The Real Exchange Rate in Developing Countries: A Study on China

China has been in a state that the currency appreciation is needed to restore the external balance. However, it appears that Chinese government worries about that the Renminbi appreciation may decrease the output. This purpose of this paper is to empirically investigate whether the contractionary hypothesis prevailing in developing countries holds for China with quarterly data over the period from 1995Q1 to 2006Q2. We apply VAR models by means of impulse response functions and variance decompositions. The empirical evidences indicate that even taking the spurious correlation into account, the real appreciation of Renminbi leads to a fall in China’s output. Thus, our findings do not support the contractionary devaluation hypothesis. Moreover, the impact of the exchange rate on output is not through the inflation rate. In the short run, real exchange rate shocks have much power in explaining the output’s variation while the U.S interest rate and government spending shocks are determinants to the variation in output in the long run. Particularly, the monetary policy has relatively weak effect on the output and the real exchange rate