The negatives of a stronger Chinese currency—higher prices and lower exports for the U.S.—offset the positives.

The Yin and Yang of Yuan Appreciation. By RAY C. FAIR
The negatives of a stronger Chinese currency—higher prices and lower exports for the U.S.—offset the positives.WSJ, Jun 01, 2010

China is under increasing U.S. pressure to allow its currency to appreciate. Many argue that a yuan appreciation would result in more American jobs. Late last year New York Times columnist Paul Krugman said his "back-of-the-envelope" calculation suggested that if there is no appreciation, then over the next several years what he calls "Chinese mercantilism" "may end up reducing U.S. employment by around 1.4 million jobs."

But that's by no means a foregone conclusion. The question of what a Chinese appreciation of the yuan would do to the world economy is complicated. There are many economic links among countries, and they need to be accounted for in analyzing the effects of exchange-rate changes. The standard link that has been stressed in the media is that if the yuan appreciates, Chinese export prices rise in dollars and the U.S. substitutes away from now more expensive Chinese exports to now relatively cheaper American-produced goods. This is good for U.S. output and employment—U.S. jobs are created.

A second link is that China may buy more U.S.-produced goods because they are now cheaper relative to Chinese-produced goods. (The yuan price of U.S. produced goods is lower because a given number of yuan buys more dollars than before.) This is also good for U.S. output and employment.

A third link is that China's output is lower because it is exporting less. With a less robust economy, China imports less, some of which are imports from America. So from this link U.S. exports are lower, which is bad for U.S. output and employment. The second link is a relative price link—China substitutes towards U.S.-produced goods. The third link is an income link—China contracts and buys fewer imports. Which link is larger is an empirical question.

A fourth link is what I will call a U.S. price link. Import prices on Chinese goods are higher. When shoppers go to Wal-Mart they will find higher prices on Chinese-produced goods. This may lead some U.S. firms to raise their own prices since Chinese price competition is now less. So prices in the U.S. will rise. An increase in U.S. prices leads to a fall in real wealth and usually a fall in real wages, since nominal wages usually adjust slowly to increasing prices. This is bad for U.S. consumption demand and thus for U.S. output and employment. In addition, the Federal Reserve may raise interest rates in response to the increase in prices (although probably not much in the present climate), which decreases consumption and investment demand.

Other issues that matter when analyzing the effects of a yuan appreciation against the dollar are what the euro, pound and yen do relative to the dollar, what the monetary authorities in other countries do, and how closely tied countries are to each other regarding trade. One needs a multi-country model to take into account all these effects. I have such a model and have used it to analyze the effects on the world economy of a Chinese yuan appreciation against the dollar. It turns out that the two positive links mentioned above are roughly offset by the two negative links—the net effect on U.S. output and employment is small. The net effect is in fact slightly negative, but given the margin of uncertainty the bottom line is roughly no net effect at all.

It thus seems to be the case, at least from the properties of my model, that the two negative links mentioned above are larger than many people realize. Chinese output is down enough to have a nontrivial effect on Chinese imports. In addition, the negative effects from the increase in U.S. prices are nontrivial. It seems unlikely that there will be a large increase in U.S. jobs if the yuan does in fact appreciate, contrary to what many think.

Mr. Fair is a professor of economics at Yale University.