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Currency Internationalization and the International Price System.


After the devastating 2008-09 global financial crisis, many monetary economists urged diversification of the international monetary system to reduce its over-reliance on single currencies, especially U.S. dollar (e.g., Zhou 2009; Lietaer and Belgin 2012). In response, China, now the world's second largest economy and largest goods-trading nation, began to strategically internationalize its national currency, the renminbi (RMB), in 2009. Since then, RMB internationalization developed rapidly (e.g., Eichengreen and Kawai 2014). On October 1, 2016, the The RMB also joined the U.S. dollar, euro, Japanese yen, and British pound and became the fifth Special Drawing Right currency of of the International Monetary Fund (IMF).

Indubitably, the internationalization of RMB will have profound impacts on the international financial system. On one hand, it may benefit the international monetary system by reducing its over-reliance on single international currencies in settling international trade and finance (Dorrucci and Mckay 2011; Eichengreen 2011). On the other hand, the sequencing of RMB internationalization would also create new systemic risks for the international economy, as China is still a developing country with heavy foreign exchange and capital account intervention (Kroeber, 2013; Jin et al. 2015; Jin and Wang, 2017).

Unfortunately, in stark comparison to the rapid internationalization of RMB in practice during the past decade, the development of associated macroeconomic models currently lags far behind, posing a significant challenge in tackling the ensuing systemic risks of RMB internationalization on the international economy, such as the 2014 American immigration crisis and the 2015-16 stock market turbulence in China.

To fill in this gap, this paper develops a two-country, China and the U.S., and two-goods model to investigate the implications of the internationalization of the renminbi (RMB, Chinese currency) on the international price system, one of the most fundamental elements of the international economy. In particular, following Batten and Szilagyi (2016), the model captures the internationalization of RMB and subsequent reduction of the liquidity premium of dollars. Results show that in the absence of home bias, RMB should be overvalued against its balanced level, however, the misalignment rate does not exceed a certain level to sustain the internationalization of RMB. Therefore, as the liquidity premium of dollars drops, RMB must be devalued accordingly. However, results also reveal that equilibrium goods prices are highly sensitive to exchange rate adjustments, which suggests that governments should rein in additional inflation and exchange rate controls to achieve international price stability.

The Model

Consider an international economy consisting of only two countries a local currency issuer and international currency issuer, China and the U.S. Both countries produce two goods A and B, with China having comparative advantage in A and the U.S. in B. In the international market, the U.S. currency, the dollar (USD), can be directly used to purchase both goods. The Chinese currency, RMB, in comparison, can only be used to purchase A, the Chinese exportable good. To import B from the U.S, the Chinese must first convert their RMB to dollars, which would inevitably incur some iceberg costs, e.g., red tape cost and shoe leather cost, to Chinese consumers. The RMB internationalization is defined as the reduction of the iceberg cost of converting RMB to dollars. We now investigate the implications of this type of RMB internationalization on the international price system.


Suppose the relative importance of two goods A and B are equal to 1/2 in both countries' consumption baskets, and the aggregate consumption in country i = c (China), u (U.S.), is defined as the following constant elasticity of substitution (CES) aggregator:

[mathematical expression not reproducible] (1)

where [C.sup.i.sub.h], [C.sup.i.sub.f] are total consumptions on the home (exportable) and foreign (importable) goods in country i, respectively; 1/[phi] > 0 is the elasticity of substitution between two goods, which takes the same value for both countries. In particular, [phi] > 1 implies the two goods are gross substitutes, while [phi] < 1 implies the two goods are gross complements. Moreover, as [phi] converges to 0, 1 and [infinity], the aggregator reduces to linear, Cobb-Douglas (C-D), and Leontief functions, respectively.

Inflation Controls

Although both currencies can serve as international currencies, we assume the two countries also implement monetary policies independently. Without loss of generality, we assume the aggregate consumer prices in both China and the U.S. are maintained as constants, since inflation-targeting has become a primary tool for monetary controls in most major economies (Roger, 2010). Accordingly, the aggregate consumer price in country i, measured by country i's currency, can be written as:

[mathematical expression not reproducible] (2)

where [P.sup.i.sub.h], [P.sup.i.sub.f] are prices of home and foreign goods; [P.sup.i] is the targeted price/inflation level.

RMB Internationalization

In international markets, dollar-holders can directly use dollars to purchase Chinese goods from exporting agencies or designated free-trade zones in China. However, to purchase U.S. exportable goods, the Chinese consumers must first convert RMB to dollars, which inevitably generates a liquidity premium of dollars over RMB in the international economy (Batten and Szilagyi 2016). Assuming full exchange rate pass through, the relationships between goods prices in China and the U.S. can be defined as follows:

[P.sup.c.sub.f] = e[P.sup.u.sub.h]/(1-[theta]), [P.sup.u.sub.f] = [P.sup.c.sub.h]/e, (3)

where [P.sup.c.sub.h], [P.sup.c.sub.f] denote home and foreign price of Chinese goods and [P.sup.u.sub.h], [P.sup.u.sub.f] are the home and foreign price of U.S. goods, 0 [less than or equal to] [theta] < 1 represents the liquidity premium of dollar over RMB in international trade and finance. e is nominal exchange rate i.e., the RMB price of dollar, which represents the amount of RMB required to purchase U.S. dollars.

RMB internationalization is defined as the reduction of the liquidity premium of dollar over RMB, [theta]. (1) Obviously, full RMB internationalization implies a zero dollar liquidity premium, [theta] = 0. In this case, both currencies are equally used in international markets, and the law of one price (LOOP) holds perfectly for both types of goods. In the following section, we will investigate the implications of this type of currency internationalization on the global price system [P.sup.c.sub.h], [P.sup.c.sub.f], [P.sup.u.sub.h], [P.sup.u.sub.f] and e.

Currency Internationalization

Noticing that [[bar.P].sup.i] are fixed in (2), we see that [P.sup.i.sub.h] and [P.sup.i.sub.f] move in opposite directions. Once we determine the change in one variable, the change of the other can be calculated immediately. Moreover, as the nominal exchange rate e is also strictly controlled by the Central Bank of China, the global price system can be further simplified as {[P.sup.c.sub.h], [P.sup.u.sub.h]). From (2) and (3) we have:

[mathematical expression not reproducible] (4)

where [P.sup.i.sub.h] = [([P.sup.i.sub.h]).sup.l -[phi]], [[bar.p].sup.i] = [([[bar.P].sup.i]).sup.l -[phi]], i = c, u; [epsilon] = e[[bar.P].sup.u]/[[bar.P].sup.c] is the real exchange rate. We now investigate the currency internationalization condition and its implications on the global price system.

Currency Internationalization Condition

First, we examine the condition that needs to be satisfied to guarantee the coexistence of dollars and RMB in international markets. Specifically, as all goods prices must be positive in reality, (4) implies lower and upper boundaries of the real exchange rate:

1 - [theta] < [epsilon] < 1, (5)

which means that in the absence of home bias, the RMB on one side must be overvalued ([epsilon] < 1) against its balanced level, while on the other side it cannot be overvalued too much during internationalization. The overvaluation rate must be smaller than the liquidity premium of dollars. (2) Violations to either boundary condition would yield a zero or negative goods price in the international market and, hence, cannot be practically sustainable. In this sense, we refer to (5) as the currency internationalization condition.

Furthermore, without loss of generality, normalize the targeted aggregate price levels to unity in both countries, i.e., [[bar.P].sup.i] = 1. Accordingly, the nominal exchange rate and real exchange rate are interchangeable: [epsilon] = e. Plugging these two equations into (4), we have

[mathematical expression not reproducible] (6)

where [epsilon] [member of] (1 - [theta], 1) and [phi] [not equal to] 1. (3) Differentiating (6) with respect to [theta] yields

[mathematical expression not reproducible] (7)

It follows that

[mathematical expression not reproducible] (8)

In other words, as 1 - [theta] increases to [epsilon], or 9 decreases to 1 - [epsilon], the price ratio of Chinese and U.S. home goods, [P.sup.c.sub.h] / [P.sup.u.sub.h], decreases steadily to zero if the two goods are complements while increases exponentially to infinity if the two goods are substitutes (Figure 1). (4) Clearly, both results are not desirable in reality. Therefore, as the liquidity premium of the dollar diminishes, RMB must be devalued accordingly to avoid the collapse of the international price system. Naturally, when RMB is fully internationalized (9 = 0), the real exchange rate would also converge to its balanced level ([[epsilon].sub.b] = 1).

Exchange Rate Adjustment on the International Price System

The previous section shows that exchange rate adjustment is also crucial to sustain the internationalization of RMB. We now investigate the implications of exchange rate fluctuations on international price stability. Without loss of generality, suppose that the real exchange misalignment rate is proportional to the dollar liquidity premium: [epsilon] = 1 - [lambda][theta], where [lambda] [member of] (0,1) is a constant coefficient. In this case, (6) would reduce to

[mathematical expression not reproducible] (9)

Therefore, even if the real exchange rate converges to its balanced level, the price ratio of Chinese and U.S. goods would still be indefinite. In particular, as A increases from 0 to 1, [P.sup.c.sub.h] /[P.sup.u.sub.h] increases from 0 to infinity if the two goods are substitutes ([phi] > 1), while [P.sup.c.sub.h]/[P.sup.u.sub.h] decreases from infinity to 0 if the two goods are complements ([phi] < 1). In other words, the equilibrium global price system is highly sensitive to exchange rate adjustments. As a result, governments may find it imperative to rein in additional inflation and exchange rate controls to achieve international price stability.


We have developed a two-country, two-goods model to investigate the key implications of the Chinese style currency internationalization on the international price system. We find a couple of interesting results that can serve as a useful reference for related issues. First, results show that to sustain currency internationalization, RMB must be overvalued initially but then be devalued gradually as the liquidity of dollars diminishes. Moreover, the RMB-USD exchange rate adjustment trajectory also has significant impacts on the final real price ratios of Chinese and U.S. goods, even if the exchange rate converges to its balanced level. This suggests that governments should seek to rein in additional inflation and exchange rate controls to sustain international price stability.

However, it worth noting that there are a number of study limitations. The first is that the model ignores all risk sharing and transmission issues and characterizes the international price system as the convergence of LOOP, yet the world economy is usually characterized by large deviations from LOOP due to the inefficiency of international risk sharing. The other limitation is the simplicity of the model, which does not contain any specific production function or policy rules. Therefore, the results of the present model should only be viewed as qualitative but not be treated as definitive criteria. For more realistic results, one would need to develop a comprehensive dynamic general equilibrium model to precisely investigate the international risk sharing and interaction among consumers, producers, and policymakers.


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Hailong Jin (1) * Wisdom Takumah (2) * Josiah Jorenby (1)

[??] Hailong Jin

(1) South Dakota State University, Harding Hall, 881 Campanile Ave, Brookings, SD 57007, USA

(2) Emory University, Rich Building, 1602 Fishburne Drive. Atlanta, GA 30322, USA

(1) In reality, this can also be reflected by the reduction of the liquidity premium of the RMB in the offshore market over the RMB in the onshore market (Cheung and Rime 2014).

(2) When there exists home bias in consumption functions, the real exchange rate will face similar lower and upper bounds, though of different values. For example, if the two goods are substitutes ([phi] > 1) and the two countries share the same home bias, then the constraint of the real exchange rate can be written as: [mathematical expression not reproducible], where a > 0.5 represents the home bias.

(3) For C-D consumption function ([phi] = 1), the limit docs not exist: [mathematical expression not reproducible] while [mathematical expression not reproducible].

(4) In simulation, the literature usually sets gross elasticity of substitution slightly above unity (e.g.. Backus et al. 1994; Hcathcote and Pcrri 2002; Engel and Matsumoto 2009). Nonetheless. Feenstra et al. (2012) estimate that the gross elasticity is not significantly different from one. Thus, we use four values of [phi] in the simulation: 0.7. 0.9, 1.1, and 1.3.
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Author:Jin, Hailong; Takumah, Wisdom; Jorenby, Josiah
Publication:International Advances in Economic Research
Article Type:Report
Geographic Code:9CHIN
Date:Nov 1, 2018
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