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 * **China, in response to the global recession, responded as did many countries including the U.S., by increasing the money supply through an economic stimulus. Now that the Chinese economy is rebounding the Central Bank of China is considering raising interest rates. Discuss the economic effect on both China and the U.S. should Chinese domestic interest rates rise dramatically and exceed those of the U.S.**

//Team: Below is Galina Hale's response to the email I sent her. I answered back ( I copied you all on my response). Hopefully, she'll respond back.... DaShawn//

I am not sure I understand the question - aren't chinese interest rates already higher than the us?

Sent from my mobile device

Galina Hale Senior Economist, Research Department Federal Reserve Bank of San Francisco 101 Market St., MS 1130 San Francisco, CA 94105 (415) 974-3131; fax (415) 974-2168

//Hey Team: This Facebook response was sent to me from a high-school friend (Trenton Tipton-Fletcher) who majored in finance and [|economics]. He's currently a [|private investor] after working in the corporate world for 20 years. DaShawn//

[|**Trenton Tipton-Fletcher**] The China question: The trouble with this issue is that the currency is fixed or pegged to the dollar. If the remnembi floated freely it would certainly appreciate substantially without any increase in rates. Higher rates would only exaggerate the effect. Assuming the currency adjustment, higher rates would ultimately cool the Chinese economy and send prices higher in the U.S. Walmart would no longer be the source of bargains. The trade deficit with China would be reduced (can't remember the J-curve effect at this hour). Even if the currency remains pegged, investment in China (foreign & domestic) would be diminished as project hurdle rates would rise with rates. Similarly, investment would rise in the U.S. as hurdle rates stay relatively low. Does that make sense? Does it help? [|[delete]]

Higher interest rates in China will indeed tighten the money supply in China. However, higher interest rates bring increased inflation and higher prices. With this, consumption will slow and their currency value should increase. With their currency value rising, their goods become more expensive to import by other countries. As China tightens the money supply, this will more than likely affect their current purchasing behavior of U.S. Treasury Bonds. Between the U.S. Federal Reserve and China, they have been the largest purchasers of U.S. Treasury Bonds. In order to keep U.S. interest rates low, U.S. Treasury Bonds were sold. So, if China tightens up their money supply, they will incur higher interest rates, which will prevent them from buying U.S. Treasury Bonds at their current pace. So, as China decides to tighten their money supply up by higher interest rates, this will have a direct affect on the U.S. interest rates. U.S. interest rates will increase as China’s purchasing of U.S. Treasury Bonds slows.

Is this a good thing? Not sure, it really depends on the rate of purchasing China adjusts to and if the U.S. Federal Reserve can increase their purchases of U.S. Treasury Bonds. In any case, China’s interest rates should increase at a more rapid pace than the U.S. If China’s currency value increases and their products become more expensive, this will have a positive affect on the U.S.

Some economists challenge the theory that high interest rates result in inflation. While the higher cost of credit does result in an increased cost of doing business which would be passed along to the consumer in the form of higher prices, this inflation occurs at a much lower rate than the inflation that results from an uncontrolled flow of currency into the system by a continued policy of low interest rates. Therefore, higher interest rates should result in a relatively lower rate of inflation in China.

In the event that inflation continues in China, the Chinese consumer will have more renminbi to spend since wages should rise along with inflation (although not necessarily keeping pace with the increased price of goods). While these renminbi in the hands of the Chinese consumer may buy fewer Chinese goods due to inflation within China, U.S. goods will become more affordable to the Chinese consumer. This is true because the exchange rate between the renminbi and the dollar (and other world currencies) is fixed. This means that a Harley-Davidson that cost 800,000 renminbi before inflation set in will still cost 800,000 renminbi after a sever inflationary period. However, the motorcycle will be more affordable to the Chinese consumer because the Chinese consumer will earn these 800,000 renminbi more quickly than before due to their inflated wages. This will therefore drive U.S. exports and potentially provide a boon to the U.S. economy. This result is in line with a broader Chinese policy of creating a stronger consumer class in China that will lead the way to an economy that relies not only on exports but on consumerism -- along the lines of the U.S. economy.

A dramatic increase in the interest rate could cause some problems domestically as well. China has relied on the high growth rate to keep millions of people employed. The interest rate increase could cool down the growth and increase unemployment. Rural China would be hit the hardest and are areas known for economic hardship or dissatisfaction with the government can often lead to protests and unrest. I would also think that interest rates that exceed those of the US would make investment in the US less attractive, not only to the Chinese, but the rest of the world. Investment in China should increase as the return investment will be greater. This may even counteract some of the unemployment issues that arise from the tightened money supply. New investment in China would increase the money supply and put people to work. On the US side, much the opposite could occur. With investment moving out of the country, there would be less capital to lend, tightening credit, slowing growth and even increasing unemployment.