Unemployment and optimal currency intervention in an open economy

•In a stationary equilibrium, a country cannot accumulate a trade surplus or deficit indefinitely.•The optimal exchange rate is that rate which yields a trade balance for each period.•A numerical example illustrates the main proposition.

This paper investigates whether China, with unemployed resources, can benefit from a trade surplus in one period and a deficit in the next by manipulating the yuan's peg. A country may be tempted to stimulate its economy temporarily by devaluation, but any surplus so generated subsequently must be expended with inescapable reverse output effect. It is shown that under reasonable conditions, nonintervention is the optimal policy and the optimal exchange rates are the equilibrium rates that yield a trade balance in each period. Numerical examples using the Cobb-Douglas utility function illustrate the main proposition.