Impact of China's currency valuation and labour cost on the US in a trade and exchange rate model

• Under free trade, a low income country has comparative advantage in trade.
• Efficiency gains from this enhance growth and household welfare in both economies.
• China's comparative advantage and US trade deficit will both be lower under Yuan revaluation and full price adjustment.
• Higher production cost and prices in China then reduce household welfare in China and trade imbalance of the US.
• Also higher relative GDP of China lowers the current account imbalance in the US.

Ricardian dynamic general equilibrium analyses show that under free trade arrangements a low income country with lower wage cost and large endowment of labour has comparative advantage in trade. Efficiency gains from this enhance economic growth and welfare of households simultaneously in both low income and advanced economies. Theoretical predictions are empirically validated here with structural VAR analysis based on quarterly data over the time period 1995:1 to 2009:1 on China's relative wage cost, interest rate differential, real effective exchange rate (REER), relative GDP and the US current account balance. It is shown how the relative prices of labour, capital and the currency affect the economic activity in China and current account balance in the US. With free capital inflows and outflows and restrictions on labour mobility, comparative advantage of China and the trade deficit of the US will both be minimised if China allows real appreciation of the Yuan and complete adjustment in prices. Higher production cost and prices in China could reduce welfare of Chinese households and the trade imbalance of the US, while higher relative GDP of China lowers the current account balance for the US.