U.S. monetary policy and China's exchange rate policy during the great recession

• DOI: http://doi.org/10.1002/ijfe.1652
• Date: 01 January 2019
• Published date: 01 January 2019
• Author: Juha Tervala

Received: 10 March 2017 Revised: 14 December 2017 Accepted: 20 June 2018

DOI: 10.1002/ijfe.1652

RESEARCH ARTICLE

U.S. monetary policy and China's exchange rate policy

during the great recession

Juha Tervala

Department of Political and Economic

Studies, University of Helsinki, Helsinki,

Finland

Correspondence

Juha Tervala,University of Helsinki, P.O.

Box 17, 00014 University of Helsinki,

Finland.

Email: juha.tervala@helsinki.fi

JEL Classification: E32; E52; F30; F41; F44

Abstract

I examine the transmission of expansionary U.S.monetary policy in cases where

emerging economies—including China—peg their currencies to the dollar. I

evaluate the value of the dollar peg as a fraction of consumption that households

would be willing to pay for the dollar peg to remain as well off under the dollar

peg as they would be under a flexible exchange rate. The value of the dollar peg

is typically positive for the dollar bloc because the United States can no longer

improve its terms of trade at the dollar bloc's expense. This provides a rationale

for fixing the exchange rate. The dollar peg is typically harmful to the United

States, providing a rationale for criticism of China's exchange ratepolicy during

the Great Recession.

KEYWORDS

beggar-thy-neighbour, dollar peg, dollar bloc, monetary policy, open economy macroeconomics

1INTRODUCTION

The international transmission of U.S. monetary policy

and China's exchangerate policy were topics of debate dur-

ing the Great Recession. The U.S. Federal Reserve (Fed)

was accused of competitive devaluation, which delib-

erately attempts to depreciate the dollar and stimulate

the U.S. economy and—in particular—its exports at the

expense of the rest of the world. Stiglitz (2008, 2010), for

instance, argued that U.S. interest rate reductions are a

beggar-thy-neighbour policy as they have depreciated the

dollar and helped to export the weakness of the U.S. econ-

omy to other countries.

Rajan (2011) argued that expansionary U.S. mone-

tary policy represents a threat to the rest of the world.

The argument goes as follows: U.S. interest rate reduc-

tions are followed by identical cuts everywhere, because

no country wants its currency to appreciate strongly

against the dollar. Consequently, the Fed ends up set-

ting monetary policy also for the rest of the world.

An expansionary U.S. monetary policy that is appropri-

ate for the U.S. economy may be overly aggressive for

emerging economies, where it leads to asset bubbles and

inflation.

The Economist (2011) emphasized that 66 countries

have either adopted the dollar as legal tender,pegged their

currency to it or managed their exchange rate against it

during the Great Recession. The dollar bloc's collective

GDP was almost 9 trillion dollars, or about 14% of the

world economy.The dollar bloc contains oil producers and

emerging economies. Erceg, Guerrieri, and Kamin (2011)

mention that various motivations for the dollar peg have

been offered, including the desire to keep currencies weak

and exports competitive and to avoid the adverse effects of

exchange rate fluctuations on the balance sheets of domes-

tic firms and households. The dollar peg also serves as a

strong and easily understood anchor for monetary policy

(Abed, Erbas, & Guerami, 2003).

The largest member of the dollar bloc—by far—is China.

It has been accused of currency manipulation to keep the

yuan weak and its exports competitive during the global

recession, when the Fed cut interest rates aggressively.

Krugman (2010) argued that this was “the most distor-

tionary exchange rate policy any major nation has ever

Int J Fin Econ. 2019;24:113–130. wileyonlinelibrary.com/journal/ijfe © 2018 John Wiley & Sons, Ltd. 113

114 TERVALA

followed,” and the U.S. Treasury should have labelled

China a currency manipulator. Importantly, political pres-

sure to do so rose during the financial crisis (The

Economist, 2010).

In this paper, I use a New Keynesian open-economy

model to examine the consequences of emerging

economies'—including China's—dollar peg for the inter-

national transmission of a U.S. monetary policy shock (the

deviation from the Taylor rule). I assume that the dollar

bloc pegs the exchange rate to the dollar by following

U.S. monetary policy. In addition, I assume that all export

prices are set in U.S. dollars, which I refer to as dollar pric-

ing. The assumption of dollar pricing is consistent with

the empirical evidence of Goldberg and Tille (2008), who

find that 99.8% of U.S. exports and 92.8% of U.S. imports

are invoiced in dollars.

The implications of the dollar bloc's currency manipula-

tion has been debated. This paper contributes to the debate

by developing a novel way to measure the value of the dol-

lar peg for the dollar bloc and the U.S. I measure the value

of the dollar peg as a fraction of consumption that house-

holds would be willing to pay for the dollar peg to remain

to be as well off under the dollar peg as under a flexible

exchange rate.

The theme is related to the classic question of whether

pegging the exchange rate is optimal. Since the publica-

tion of Obstfeld and Rogoff (2002), a strand of the recent

literature has analysed the optimal choice of the exchange

rate regime in the face of monetary and real shocks based

on rigourous welfare analysis. Lahiri, Singh, and Vegh

(2008) say that the classical finding in the world of sticky

prices and perfect capital mobility is that a flexible (fixed)

exchange rate is optimal if shocks are mainly real (mon-

etary). This literature addresses the question of whether

fixing the exchange rateduring domestic shocks is optimal.

However, the literature has not addressed the question

of whether it is optimal for foreign countries to fix their

exchange rates during domestic monetary shocks.

One of the main findings of this paper is that the value

of the dollar peg is positive for the dollar bloc (including

China), unless the cross-country substitutability (the elas-

ticity of substitution between domestic and foreign goods)

is very low, when U.S. interest rates fall. This provides a

rationale for fixing the exchange rate to the dollar dur-

ing a period of expansionary U.S. monetary policy. The

positive value of the dollar peg stems from the ability of

the U.S. to improve its terms of trade and consumption

at the dollar bloc's expense under flexible exchange rates.

The dollar peg prevents this, thereby increasing welfare.

As Rajan (2011) suggested, the combination of the dollar

peg and aggressive U.S. monetary policy can lead to an

overheating of the dollar bloc. In the model, however, the

dollar peg is optimal for the dollar bloc because it prevents

a negative spillover effect of U.S. monetary expansion.

A limitation of this paper is that the other types of shocks

are not modelled. Therefore, so one should bear in mind

that the optimal choice of exchange rate regime should

depend not only on foreign monetary policy shocks but

also on the other types of shocks.

McKinnon and Schnabl (2012) and Schnabl (2010) anal-

yse the costs and benefits of the dollar peg for China, East

Asia and the rest of the World and argue that it plays an

important role in the pursuit of macroeconomic stability

also in the case of U.S. monetary expansion. This paper

supports the view that the benefits may exceed the costs,

not because of macroeconomic stability, but despite the

macroeconomic instability (higher output fluctuations)

caused by the dollar peg.

Another of the main results of this paper is that the value

of the dollar peg is negative for the United States, unless

the cross-country substitutability is very low.In the normal

case, U.S.monetary policy is a beggar-thy-neighbour policy

because the United States can raise welfare by improving

its terms of trade. The dollar peg prevents this, so its value

for the United States is negative.

If the cross-country substitutability is sufficiently low,

the value of the dollar peg is positive for the U.S. Expan-

sionary U.S. monetary policy under the flexible exchange

rate causes a deterioration in the U.S. terms of trade in

cases of very low cross-country substitutability. The dol-

lar peg eliminates this, and therefore, the value of the

dollar peg for the United States becomes positive when

the cross-country substitutability is sufficiently low. How-

ever, the results show that for the typical parameter values

of the cross-country substitutability, the value of the dol-

lar peg is negative for the United States. This provides a

novel rationale for criticism of China'sexchange rate policy

during the Great Recession. It is, however, worth observ-

ing that expansionary U.S. monetary policy also increases

U.S. welfare in the cases where the dollar bloc pegs the

exchange rate to the dollar. The dollar peg just reducesthe

welfare gain of expansionary U.S. monetary policy to U.S.

households.

The rest of the paper is organized as follows: Section 2

introduces the model, Section 3 discusses the parameter-

ization of the model, Section 4 analyses the international

transmission of U.S. monetary policy and the value of the

dollar peg, and Section 5 concludes the paper.

2MODEL

In this section, I develop a New Keynesian open-economy

model in which the world economy consists of two coun-

tries: the United States and the dollar bloc. The dollar bloc

refers to economies that have pegged their currencies to

the U.S. dollar. A continuum of firms and households are