Sorry, guys but i just cant help myself. :P
I have an intermediate macro economics final on thursday.
well basically its not really that big of a deal. The way it works is China is on a fixed exchange rate and the U.S is on a floating exchange rate.
As more U.S consumers buy and demand goods to China, they have to exchange dollars for Yuan. Which should drive up the Yuan price, but CHina is on a fixed exchange rate. This upward pressure has to be relieved somehow. So China has to inturn fixes the problem by buying the excess u.s dollars that puts an upward pressure on its own currency.
This puts a downward pressure on the u.S currency, but China fixes it for us by pegging their currency to ours.Theoretically speaking, in the models that we are constructing, an increase in imports should eventually even out to a balanced rate, since increased imports creates a lower exchange rate, thus making it more appealing for other people to invest in your country, so eventually it should stable out.
The problem arises when China has an excess supply of u.s dollars. What are they going to do with all the money? They will use it to buy U.S Bonds to get somekind of return on the extra u.s dollar supply. The biggest problem is the fact that there is an extreme upward pressure on its currency. If they continue buying u.s debt and bonds it will cause the Chinese government to lose money, as the Yuan drifts and drifts higher against the dollar.
It only becomes a problem for us if the Chinese stops buying our u.s bonds. Infact, over the past couple of years, chinese purchases of U.S bonds has been one of the reasons why the U.S inflation rates are so low. As there is more and more pressure on the yuan to apperciate, the Chinese government might stop buying U.S bonds or start diversifying which could drive up interest rates in the U.S. There is only so much money in the world.