Why China Should Keep its Dollar Peg: A Historical Perspective from Japan

This paper establishes the monetary rationale for China to use its dollar peg as an anchor for its domestic price level, thereby avoiding a zero interest liquidity trap. As a prelude, the author’s own monetary approach to the nominal exchange rate and price level is contrasted with the emphasis many economists place on the need to change real exchange rates to “correct” trade imbalances. The paper then compares the situations of China and Japan and concludes that, in the long run, in both China and Japan, exchange rate stability against the dollar is needed to prevent unduly low interest rates and deflationary traps. The author hypothesizes that if both China and Japan successfully stabilize their dollar exchange rates the smaller Asian economies likely will follow suit.