| Abstract | The “RMB undervaluation puzzle” refers to two related facts: 1) that the RMB real exchange rate has been depreciating along with China’s strong economic growth; 2) that most Western researchers agree that the RMB is seriously undervalued in recent years. We propose that this puzzle is mainly caused by an inter-regional race to the bottom in China, which reduces average input usage and labor cost, thus seriously depressing the general price and wage level through three types of “price multiplier effects”. We extend the standard input-output model to simulate the price-level effect of racing to the bottom in two key sectors (road transportation and coal mining), using actual input-output data. The results show that, quantitatively, our model can fully explain the “RMB undervaluation puzzle”. The implication is that in order for the RMB real exchange rate to reach and remain at a proper level, inter-regional race to the bottom in China must be effectively tackled, which entails a radical overhaul of China’s economic system and the transition of its development model. |