Currency Pegs, Trade Imbalances and Unemployment: A Reevaluation of the China Shock

We develop a dynamic quantitative model of trade and labor adjustment, incorporating nominal wage rigidity and consumption–saving decisions, to study how China’s currency peg interacted with its rapid growth in shaping the US economy. We show that the peg temporarily boosts China’s export growth by preventing an appreciation of the Chinese currency, thereby amplifying the US labor-market consequences of the China shock. At the same time, the temporary export boom increases China’s savings and leads to a larger US trade deficit. Calibrating the model to match trade and labor-market flow data, we find that China’s currency peg played a quantitatively important role in the US manufacturing decline, the widening US trade deficit, and unemployment dynamics. These results underscore the importance of exchange-rate adjustment (or the lack thereof) for understanding trade shocks. We also find that the overall welfare impact of the China shock remains significant and positive.