Free-Response Question

1. Question

   Draw a correctly labeled graph showing equilibrium in the U.S. foreign exchange market for Chinese yuan.

   
   

   
   

   1. Assume the real interest rate in China falls relative to the real interest rate in the United States. Show the impact of the change in the real interest rate on each of the following.

      
      
      
      

      1. The demand for Chinese yuan. Explain.

         
         
      
      

      2. The value of Chinese yuan relative to the U.S. dollar.

         
         
      
      
      
      
   
   

   2. Assume that the U.S. current account balance is zero. Based on the change in the value of the yuan, will the U.S. current account balance move to a surplus, move to a deficit, or stay the same? Explain. (6 points)

      
      
   
   

   Rubric for FRQ (6 points)

   1 point: A foreign exchange market graph labeled “Dollar/yuan” on the vertical axis and “Quantity of yuan” on the horizontal axis, with a downwardsloping demand curve and an upward-sloping supply curve.

   1 point: The equilibrium exchange rate is labeled on the vertical axis and the equilibrium quantity of yuan is labeled on the horizontal axis, and both values correspond with the intersection of the supply and demand curves.

   1 point: The demand curve shifts to the left and a new, lower value of the Chinese yuan is labeled on the vertical axis to the left of the new equilibrium point.

   1 point: The demand for Chinese yuan decreases because the lower real interest rate in China leads to lower returns on financial investments, which decreases capital inflow from the United States.

   1 point: The U.S. current account balance will move to a deficit.

   1 point: The decrease in the value of the Chinese yuan will decrease U.S. exports to China and increase U.S. imports from China, because U.S. exports become more expensive and imports from China become less expensive. These changes result in a current account deficit in the United States.