A Study into the Equilibrium Exchange Rate of RMB

Abstract

Beginning from the classical theory of purchasing power parity, we will probe into the reasonability of RMB exchange rates step by step. Purchasing power parity requires that the de facto exchange rate should remain constant, which is not true in reality, because real impact, such as productivity improvement, would change the de facto exchange rate. The Balassa-Samuelson effect makes amendment to this theory; however, its conclusion is just the opposite of China’s condition, which implies productivity improvement may lead to the rise of the de facto exchange rate. This article makes an in-depth analysis of that theory and modifies the hypothesis. Finally we make a theoretical model on RMB's de facto exchange rate conforming to China’s condition and make verification based on the current situation, which gives a good explanation of the fluctuation of RMB exchange rate empirically.