366 | P A R T I V Business Cycle Theory: The Economy in the Short Run

the fixed exchange rate. That is, the Chinese central bank had to supply yuan and demand dollars in foreign-exchange markets to keep the yuan at the pegged level. If this intervention in the currency market ceased, the yuan would rise in value compared to the dollar.

The pegged yuan became a contentious political issue in the United States. U.S. producers that competed against Chinese imports complained that the undervalued yuan made Chinese goods cheaper, putting the U.S. producers at a disadvantage. (Of course, U.S. consumers benefited from inexpensive imports, but in the politics of international trade, producers usually shout louder than consumers.) In response to these concerns, President Bush called on China to let its currency float. Senator Charles Schumer of New York proposed a more drastic step—a tariff of 27.5 percent on Chinese imports until China adjusted the value of its currency.

In July 2005 China announced that it would move in the direction of a floating exchange rate. Under the new policy, it would still intervene in foreignexchange markets to prevent large and sudden movements in the exchange rate, but it would permit gradual changes. Moreover, it would judge the value of the yuan not just relative to the dollar but also relative to a broad basket of currencies. By January 2009, the exchange rate had moved to 6.84 yuan per dollar—a 21 percent appreciation of the yuan.

Despite this large change in the exchange rate, China’s critics continued to complain about that nation’s intervention in foreign-exchange markets. In January 2009, the new Treasury Secretary Timothy Geithner said,“President Obama—backed by the conclusions of a broad range of economists—believes that China is manipulating its currency. . . . President Obama has pledged as president to use aggressively all diplomatic avenues open to him to seek change in China’s currency practices.” As this book was going to press, it was unclear how successful those efforts would be. ■

12-6 From the Short Run to the Long Run: The Mundell–Fleming Model With a Changing Price Level

So far we have used the Mundell–Fleming model to study the small open economy in the short run when the price level is fixed. We now consider what happens when the price level changes. Doing so will show how the Mundell–Fleming model provides a theory of the aggregate demand curve in a small open economy. It will also show how this short-run model relates to the long-run model of the open economy we examined in Chapter 5.

Because we now want to consider changes in the price level, the nominal and real exchange rates in the economy will no longer be moving in tandem. Thus, we must distinguish between these two variables. The nominal exchange rate is e and the real exchange rate is e, which equals eP/P*, as you should recall from Chapter 5. We can write the Mundell–Fleming model as