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CESifo Area Conference on Global Economy 10 – 11 December 2004 CESifo Conference Centre, Munich Chinese Renminbi Revaluation and the Optimal Exchange Rate Hui Huang, Yi Wang, Yiming Wang, John Whalley, Shunming Zhang CESifo Poschingerstr. 5, 81679 Munich, Germany Phone: +49 (89) 9224-1410 - Fax: +49 (89) 9224-1409 E-mail: [email protected] Internet: http://www.cesifo.de Chinese Renminbi Revaluation and the Optimal Exchange Rate∗ Hui Huang† Yi Wang‡ Yiming Wang§ John Whalley¶ Shunming Zhang December 3, 2004 First Rough Draft Abstract We present a model of combined interspatial and intertemporal trade between countries recently used by Huang, Whalley and Zhang (2004) to analyze the merits of trade liberalization in services when goods trade is restricted. We combine this model with a model of foreign exchange rationing due to Clarete and Whalley (1991) in which there is a fixed exchange rate with a surrender requirement on foreign exchange generated by exports. Under either auctioning of foreign exchange by the central bank to importers, or some nonauctioned allocation mechanism with domestic trading trading in foreign exchange, there will be a premium value on foreign exchange established which is endogenously determined and operates akin to a tariff on imports. Domestic monetary policy in such a model is nonneutral with respect to trade while trade liberalization (tariff reduction) merely changes the premium value on foreign exchange, in simple models, leaving trade unchanged. In this combined model, when services remain unliberalized there is some optimal trade intervention, even in the small open price taking economy case. Given monetary policy and an endogenously determined premium value on foreign exchange, an optimal setting of the exchange rate will provide the optimal trade intervention. The implication is that in this model a move to a free float may be welfare worsening if services remain largely unliberalized, the situation that applies currently in China. We use numerical simulation methods to explore the properties of the model, which has no closed form solution. These analytics run counter to those presently advocating a free Renminbi float. ∗ This is an analytical paper drawing on a wider project on Financial Liberalization in China conducted under the auspices of the Centre for International Governance and Innovation (CIGI), Waterloo, Ontario. The fourth author acknowledge support form SSHRC (Ottawa). † University of Western Ontario ‡ Shanghai University of Finance and Economics and Unicentury Holding Co. Ltd. § Peking University ¶ University of Western Ontario, CIGI, NBER, and CES - ifo Munich University of Western Ontario 1 1 Introduction This paper is motivated by current debate on financial liberalization in China, and specifi- cally the issue of Renminbi (RMB) revaluation which China’s OECD trading partners are now advocating given both the size of the Chinese trade surplus, and their desire for improved access to Chinese markets. China has long maintained a fixed exchange rate with tight regulation of domestic banks, and strict limits on entry to the Chinese market for foreign financial institutions. In past, this has reflected a desire for macro stability, but the Chinese banking system also differs sharply from those in OECD countries with small but growing personal banking, and state owned banks acting in part as mechanisms for recapitalizing loss making state owned enterprises. Thus, part of what is at state in debate on financial liberalization in China and the choice of exchange rate regime is the form and operation of the Chinese banking system and how this would change with a freely floating fully convertible Renminbi (see the discussion Zhang and Pan 92004) and Chang and Shao (2004)). In seeking to contribute to the debates, this paper takes as its point of departure macro literature on the choice of exchange rate regime. While the choice between a fixed and feasible exchange rate regime has long been argued and debated in classical monetarist terms (that a fixed exchange rate implies accommodating monetary policy, and monetary policy determines the floating rate) as in Friedman’s (1956) classic discussion, little literature suggests that there may exist an optimal exchange rate. Such a contention is clearly relevant to current policy debate in China, since with an optimal exchange rate a freely floating rate may be welfare worsening. We present a model of combined inter-spatial and inter-temporal trade between countries recently used by Huang, Whalley and Zhang (2004) to analyze the merits of trade liberalization in services. In this model, in the presence of tariff on inter-spatial trade, free trade in services, even for a small open price taking economy, may not be welfare improving, and free trade in goods if services remain unliberalized may not be Pareto optimal. We combine this with a related simple model of spatial trade due to Clarete and Whalley (1991) in which there is a fixed exchange rate accompanied by a surrender requirement for foreign exchange generated by exportors. Under either auctioning of foreign exchange by the central bank to importers, or some non auctioned allocation mechanism with domestic trading in foreign exchange, there will be a premium value on foreign exchange established which is endogenously determined and operates akin to a tariff on imports. Domestic monetary policy in such a model is non neutral 2 with respect to trade, while trade liberalization (tariff reduction) merely changes the premium value on foreign exchange, in simple models, leaving trade unchanged. When we combine these two models we create a world in which monetary policy is non - neutral, and when services remain unliberalized there is some optimal trade intervention. Given monetary policy and an endogenously determined premium value on foreign exchange, an optimal setting of the exchange rate will provide the optimal trade intervention. By allowing for a freely floating exchange rate any departure from this optimal rate will typically inflict welfare losses. We present such a combined model, and illustrate these possible outcomes using numerical simulation. We would not pretend that this model realistically captures all of the relevant features of the financial and real sides of the Chinese economy, and hence may only be suggestive in its implication for current policy. But the implication that a more to a free float if services remain largely unliberalized (as in China today) seems clear and relevant, and should perhaps be kept in mind by those advocating a free Renminbi float. 3 2 A Simple Single-Country Model of Spatial and Inter-Temporal Trade We begin by presenting a single country version of the two country model presented by Huang, Whalley and Zhang (2004) which incorporates both spatial and inter-temporal trade. In this model monetary policy in its conventional form reflecting money as a means of exchange is absent, but there is inter-temporal trade possible in the sense of Duffie and Sharfer (1985) through established lines of credit. We can present the 2 period (t = 0, 1) 1 country 2 good (l = 1, 2) pure exchange international trade case of a small open price taking economy as follows. The country has a single representative consumer, with endowments of the two goods in each period (Elt ; t = 0, 1, l = 1, 2). For simplicity, a time-additive Cobb-Douglas utility function of the form U= 1 t=0 1 1 ut (X1t , X2t ) = u0 (X10 , X20 ) + u1 (X11 , X21 ) t (1 + ρ) 1+ρ t (1) t is used where ut (X1t , X2t ) = [X1t ]α1 [X2t ]α2 for t = 0, 1. This can be represented more explicitly as 0 0 U = [X10 ]α1 [X20 ]α2 + 1 1 1 [X 1 ]α1 [X21 ]α2 1+ρ 1 (2) where ρ is inter-temporal discount factor, Xlt denotes consumption of good l at date t, and αlt is share parameter for good l at date t ( 2l=1 αlt = 1). For any good l, in any period t, the exogenous world price is Πtl and we can allow the country to impose tariffs at rate Tlt on each imported good l (i.e. if Xlt ≥ Elt , then Tlt ≥ 0). Tariffs are set to zero for any export (i.e. if Xlt ≤ Elt , then Tlt = 0). Internal (gross of tariff) prices for good l at date t are thus Plt = Πtl (1 + Tlt ), t = 0, 1, l = 1, 2. (3) t = 0, 1 (4) These are also sellers prices of good l. Tariff revenues collected in period t are t R = 2 Πtl Tlt (Xlt − Elt )+ , l=1 where Elt denotes the initial endowment of good l, and the total income in period t is given by It = 2 Plt Elt + Rt , l=1 4 t = 0, 1. (5) To simplify matters, we assume that there is service autarky and that in this case as a strong assumption there are no intermediation services provided by domestic service providers. 1 This enables us to appeal directly to literature on multi-commodity inter-temporal mod- els from Radner(1972), Hart (1975), Duffie and Shafer (1985), Werner (1985), Duffie (1987), Geanakopolos (1990), Magill and Shafer (1991), and Magill and Quinzii (1996) in analyzing the effects of service liberalization in this model in a simple way. We do this without the added complication of uncertainty which is in practice central to this liberalization. Most of this literature is concerned with existence issues; our focus here is comparative statics. In the services autarky case, period by period budget constraints apply in each period t, i.e. 2 Plt Xlt = I t , t = 0, 1. l=1 These imply that 2 Πtl (1 + Tlt )Xlt = l=1 2 Πtl (1 + Tlt )Elt + Rt , t = 0, 1. (6) l=1 The combined budget constraint over the two periods is 2 1 t=0 l=1 which implies 2 1 t=0 l=1 Πtl (1 + Tlt )Xlt = Plt Xlt = 2 1 t=0 l=1 1 It t=0 Πtl (1 + Tlt )Elt + 1 Rt . (7) t=0 This simple treatment of services allows us to consider two different single country equilibria, one with period by period budget constraints, and the other only with across period budget constraints which reflects international liberalization of banking services with such services being supplied by foreign service providers. Moving from period by period budget constraints to an across period budget constraint can thus be thought of as allowing for inter-temporal intermediation in consumption activities across periods where non previously occurred. The interpretation is that initially there is autarky in trade in intermediation services since none can be provided domestically. We can then open up the economy to international trade in intermediation services, which are costlessly provided, as a simple form of trade liberalization in inter-temporal intermediation services. In this model, we can thus consider goods trade liberalization as a reduction in tariffs where no service liberalization occurs, or service liberalization 1 See the discussion of barriers to trade in intermediation services in practice in the Chen and Schembri (2002), Francois and Schuknecht (2000), Kalirajan, McHuire, Nguyen and Schuele (2001), and Mattoo (1999). 5 where no tariff liberalization occurs. We can also consider services liberalization in a tariff-free world, and tariff liberalization in a world either with or without service restrictions. Finally, we can consider joint tariff and services liberalization. This joint spatial inter-temporal economy can be thought of as one in which there are a series of spot markets in goods, and in the presence of services liberalization a system of asset markets which permit the transfer of income among spot markets in the sense first analyzed by Arrow (1964) and later by Hart (1975), Werner (1985), and Magill and Shafer (1991). It contrasts with earlier inter-temporal equilibrium formalizations of a set of Arrow-Debreu contingent commodity markets as in Debreu (1959). 2 The one single country equilibria we consider for this structure can be stated as follows. Definition 1 Country Equilibrium with Period by Period Budget Constraints (Service Autarky) A general equilibrium for this economy with period by period budget constraints is characterized by consumption of goods (Xlt : t = 0, 1; l = 1, 2) such that (Xlt ; t = 0, 1, l = 1, 2) solve the utility maximization problem subject to the period by period budget constraints (6), 1 u1 (X11 , X21 ) 1+ρ 2 2 Πtl (1 + Tlt )Xlt = Πtl (1 + Tlt )Elt + Rt , max U = u0 (X10 , X20 ) + s.t. l=1 t = 0, 1 l=1 Definition 2 Country Equilibrium with Across Period Budget Constraints (Service Liberalization) A general equilibrium for this economy with combined budget constraints over periods is characterized by consumption of goods (Xilt : t = 0, 1; l = 1, 2) such that (Xlt ; t = 0, 1, l = 1, 2) solves the utility maximization problem subject to the combined across period budget constraint (7), 1 u1 (X11 , X21 ) 1+ρ 2 2 1 1 1 Πtl (1 + Tlt )Xlt = Πtl (1 + Tlt )Elt + Rt max U = u0 (X10 , X20 ) + s.t. t=0 l=1 2 t=0 l=1 t=0 Hart (1975) showed that with uncertainty and hence incomplete markets an equilibrium may not exist, or an inefficient equilibrium may result. Werner (1985) discusses the general issue of existence for such economies; Magill and Shafer (1991) show among others results how in the certainty case the multi-commodity inter-temporal equilibrium is equivalent to one in which an interest rate is endogenously determined and equals the ratio of the shadow prices of period by period budget constraints for each of the individuals in the economy. 6 The combined across periods budget constraint (7) for can also be written as 2 Π0l (1 + Tl0 )Xl0 + F = 2 Π0l (1 + Tl0 )El0 + R0 (8) Π1l (1 + Tl1 )El1 + R1 + F (9) l=1 2 l=1 Π1l (1 + Tl1 )Xl1 = 2 l=1 l=1 where F represents the amount of lending (borrowing) by (from) one period to (by) another. The across period budget constraint equilibrium is the same as an equilibrium characterized by consumption of goods (Xlt : t = 0, 1; l = 1, 2) such that (Xlt ; t = 0, 1, l = 1, 2) solve the utility maximization problem subject to the budget constraints (8) - (9) 1 u1 (X11 , X21 ) 1+ρ 2 2 Π0l (1 + Tl0 )Xl0 + F = Π0l (1 + Tl0 )El0 + R0 max U = u0 (X10 , X20 ) + s.t. l=1 2 l=1 2 Π1l (1 + Tl1 )Xl1 = l=1 Π1l (1 + Tl1 )El1 + R1 + F l=1 Setting the interest rate for lending and borrowing equal to r, the combined budget constraints become 2 Pl0 (1 + Tl0 )Xl0 + F = l=1 2 2 Pl0 (1 + Tl0 )El0 + R0 (10) l=1 Pl1 (1 + Tl1 )Xl1 = l=1 2 Pl1 (1 + Tl1 )El1 + R1 + [1 + r]F (11) l=1 Thus, the across period equilibrium (service liberalization) is equivalent to an equilibrium with the same lending and borrowing interest rate, characterized by consumption of goods (Xlt : t = 0, 1; l = 1, 2) such that (Xlt ; t = 0, 1, l = 1, 2) solve the utility maximization problem subject to the budget constraints (10) - (11) 1 u1 (X11 , X21 ) 1+ρ 2 2 0 0 0 Pl (1 + Tl )Xl + F = Pl0 (1 + Tl0 )El0 + R0 max U = u0 (X10 , X20 ) + s.t. l=1 2 l=1 l=1 Pl1 (1 + Tl1 )Xl1 = 2 Pl1 (1 + Tl1 )El1 + R1 + [1 + r]F l=1 If tariff rates are zero on both products at both dates (Tlt = 0 for t = 0, 1 and l = 1, 2), then these equilibria are also free trade competitive equilibria. 7 Comparing across these equilibria in this simplified world enables the effects of services liberalization (in the sense assumed here) in the presence of restrictions on goods trade to be evaluated. Huang, Whalley and Zhang (2004) analyze a 2 country version of this structure and show examples where services liberalization in the presence of preexisting tariffs can be welfare worsening. They use this structure to raise the wider policy issue of whether service trade liberalization in GATS can be defended if goods trade is not free of restrictions. 8 3 A Model of Spatial and Inter-temporal Trade with Exchange Rates and Monetary Policy We now consider an extension of the simple 1 country 2 period (t = 0, 1) 2 good (l = 1, 2) trade model from previous section which now also captures exchange rate policy in a world with both services and goods and monetary non-neutralities. In this model domestic currency is needed to execute domestic transactions and foreign currency is needed for purchase of imports and yielded by sale if exports. We assume services remains unliberalized in the sense that budget constraints within period apply and consider changes in exogenous exchange rates, We again assume this country also has a single representative consumer with a time-additive Cobb-Douglas utility function of the form (1) and (2), and endowments of the two goods in each period (Wlt ; t = 0, 1 and l = 1, 2). To represent an equilibrium in the presence of foreign exchange rationing, we consider the case of a small open price-taking economy in which there is no production and all goods are traded. The world prices for 2 goods are given as Πtl for t = 0, 1 and l = 1, 2. The domestic (gross of tariff and gross of foreign exchange premia for imports) prices for 2 goods are denoted as Plt for t = 0, 1 and l = 1, 2. We assume that the government fixes the exchange rate at et , and requires all foreign exchange earned by exporters to be surrendered to the Central Bank at the rate et . It then allocates rights to purchase available foreign exchange at the same rate et to importers. We assume that exporters comply with this policy and fully meet the surrender requirement, even though there are obvious incentives for exporters to conceal foreign exchange and attempt to sell it on parallel (black) markets rather than surrender it at lower fixed rate. A simple modeling of the allocation process of foreign exchange among importers is to assume that the government auctions (or sells) foreign exchange. In practice, allocation schemes actually followed are more complex than this involving priority allocation of various forms, but we abstract from these. Under a simple auction scheme, if desired imports require more foreign exchange then the government offers for sale, the price of foreign exchange paid by importers will be bid up. This price will thus include a foreign exchange premium above the fixed rate et , which we designate as λt . This premium acts as a surcharge on foreign exchange bought by importers, and adjusts so as to clear the foreign market. The net effect of foreign exchange rationing in this case is akin to a general tariff on all 9 imports, since the exchange rate received by exporters differs from the gross of premium value exchange rate paid by importers. As modeled above, the foreign exchange premium accrues to the government, but if rights to purchase foreign exchange at the rate et are allocated by the government without charge, the premium would instead go directly to importers. t at date t is given by the value of domestic demands in The domestic demand for RMB MD domestic currency t MD = 2 Plt Xlt , t = 0, 1 (12) l=1 where r is interest rate. The domestic supply of RMB at date t is assumed set by the monetary authorities and is given by MSt . Because of the foreign exchange premium, relative domestic prices of the 2 traded goods will now differ from world prices, depending upon whether they are imported or exported. Domestic prices Plt are given by Plt = et Πt , l if Xlt − Wlt ≤ 0 (1 + λt )et Πt , l if Xlt − Wlt (13) ≥0 where Xlt − Wlt denotes the net import of goods l, and λt is the premium value over the official exchange rate paid by purchasers of imports. t at date t is given by the value of import The demand for foreign currency (US dollar) ND of goods t ND = 2 Πtl [Xlt − Wlt ]+ , t = 0, 1. (14) l=1 The supply of foreign currency (US dollar) NSt at date t is given by the value of export of goods NSt = 2 Πtl [Xlt − Wlt ]− , t = 0, 1. (15) l=1 The total demand for foreign currency is ND = currency is NS = 1 NSt 1 t=0 t ND . The total supply of foreign (1 + r)t . (1 + r)t The trade balance implies that the total value of import of goods is equal to the total value t=0 of export of goods, ND = NS , 1 t=0 2 2 2 1 1 1 1 t t t 0 0 0 Πl [Xl − Wl ] = Πl [Xl − Wl ] + Πl [Xl − Wl1 ] = 0. (1 + r)t 1+r l=1 l=1 l=1 10 (16) Total revenues accruing to sellers of rights to purchase foreign exchange at the rate et are t t t R =λe 2 Πtl [Xlt − Wlt ]+ , t = 0, 1 (17) l=1 These rents accrue either directly to the household sector as additional revenues of importers who are given allocations of foreign exchange by the government which they resell on premium markets, or indirectly as recycled government revenues. Because anticipated revenues Lt from rights of access to foreign exchange affect commodity demands and are a component of income for at least one of the agents in the model, market demand functions have to be rewritten to reflect this. Both Lt and Rt are each endogenously determined, and only in equilibrium Lt = Rt . The rationale for the homogeneity property assumed for demand functions can be seen from the budget constraint for the household sector, which includes initial holdings of money balances, and is given by It = 2 Plt Wlt + MSt + Lt , t = 0, 1 (18) l=1 If two periods are considered for this model with no trading allowed across periods, as in the earlier section, to represent unliberalized services trade in financial intermediation services, the total value of expenditures must satisfy the household budget constraint in each period, i.e., 2 0 0 0 0 l=1 Pl Xl + MD + F = I (19) 2 P 1 X 1 + M 1 = I 1 + (1 + r)F l=1 l D l where as in the earlier section F is the amount deposited to Central Bank, in this case, 2 2 0 0 0 0 0 0 0 l=1 Pl Xl + MD + F = l=1 Pl Wl + MS + L 2 P 1 X 1 + M 1 = 2 P 1 W 1 + M 1 + L1 + (1 + r)F l=1 l l=1 l D S l l e0 2 Π0 [X 0 − W 0 ] + (M 0 − M 0 ) + (R0 − L0 ) + F = 0 l=1 l D S l l e1 2 Π1 [X 1 − W 1 ] + (M 1 − M 1 ) + (R1 − L1 ) = (1 + r)F l=1 l D S l l and e0 2 l=1 Π0l [Xl0 − Wl0 ] + (20) (21) 2 1 1 1 1 Πl [Xl − Wl1 ] + (MD − MS ) + (R − L) = 0 e 1+r l=1 11 (22) 1 1 is total domestic demand for RMB, M = M 0 + 1 M 1 is total MD S S 1+r 1+r S 1 domestic supply for RMB, R = R0 + R1 is total revenues accruing to sellers of rights to 1+r 1 L1 is total anticipated revenues. purchase foreign exchange, and L = L0 + 1+r A country general equilibrium for this model is given by values of (λt , Lt ) which satisfy the 0 + where MD = MD conditions: [1] (Xlt : t = 0, 1; l = 1, 2) solves max s.t. U (23) 2 2 0 +F = 0 0 0 0 + MD l=1 Pl Wl + MS + L 2 2 1 1 1 1 1 1 1 l=1 Pl Xl + MD = l=1 Pl Wl + MS + L + (1 + r)F 0 0 l=1 Pl Xl [2] 1 t=0 2 1 et Πtl [Xlt − Wlt ] = 0 t (1 + r) and Rt − Lt = 0 f or t = 0, 1 (24) l=1 [3] t MD − MSt = 0 f or t = 0, 1 (25) In this model reflecting a model of foreign exchange rationing combined with the service and goods flow structure of the previous section, if services trade remains unliberalized there is an optimal trade intervention even for a small open economy. If tariffs are bound under WTO / GATT (as in China) monetary policy provides an instrument for achieving this optimal intervention. If monetary policy is given, an optimal exchange rate will exist, and any departure from this via a free float will impose welfare losses. 12 4 Some Numerical Simulation Results Yielding an Optimal Exchange Rate We have used the structure set out in Section 3 in numerical simulations which show how in the presence of given monetary policy (in the form of a setting on the size of the money supply), WTO bound tariffs on goods flows, and service trade remaining unliberalized, there will be an optimal exchange rate. In such cases welfare losses will occur with any move to a freely floating exchange rate, raising questions as to the desirability of a free Reminbi float in China. In our simulations we assume Cobb-Douglas preferences and consider a case where period by period budget constraints apply reflecting unliberalized services trade. The model parameter settings we use are given in Table 1. Table 1: Parameters Values Used in A 1 Country 2 Period 2 Good CD Model 1.1 Model Characteristics • Small Open Price Taking Economy • 1 Country 2 Period 2 Good • Cobb-Douglas utility function 1.2 Model Parameterization Utility Discount Rate ρ = 0.10 Share Parameters Good 1 Good 2 Period 1 0.50 0.50 Period 2 0.60 0.40 Initial Endowments Good 1 Good 2 Period 1 20 80 Period 2 25 75 World Prices Good 1 Good 2 Period 1 1.00 1.00 Period 2 1.00 1.00 Exchange Rates e0 = e1 = 1.50 Domestic Supply of Renminbi 13 MS0 = 120 and MS1 = 200 Table 2: An Equilibrium for the Model Parametrization Set Out in Table 1 Interest Rate Premium Rate r = 0.08871442 λ0 = λ1 = 0.10321541 Domestic Prices Good 1 Good 2 Period 1 1.65482311 1.50000000 Period 2 1.65482311 1.50000000 Utility Value U = 96.38235433 Consumptions Good 1 Good 2 Period 1 36.25765176 40.00000000 Period 2 72.51530352 53.33333333 Imports of Good 1 Exports of Good 2 Period 1 16.25765176 40.00000000 Period 2 47.51530352 21.66666667 Demand Supply Period 1 16.25765176 40.00000000 Period 2 47.51530352 21.66666667 Total 59.90114791 59.90114791 Imports and Exports US Dollar Total Revenue Income R0 =2.51706019 and R1 =7.35646700; R = 9.27408193 I 0 =275.6135 and I 1 =361.2270 Money Deposit F = 35.61352236 14 For this parametrization, we take monetary policy as given and then compute equilibrium solutions for alternative settings of the exchange rate to explore the behaviour of the optimal exchange rate. Table 2 presents an equilibrium solution for this model, given the exchange rate and monetary policy in Table 1. Figure 1 shows the optimal exchange rate for this case, and the welfare costs which would follow with a move to a freely floating exchange rate under which the premium value on foreign exchange is eliminated. Concave utility first increases then decreases when the exchange rate increases. It reaches a maximal value when the exchange rate e0 = e1 = 1.540198. Table 3 reports the utility loss when a freely floating exchange rate preruids. In this case the loss is relative small, but this emphasizes the presumption in favour of a fixed over a floating exchange rate in this case. Table 3: Maximum Utility when Exchange Rate Changes Exchange Rate (e0 = e1 ) Total Utility Value λ’s are endogenously determined 1.540198 96.40979619 λ0 = λ1 = 0 1.58497214323959 96.3790727500288 Table 4 and Figure 2 show the relation between utility and domestic money supply changes, since changed monetary policy provides a substitute instrument for exchange rate policy in this case. Concave utility first increases then decreases when RMB supply increases. It reaches a maximal value when RMB supply MS0 equals 112. Table 4: Utility when Domestic Supply of RMB Changes Domestic Supply of RMB MS0 Total Utility Value λ’s are endogenously determined 112.0000 96.41771120 λ0 = λ1 = 0 103.620927249971 96.3790727500288 Figures 3 - 6 report the behaviour of interest rate and premium values, when exchange rates and monetary policy vary. 15 Figure 1: Concave Utility form the Model in Table 1 when Exchange Rate Increases 96 94 92 90 1 1.2 1.4 1.6 Exchange Rate Exchange Rate --- Equilibrium Utility Value Figure 2: Concave Utility form the Model in Table 1 when RMB Supply Increases 97 96 95 94 93 100 150 RMB Supply RMB Supply --- Equilibrium Utility Value 16 200 Figure 3: Equilibrium Interest Rate Decreases when Exchange Rate Increases .2 .15 .1 .05 1 1.2 1.4 1.6 Exchange Rate Exchange Rate --- Equilibrium Interest Rate Figure 4: Equilibrium Premium Value Decreases when Exchange Rate Increases 1.5 1 .5 0 1 1.2 1.4 Exchange Rate Exchange Rate --- Equilibrium Premium Value 17 1.6 Figure 5: Equilibrium Interest Rate Increases when RMB Supply Increases .14 .12 .1 .08 100 150 RMB Supply 200 RMB Supply --- Equilibrium Interest Rate Figure 6: Equilibrium Premium Value Increases when RMB Supply Increases .8 .6 .4 .2 0 100 150 RMB Supply RMB Supply --- Equilibrium Premium Value 18 200 5 Concluding Remarks This paper presents a model of international trade with both inter-temporal and spatial trade motivatedly by current debate on Reminbi revaluation in China. In this model if intertemporal trade is restricted by service regulation, even for a small open price taking economy free trade in goods will typically not be the best policy. A fixed exchange rate policy with a surrender requirement on exporters and rationing (or auctioning) of foreign exchange among importers can then be a welfare improving intervention compared to a free floating exchange rate. In China with services unliberalized until 2007 when the terms of China, WTO accession apply (see Whalley (2003)) and tariff rates bound under WTO accession terms this analysis seems relavant to the present debate. While this analysis may not be fully realistic of the situation in economies such as China under international pressure to liberalize the exchange rate regime, it does provide possible inter-lectural coherence to a position opposed to seeming international conventional wisdom that China’s best policy is to move to a free float. 19 References [1] Arrow, K.J. 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