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Date of Award

Spring 2012

Degree Name

Bachelor of Science

Major

Economics

First Advisor

Dr. James G Wen; Dr. William N Butos

Abstract

This paper argues that exchange rate fluctuations may not necessarily lead to slower growth of employment in China’s tertiary industry. After examining the current economic conditions in China, we believe that the country still remains as an export-oriented economy and the service sector is substantially underdeveloped. However, developing the service sector will create more job opportunities as well as boost the overall growth of the entire economy. Therefore it has become a pressing concern for the Chinese government to design a future growth strategy that aims for a tertiary industry expansion, especially under the current conditions where China is not only facing a substantial amount of international pressure for a currency appreciation but also a slowdown in its manufacturing sector due to the negative impact from the most recent financial crisis.

After carefully examining a recent empirical analysis conducted by two IMF economists on the relationship between the real exchange rate and employment growth in both tradable and non-tradable sectors in China, we found significant limitations in their empirical design that might undermine the significance of the implications that their results suggest. As they show a real currency appreciation leads to sizeable growth contractions in both tradable and non-tradable sectors, we argue that exchange rate fluctuations may not necessarily lead to slower growth of employment in China’s tertiary industry. Our argument is based on the fact that various structural distortions existing in the economy have greatly restricted efficient labor market adjustments in China. We then analyze two of the most marked institutional barriers in the country that have been substantially holding back the development of the tertiary industry.

It is worth mentioning that we do not ignore any possible impact on employment from a real exchange rate shock. However, in preparing the reform of a more flexible foreign exchange rate regime, China has to address those institutional problems before it can fully exploit the great potential of its tertiary industry in absorbing surplus labor from rural areas. A real appreciation should therefore be accompanied by government policies to reduce the structural and institutional frictions in the market. Future reforms in the hukou system and a marketization of land in China will stimulate a more efficient labor reallocation across sectors and help minimize the negative impact on the labor market from any possible real exchange rate shocks in the future.

Comments

Senior thesis completed at Trinity College for the degree of Bachelor of Science in Economics. Accessible to members of the Trinity community only.

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