das,
2019)
3.2. Impact of this action on export
After that shock on exchange rate, total exported value of China reduced from USD
2,273,468,224 thousand to USD 2,097,637,172 thousand before significantly increase to USD
2,263,370,504 thousand and USD 2,494,230,195 thousand in 2017 and 2018 respectively. While
similar partners can be witnessed for exported value of China to some of its largest trading
partners including USA, South Korea and Vietnam, the figure for Hong Kong is quite different.
Total exported value of China to Hong Kong still fell 2 years after the devaluation and started to
rising in 2018.

Figure 9: Exported value of China

from 2014 to 2018 (5) (USD thousand)
3000000000
2500000000
2000000000
1500000000
1000000000
500000000
0
2014 2015 2016 2017 2018

World United States of America Hong Kong, China

Japan Korea, Republic of Viet Nam
 Data source: Trademap.org
The J-curve effect explains the reason why total exported value did not increase immediately
after the shock. This effect describes the “path” of trade balance following the devaluation or
depreciation of its currency. Export initially goes down, then begins to surge above the starting
position. The reason for it is that it takes time to adjust the volume of trading goods. A
devaluated currency instantly increases the value of import but the value of export decreases due
to the unchanged in consumer behavior. However, after a period of time, the lower price rises the
competiveness of China goods for both domestic and foreign customers, stimulating export and
restricting import. As a result, the value of export steady goes up (Ngoc, 2006). Another reason
for the growth in value of export is the promotion of trade liberalization in China. The FTA
between China and South Korea, one of the biggest trading countries of China, went into force in
December 2015, enhancing the amount of goods exporting (3).
However, the rapid expansion of China export can lead to several consequences. One of them is
trade war with the US. The trade surplus with the USA is dramatically increasing while USA
witnesses a trade deficit which threats to US employment. In order to protect domestic
manufacturing, USA impose punitive tariffs on some China goods, such as on 24 Sep 2018, U.S.
implements 10% tariffs on $200 billion of Chinese imports (Reuters, 2019).
4. Conclusion
The Mundell-Fleming model is used to explain the effects of a shock in exchange rate on export
of a small open economy. In a large open economy like China, we combine the Mundell-Fleming
model and IS – LM model and the final effect is between the effect of each model. There are
many factors causing a shock in exchange rate of China including a devaluation currency. The
model illustrates well in this case since lower value of the yuan can boost export; however, in
reality, this shock also has negative impacts on China export as it leads to a trade war between
China and USA and USA imposes tariffs to reduce the amount of goods importing from China.
5. Note
(1) Figure 1, 2, 3, 4, 5, 6, 7, 8 and table 1 are retrieved from slides of Macroeconomics for Public
Policy course, part of Professor Vinh.
(2) Source: World Development Indicators database 2018
(3) See China FTA Network announcement on China-ROK, China-Australia FTA to take effect
on December 20, December, 11, 2015.
http://fta.mofcom.gov.cn/enarticle/enkorea/enkoreanews/201601/30417_1.html
6. References
Das S. (2019). China’s Evolving Exchange Rate Regime. IMF Working Papers.
Inman P. (2015). Global stock markets boosted amid speculation China may devalue. Retrieved
from https://www.theguardian.com/business/2015/aug/10/stock-markets-boosted-speculation-
china-devalue
Inman P. (2015). Why has China devalued its currency and what impact will it have? Retrieved
from https://www.theguardian.com/business/2015/aug/11/china-devalues-yuan-against-us-dollar-
explainer
Mankiw N. G. (2010). Macroeconomics (7th Edition). Worth Publishers.
Ngoc N. V. (2006). Tu Dien Kinh Te Học [Dictionary of Economics], Hanoi, National
Economics University Publishing House.
Reuters (2019). Timeline: Key dates in the U.S.-China trade war. Retrieved from
https://graphics.reuters.com/USA-TRADE/010091TL2VV/index.html
https://trademap.org/