Suppose that China operates a fixed-exchange-rate system and is running a large current-account surplus. The government supports the system by buying large quantities of dollars in the foreign exchange market. Assume that the resulting increase in the supply of yuan leads to an increase in bank reserves.
a. Explain why this would lead to a monetary expansion and lower interest rates in China. Further explain why this would lead to an expansion in aggregate demand, higher output, and a higher price level. (This answer relies on the analysis presented in Chapters 23 and 24.)
b. Explain why, as prices rise because of the effects you described in a, Hume's four-pronged mechanism would eventually reduce the Chinese current account surplus. Interpret your answer as the modem, updated version of Hume's mechanism.