| Over the past decade, China has experienced two important macroeconomic phenomena, and undervalued exchange rate and low interest rates. This thesis uses a stock flow consistent model to explore these issues. This is a post Keynesian method of macroeconomic modeling. Along with examining the effect of an undervalued exchange rate and low interest rate, the effectiveness of this method in modeling China’s economy will be shown.In order to understand the specialties of post Keynesian economics, it can be compared with the currently dominant new classical school. After world war two, Keynesian economics became dominant and eventually split into the above mentioned two schools. Neo-classical economists use the following methods:the quantity theory of money and inflation, general equilibrium and rational maximizing agents. Post Keynesian Economists generally reject these, and use other methods including non-rational agents, mark-up pricing and multiple equilibrium models. In particular, the model used in this thesis will use the following post Keynesian techniques: demand lead growth, mark-up pricing, endogenous money supply, many interest rates and an explicitly modeled financial sector.Since2000, there have been several clear macro-economic trends in China. Most often reported in the media was China’s undervalued exchange rate. Related to this are issues surrounding China’s balance of payments, a large current account surplus and a corresponding large financial account deficit. Internally the economy is also seen as being out of balance. When compared to consumption Investment as a share of GDP is very high by historical standards. Another trend that stands out is the large accumulation of foreign reserves by the central bank. This thesis will show how these trends are related to low a low interest rate and an undervalued currency.A related concept is financial repression. China’s current financial system has in place several polices which can be classified as financial repression including, interest rates set by the government, high bank reserve requirements and capital controls. These polices are used to control the "natural" workings of financial markets. The government puts these polices in place for its own benefit. In China these benefits include low interest rates, which means interest payments on government securities are low and sterilization costs from having a fixed exchange rate are also kept low. The model used in this thesis will explicitly model the effects of financial repression.The modeling method used in this thesis is adopted from the book "Monetary Economics" by Wynne Godley and Marc Lavoie. This is a post Keynesian modeling method, which has also been influenced by the mainstream economist, James Tobin. In order to study China’s trade imbalance, this the sis’s model needs to be an open economy with at least two countries. In order to study the effect of interest rates on investment and economic growth, the model used also must include economic growth. Therefore, this thesis’s model is broken into two countries, china and America. The economic sectorsthat are modeled include households, enterprises, banks, the central bank and government. These sectors interact with each other using the following types of transactions, consumption, investment, international trade, government expenditure, taxes, wages, interest payments and changes in the stock of loans, government bills and deposits.These transactions are represented in the model by behavioral equations. The model assumes fixed wages and costs, which means that the price level is fixed. Important behavioral equations include those determining investment, consumption, interest rates and government bill demand. Investment is determined by capacity utilization and the interest rate on loans. Consumption is determined by households propensity to consume and their disposable income. Bill and loan interest rates are fixed by the central bank, while deposit interest rates can float in order to keep banks profitable. Demand for government bills is set by demand from banks and the central bank. International trade is determined by a propensity to import and the exchange rate. Any changes in the exchange rate are assumed to be deviations from purchasing power parity between the two countries.In order to understand the above described phenomena’s impact on China’s economy, the impact on the model of low interest rates and an undervalued is examined. These are modeled as exogenous shocks to the economy, and then the model is iteratively run to examine the long term effects of these shocks.After running these shocks through the model, we are able to reach several conclusions:1. The model used by this thesis does a good job in modeling the effects of an undervalued currency and a low interest rate on the Chinese economy. The major trends in the model match those of the historical record.2. In the model, an undervalued exchange rate leads to a current account surplus and a financial account deficit. Because the central bank keeps the interest rate fixed, they must adjust the supply of bills to match demand. If the central government does not supply enough bills, the central bank must offer its own bills. This is a type of "sterilization policy," however it is not used to control inflation, but to maintain a certain interest rate.3. A low exchange rate and limited financial products leads to a transfer of benefits from households tofirms. This process is intermediated by the banks.4. A low interest rate indirectly leads to an increase in the growth rate of capital investment and GDP. This also means that corporate profits will increase when interest rates are low.5. If the interest rate on bills issued by the central bank is higherthan the American bills it holds as reserves than the central bank will lose money. An undervalued exchange rate leads to a large accumulation of American bills so it increases this danger. A low interest rate policy can prevent this loss from happening. 6. When China has a current account surplus, savings must be higher than investment. This means that relative to a time when there is no surplus, the amount of deposits is higher and the amount of loans are lower. In order to preserve bank profitability, the spread between the loan and the deposit rates must be increased. |
PDF Full Text Request