AP_Krugman_Textbook

Module 43

Check Your Understanding

1. The accompanying diagram shows the supply of and
   demand for the yuan, with the U.S. dollar price of
   the yuan on the vertical axis. In 2005, prior to the
   revaluation, the exchange rate was pegged at 8.28
   yuan per U.S. dollar or, equivalently, 0.121 U.S. dollars
   per yuan ($0.121). At the target exchange rate of
   $0.121, the quantity of yuan demanded exceeded the
   quantity of yuan supplied, creating the shortage
   depicted in the diagram. Without any intervention by
   the Chinese government, the U.S. dollar price of the
   yuan would be bid up, causing an appreciation of the
   yuan. The Chinese government, however, intervened to
   prevent this appreciation.

a.If the exchange rate were allowed to float more freely, the

U.S. dollar price of the exchange rate would move toward

the equilibrium exchange rate (labeled XR* in the accom-

panying diagram). This would occur as a result of the

shortage, when buyers of the yuan would bid up its U.S.

dollar price. As the exchange rate increased, the quantity

of yuan demanded would fall and the quantity of yuan

supplied would increase. If the exchange rate were

allowed to increase to XR*, the disequilibrium would be

entirely eliminated.

Exchange rate

(euros per

U.S. dollar)

E 2

S 2

E 1

Supply of

U.S. dollars, S 1

D

XR 1

XR 2

Quantity of U.S. dollars

E

S

D

Exchange rate

(U.S. dollars

per yuan)

$0.121

0 Quantity of yuan

Target

exchange

rate

Shortage

of yuan

b.Placing restrictions on foreigners who want to invest in

China would reduce the demand for the yuan, causing

the demand curve to shift in the accompanying diagram

from D 1 to something like D 2. This would cause a reduc-

tion in the shortage of the yuan. If demand fell to D 3 , the

disequilibrium would be completely eliminated.

c.Removing restrictions on Chinese who wish to invest

abroad would cause an increase in the supply of the yuan

and a rightward shift of the supply curve. This increase in

supply would reduce the size of the shortage. If, for

example, supply increased from S 1 to S 2 , the disequilibri-

um would be eliminated completely, as shown in the

accompanying diagram.

E 1

E 2

S

DD^1

D 32

Exchange rate

(U.S. dollars

per yuan)

$0.121

0 Quantity of yuan

Target

exchange

rate

E

S

D

Exchange rate

(U.S. dollars

per yuan)

$0.121

XR*

0 Quantity of yuan

Target

exchange

rate

Equilibrium

exchange

rate

S 1

E 1

E 2

D

Exchange rate

(U.S. dollars

per yuan)

$0.121

0 Quantity of yuan

S 2

Target

exchange

rate

SOLUTIONS TO AP REVIEW QUESTIONS S-25