CATO JOURNAL Ina nas alread dy integrated itself into the world econo\ the foreign exchange rate will adjust. During the last decade, certain adjustments were already made to adjust the real exchange rate through price-level increases (inflation)and appreciation of the nom- inal exchange rate. Either of those two means can correct the dise quilibrium. They differ in that the exchange rate and price level are macro variables reflecting the relative prices among nations, while the prices of individual commodities reflect the parity variations among various kinds of commodities within a country. Price adj ments are sticky. In an economic system in which the market deter- mines exchange rates, fast adjustments to disequilibrium occur more ften than not. Using the exchange rate mechanism to achieve exter- nal balance avoids the danger of inflation, and is less costly than try- ing to adjust the general level of prices Price Adjustments: Rising Prices of Factors and Assets Mundell, McKinnon, and Scandinavian models predict that when wages grow in line with labor productivity or total factor productivi- ty, stable exchange rates will be maintained. In the last 10 years, except for relatively low CPI inflation, most factor and asset prices have increased at a fast pace. From 1997 to 2005, the average real age of Chinese employees rose by nearly ll percent per year. During the same period, wage growth in the United States and Europe was only 2-3 percent per year. Moreover, prices of raw mate- rials, energy, and real estate in China have all increased significantly in recent years. From 2003 to 2006, the overall purchasing price indexes of raw materials, fuel, and power rose by 32.6 percent, and in 35 medium and large Chinese cities, average real estate price ave escalated by more than 5 percent per year. These price increas es have pushed the real effective exchange rate closer toward equi- librium Excess Liquidity and Pricing Adjustment In early 2003, the People's Bank of China found that the growt liquidity was relatively high and began to issue central bank notes and also increased the required reserve ratio. From 2003 to 2007 Chinas foreign exchange reserves expanded by roughly $l trillion To prevent inflation, the PBOC issued a large amount of central bank notes, which sterilized the increase in the monetary base due to the194 Cato Journal China has already integrated itself into the world economy, and the foreign exchange rate will adjust. During the last decade, certain adjustments were already made to adjust the real exchange rate through price-level increases (inflation) and appreciation of the nom￾inal exchange rate. Either of those two means can correct the dise￾quilibrium. They differ in that the exchange rate and price level are macro variables reflecting the relative prices among nations, while the prices of individual commodities reflect the parity variations among various kinds of commodities within a country. Price adjust￾ments are sticky. In an economic system in which the market deter￾mines exchange rates, fast adjustments to disequilibrium occur more often than not. Using the exchange rate mechanism to achieve exter￾nal balance avoids the danger of inflation, and is less costly than try￾ing to adjust the general level of prices. Price Adjustments: Rising Prices of Factors and Assets Mundell, McKinnon, and Scandinavian models predict that when wages grow in line with labor productivity or total factor productivi￾ty, stable exchange rates will be maintained. In the last 10 years, except for relatively low CPI inflation, most factor and asset prices have increased at a fast pace. From 1997 to 2005, the average real wage of Chinese employees rose by nearly 11 percent per year. During the same period, wage growth in the United States and Europe was only 2–3 percent per year. Moreover, prices of raw mate￾rials, energy, and real estate in China have all increased significantly in recent years. From 2003 to 2006, the overall purchasing price indexes of raw materials, fuel, and power rose by 32.6 percent, and in 35 medium and large Chinese cities, average real estate prices have escalated by more than 5 percent per year. These price increas￾es have pushed the real effective exchange rate closer toward equi￾librium. Excess Liquidity and Pricing Adjustments In early 2003, the People’s Bank of China found that the growth of liquidity was relatively high and began to issue central bank notes and also increased the required reserve ratio. From 2003 to 2007, China’s foreign exchange reserves expanded by roughly $1 trillion. To prevent inflation, the PBOC issued a large amount of central bank notes, which sterilized the increase in the monetary base due to the