Monetary Economics 101 -- Quiz Answers

Ok folks. Here are my answers to the quiz I gave you yesterday. If you feel different, post your comments.

1) Why is China selling T Bills = quantitative easing of US money supply?

Answer: Selling T Bills by China to the US means Uncle Sam is buying them. Buying T bills means more US dollars are injected in the monetary system which is equivalent to quantitative easing as Paul Krugman stated.

No other countries except the US would a) take on the sizes of T Bills China wants to sell, and b) why would they buy more US T Bills when the currency is likely to go lower anyway. In other words, China can only sell the T Bills back into the US system. Either the US government buys them back immediately or they will end up buying them at some point as another buyer cashes in at maturity.

2) What "harm", if any, would that cause to Japan and Europe?

Answer: Krugman assumes China would use the sales proceeds from T Bills to buy non-US currencies such as Yen and Euro driving them higher hurting their exports.

2) In what way, if any, US has "nothing" to fear?

Answer: I believe Krugman assumes China would prefer to have a low US dollar to which the RMB is more or less tied. The dollar is also the universal unit of exchange in global trade.

In this logic while Beijing keeps bitching about the lower dollar that is diminishing the value of its $2.2T + reserves -- if translated into Euro or Yen, the Chinese government is also benefiting from a higher than otherwise rate of exports from a lower dollar.

Then there is the issue of liquidity. The dollar remains the most liquid global currency. China if it tries to diversify large amounts of its reserves into Euro or Yen will be chasing after higher Euro or Yen caused by its own buying.

Once the currency market knows China is buying Euro or Yen, these 2 currencies will go through the roof as traders will front run Chinese purchases forcing Beijing to pay higher and higher for non US currencies. Don't forget the market for Euro and Yen are much smaller than US$. Very quickly China will be overpaying.

3) In what way, if any, China selling US dollars massively could be negative?

Answer: I will still let you think this through. Until I post my own view, have fun.