Hoarding of international reserves in China: Mercantilism, domestic consumption and US monetary policy

We develop a two-country two-period model able to reproduce the key qualitative aspects of the US-China co-dependency (and imbalances) as the result of the Chinese and American authorities pursuing different but complementary objectives. We show that a mercantilist reserve hoarding has served well the Chinese policy goals (fast GDP expansion and labor mobilization) and has been compatible with the US ones (high households' consumption). If the US authorities keep monetary policy sufficiently loose, thus reducing the real value of the US liabilities held by China, this latter finds less tempting to stop financing the US external deficit, appreciate the currency and increase consumption. On the contrary, if the policy goals in China change from the maximization of GDP growth to higher households' standards of living, a rebalancing process may be ignited. We then discuss the model and its theoretical predictions, also in light of the Five-Year Plans approved by the Chinese ruling Party. (C) 2012 Elsevier Ltd. All rights reserved.