What do Chinese economists and Rhianna’s feet have in common?

Trick question. Nothing.

Armed now with your newfound knowledge on interest rates and the money supply from The wonderful Central Bank of Oz it’s time to take it to the next level.

China has had its currency fixed to the US dollar more or less since 2004. The low value at which the renminbi is set makes renminbi cheap to buy for Americans, and hence Chinese goods are cheap to buy. A currency is said to be relatively cheap if you dont haveto part with much of your currency in order to get one unit of another. If the renminbi price of a Chinese good stays the same, then the less of your currency that you haveto give to get one unit of renminbi, the cheaper a good becomes. This process is described in slightly more in detail in Is the Australian economy “diseased?” This creates a large demand for Chinese goods from America. If this demand becomes great enough, it outstrips the Chinese manufacturing sector’s ability to produce (or supply) the goods, and prices begin to rise. This is the same effect described in Is gold a good hedge against inflation? except that the demand pull comes not from the domestic government printing money and spending it, but from Americans taking advantage of relatively cheap goods. As described in Is the Australian economy diseased? if the currency were floating and not fixed, the value of the renminbi would tend to rise as Americans scrambled to get their hands on it to buy cheap Chinese goods. The more expensive renminbi would make Chinese goods more expensive and the American demand would subside.

With the fixed exchange rate however, Americans can keep enjoying cheap goods indefinitely. But to stop the increased demand for renminbi from raising its price (and maintain the fixed "peg") the government must raise its supply. They print renminbi to give to Americans, which as we know results in inflation. But we also know the government can mop up this extra liquidity (cash) by selling bonds as we saw in The wonderful Central Bank of Oz , which is equivalent to raising interest rates. The other side of the "interest rate money supply coin" is that the Chinese are raising interest rates, to curb demand by the Chinese, to "make way" for the extra demand from Americans (who are not directly affected by the interest rate increase). But this works fine only while China has capital controls in place to stop money flowing into the country. The reduction in capital controls announced greatly dilutes China’s ability to reduce its money supply as we’ll see in the next article.