Readers Question: How about the case of cost push inflation like that of China? there’s high inflation and yet the economy is not operating at its full level of employment and due to the fact that its exchange rate is fixed, monetary policies would not be effective but fiscal policies would further increase unemployment. What policies can be implemented to reduce this cost push inflation in a fixed exchange rate system?
Comment on post: Economic Policies to reduce inflation
It’s a good question. Inflation in China has recently reached an 11 year high of 7.1% (inflation China)
The Chinese blame rising food prices and rising oil prices. However, I would also blame the Chinese government for allowing demand to rise too quickly.
Loose Monetary Policy. The benchmark interest rate in China is currently 7.4%. Although it has been increased several times in the past 12 months, it still represents a very low real interest rate 0.3% (7.4-7.1%) Compare that to the UK, where real interest rates are closer to 3.0%. The low cost of borrowing is encouraging a boom in borrowing, but often the borrowing is badly directed and it could contribute towards a boom and bust in the Chinese property markets.
Undervalued Exchange Rate. Although the Yuan has appreciated in the past couple of years (although the exchange rate is supposed to be fixed it has been allowed to be gradually revalued) However, it is arguably still undervalued. The Chinese government is keen to keep it artificially low to stimulat export led growth. The weakness of the Yuan is indicated by the size of the Chinese Current account surplus.
The problem for the Chinese economy is that growth is very unbalanced. Although some sectors are growing very strongly (manufacturing exports) some areas are not benefitting from growth at all. As you suggest, there is still a high level of unemployment resulting from the poor incomes to be found in farming. Many farmers in the north effectively have very little income so they migrate to the south in the hope of finding better incomes and jobs. The Chinese government is worried that if it doesn’t keep growth at 10% a year, there will be a rise in unemployment and social unrest. (Unemployment also occurs due to the process of privatisation)
However, the problem is that China is taking a very short term view and are risking the future economic stability of the economy. China needs to moderate its inflationary growth through tighter Monetary policy and an appreciation in the exchange Rate. Admittedly you say what policies should they use in a fixed exchange rate, but I would argue why stay in a fixed exchange rate? The government also needs to take steps to reduce the regional and sectoral imbalances in the economy. If they could reduce food inflation, through improving agricultural techniques that would help. There is also a case for trying to combine very small farms so they can benefit from economies of scale and boost productivity. However, these kinds of supply side policies will take a long time to have an effect.
Just goes to show, even with growth rates of 10% a year and you can still have many economic problems (to say nothing of all the pollution created by the growth)