China is one of the few countries in the world to have a fixed exchange rate. In the past, it has experienced a huge increas in exports of goods. Use a "FOREX" diagram to show the effect of the increase in exports. In your answer you must explain the effect of the export surge on the money supply, the holdings of the Chinese Central Bank of gold and foreign exchange, the Current Account and Capital Account balances, and on China's overall Balance of Payments. For convenience you can assume that the Current Account is in deficit and the Capital Account is in surplus

I know the export increase will results in the large demand for Chinese currency, therefore in the demand-supply graph,the demand curve for chinese currency will shift rightwards, this should reduce the exchange rate, however the government use fixed exchange rate policy, so it requires the government to buy foreign currency or gold to satisfy this excess demand.

Overall the money supply of Chinese currency will increase, the GFE(CB) will increase. But how about the rest? the Current account and Capital Account balances? Why the question mention the 2 assumptions?

To analyze the effects of the export surge on China's economy, we can use a "FOREX" diagram which shows the relationship between supply and demand for a currency in the foreign exchange market.

1. Effect on Money Supply (M):

With an increase in exports, there will be a greater demand for Chinese goods and therefore a greater demand for the Chinese currency (RMB). This increased demand for RMB would typically result in an appreciation of the currency (an increase in its value relative to other currencies). However, since China has a fixed exchange rate policy, the government will intervene to maintain the exchange rate at a predetermined level. To do so, the government will need to buy foreign currency or gold using its reserves, and in turn, this will increase the money supply (M) of Chinese currency.

As a result, the money supply curve (Ms) in the FOREX diagram will shift to the right, representing the increase in the money supply.

2. Effect on Chinese Central Bank's Holdings of Gold and Foreign Exchange (GFE(CB)):

As mentioned earlier, to maintain the fixed exchange rate, the Chinese Central Bank will need to buy foreign currency or gold. This action will result in an increase in the Central Bank's holdings of gold and foreign exchange reserves, represented as GFE(CB) in the FOREX diagram.

3. Effect on Current Account and Capital Account balances:

Based on the assumption provided in the question that the Current Account is in deficit and the Capital Account is in surplus, we can infer the following:

a) Current Account: With an increase in exports, the Current Account balance is likely to improve. This is because exports generate inflows of foreign currency, which contribute to a surplus in the Current Account. However, since the question states that the Current Account is in deficit, it suggests that even with the export surge, there are still more outflows (such as imports, interest payments, etc.) than inflows of foreign currency.

b) Capital Account: The Capital Account is in surplus, indicating an overall inflow of foreign capital into China. This could be due to foreign investments, loans, or other capital inflows. The surplus in the Capital Account helps to offset the deficit in the Current Account, ensuring a balance in the overall Balance of Payments.

4. Effect on China's Overall Balance of Payments:

Considering the Current Account deficit and Capital Account surplus, the export surge will likely lead to an improvement in China's overall Balance of Payments. The surplus in the Capital Account helps to offset the deficit in the Current Account, contributing to a more balanced overall situation.

Therefore, the export surge in China would result in an increase in the money supply, an increase in the Chinese Central Bank's holdings of gold and foreign exchange, an improvement in the Current Account balance (though still in deficit), a surplus in the Capital Account, and an overall improvement in China's Balance of Payments.

The increase in exports in China will have various effects on different aspects of the economy. Let's break it down step by step:

1. Money Supply: As you correctly mentioned, the increase in exports will lead to a higher demand for Chinese currency (Yuan). This increased demand will put upward pressure on the value of the Yuan, which would typically result in an appreciation of the exchange rate. However, since China operates with a fixed exchange rate policy, the government will intervene to maintain the exchange rate at a pre-determined level. To achieve this, the government will need to buy foreign currency or gold, which increases the money supply.

2. Chinese Central Bank Holdings: To satisfy the excess demand for Yuan resulting from increased exports, the Chinese Central Bank (CB) will need to use its foreign reserves to purchase foreign currency or gold. So, the CB's holdings of foreign exchange will decrease as it sells its foreign reserves to meet the demand for Yuan.

3. Current Account Balance: The Current Account records the trade of goods and services, as well as income from investments, between countries. In this scenario, since China experiences a surge in exports, it implies that its exports will likely exceed its imports. This will contribute to a surplus in the Current Account balance. However, the question assumes that the Current Account is in deficit, which goes against the usual trend. It is important to note that a Current Account deficit means that imports exceed exports, whereas a surplus means that exports exceed imports.

4. Capital Account Balance: The Capital Account records capital flows in and out of a country, including foreign direct investment (FDI) and portfolio investments. According to the given assumption, the Capital Account is in surplus. This suggests that China is receiving more capital inflows from foreign investment than it is investing abroad. The surplus in the Capital Account serves as an offset to the Current Account deficit, contributing to an overall balance in the Balance of Payments.

5. Balance of Payments: The Balance of Payments is a record of all economic transactions between a country and the rest of the world in a specific period. In this case, the increase in exports will contribute to a surplus in the Current Account. The surplus in the Current Account, along with the surplus in the Capital Account (as assumed), will help to offset each other and maintain the overall balance in the Balance of Payments.

It should be noted that the assumptions mentioned in the question - a Current Account deficit and a Capital Account surplus - do not align with the usual trend when a country experiences an export surge. Nevertheless, based on these assumptions, the effects on the money supply, Central Bank holdings, Current Account, Capital Account, and Balance of Payments as outlined above can be inferred.