China buys US bonds

In order to maintain a trade imbalance we know that the Chinese central government needs to keep its currency artificially weak. And to do that they essentially can print their currency and use that to buy US dollars. So what they do is they increase the supply of yuan and they increase the demand for dollars, keeping their currency weak. Now, the next question you might ask is what do they do with the actual dollars that they bought with the yuan that they printed. Well, they don't want to just sit on those dollars. They'd prefer to be collecting some type of interest on that money. So instead of just keeping it all in some warehouse someplace they actually just lend that money to the US government. And they lend that money by buying US Treasury bonds, by buying T-bills and T-notes. So that money that they use that they bought with their printed yuan, that goes to the US Treasury. And the US Treasury gives the Chinese Central Bank treasury bonds. So these are treasury bonds. Now, what's the effect of this? Clearly, the Bank of China is getting interest on its money now. It's helping to finance the US government's debt. But maybe even more interestingly, it is creating incremental demand for T-bonds, for treasury bonds. Now, what does that do? Well, if you're increasing the demand for anything that's also going to increase the price. So the price of treasury bonds, of T-bills and T-notes, goes up. T-bills are durations less than one year. Notes are durations more than a year. So the price goes up. But what happens if the price goes up? That means that the interest that the government has to pay on this debt goes down. And I explained that in more depth in other videos. Now, the interest goes down. That means that the cost of borrowing for the US government goes down. But that's also the benchmark rate for the cost of debt in general. So in general it finances US debt, both of the government and really just credit more broadly. So debt becomes cheaper inside of the United States. This is Salman Kahn from the Khan Academy for CNBC.