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IN 2005, CHINA ENDED its policy of maintaining a firm exchange rate for its currency, the renminbi (RMB). Instead of being pegged to the US dollar, the RMB was now going to be allowed to float with respect to a basket of currencies chosen by the Chinese government. This would allow the RMB to artificially replicate a fully free-market floating currency. However, the RMB was not to be allowed to move completely freely - it could only float about 0.3% around a central parity estimate given by China. This band was later increased to 0.5% in 2007. Despite this seemingly small floating capability, the RMB has appreciated about 21% since 2005.
In spite of this appreciation, several American politicians still argue that the RMB is undervalued and, in the midst of a financial crisis, they are turning their eyes to China to find an easy escape from a recession. They want China to appreciate its currency so that US products can perform better in both domestic and international markets, which they argue would alleviate the recession by increasing production. However, the truth of the matter is not as simple as portrayed.
As in any open economy, imports flow into the country and...