Milton Friedman famously taught that inflation is, and can only be, a monetary phenomenon. China is no exception. Although people can point out the various structural reasons behind the asset bubbles and consumer price hikes in China, the fundamental cause of the problems is excess liquidity. Too much money is chasing a limited supply of goods and assets.

  But that doesn't limit China's policy options for responding to inflation as much as it might seem. Discussion of possible solutions generally focuses on raising interest rates or appreciating exchange rates or both. China, however, needs a different solution to the excess supply of money creating its inflation.

  The first step to a new solution is understanding the source of the problem: The superb performance of China's export sector has caused a huge trade surplus and a record inflow of foreign exchange. Because of the managed exchange rate, the People's Bank of China, the central bank, has had to issue new yuan to purchase the surplus foreign exchange. In 2007, the central bank issued more than 3.9 trillion yuan ($569 billion) to accommodate the economy's foreign exchange surplus. During the same period, the central bank was able to sterilize only about 470 billion yuan through its open market operations. In the first four months of 2008, the central bank issued 1.8 trillion yuan and sterilized 860 billion.

  Steady appreciation of the yuan relative to the dollar has exacerbated this problem. Tens of billions of dollars of speculative money have poured into China through various channels to take advantage of this appreciation. This has fueled the liquidity problem and contributed to the bubbles in the stock and real estate markets, and also consumer price inflation. The fast appreciation of asset prices has, in turn, stimulated the transfer of even more hot money into China.

  Any economically and politically viable solution would need to stem these excess inflows while inflicting minimal, or no, damage to the underlying economic development. One common proposal -- a one-step appreciation of the yuan in the range of 10% to 15% against the dollar -- fails this test. Advocates of this plan argue it would immediately eliminate market expectations of future appreciation, thus stopping speculative inflows. And the yuan price of imported goods would go down, stemming inflation. But this "killing two birds with one stone" policy is both myopic and fundamentally detrimental to China's economic development.

  China's core competence lies not in its technological or managerial superiority, but rather in its abundant and cheap labor. The rapid appreciation of the yuan would dramatically diminish the competitiveness of its export sector, especially with a weak U.S. economy. Many labor-intensive businesses would immediately fail after a jump in the yuan exchange rate. This would significantly disrupt the ongoing process of urbanization and industrialization of the Chinese economy.

  Some people claim this is a great opportunity to force Chinese firms to upgrade their businesses. But that doesn't reflect the reality in China, a country still facing a daunting challenge to assimilate its large number of excess rural laborers into the industrialized sector. A technological "great leap forward" could have disastrous social and economic consequences.

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  Instead of a dramatic one-off revaluation, China should stop its current policy of fast appreciation. It would be better to focus on administrative measures to diminish the flow of hot money into China.

  Rather than allowing all foreign exchange inflows to convert into yuan before attempting to sterilize them, China's central bank could set an upper limit on the percentage of surplus foreign exchange that any enterprise can change into yuan. At the same time, the central bank could set up special savings accounts to store the additional foreign exchange that these enterprises generate, but are not allowed to convert into yuan directly.

  When an exporting enterprise had a legitimate need to use more yuan for domestic economic activities, it could use various channels to convert its balance in the special foreign exchange savings account into yuan, under close scrutiny from the central bank. For example, the enterprise could use the foreign exchange account as collateral to borrow up to a certain percentage (say 80%) of the balance amount from commercial banks; or it could sell its foreign exchange positions in an inter-bank market, with the transaction subject to a fee imposed by the central bank. That fee could be adjusted to tighten or loosen control on the liquidity.

  China should also find channels to get excessive liquidity out of its economy. One particular channel is the Qualified Domestic Institutional Investors mechanism, whereby domestic investors purchase foreign exchange using yuan, and then invest the acquired foreign exchange in global capital markets. The challenge to this strategy so far has been that the enthusiasm of domestic investors to invest abroad through QDII has waned amid rapid currency appreciation and a hot domestic stock market. To address this problem, the Chinese government needs to set a clear expectation that the yuan will not hugely appreciate. Greater investor education on the benefits of international diversification is also necessary.

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  Such steps might not assuage those in the U.S. pressing China for faster yuan appreciation. Indeed, China cannot ignore the interests of other economies. Yet, China should also never passively yield to every demand of the U.S., but rather actively communicate and seek compromise so as to better protect its own national interest.

  Fortunately, China and the U.S. at this time have significant overlapping interests in the area of yuan exchange rates. The U.S. Federal Reserve's attempts to salvage the economy in the wake of the subprime mortgage crisis have justifiably generated worries that measures intended to boost confidence in U.S. markets might inadvertently weaken confidence in the dollar as a global reserve currency.

  At a time when the injection of Fed funds into the U.S. private sector triggers inflationary pressures, a stabilizing policy on the yuan by China will allow a more stable dollar, even giving more leeway to the Fed's actions. On the other hand, if China were to quickly appreciate the yuan, the biggest net effect may be an increase in U.S. consumer prices; Chinese firms will simply either pass along the higher costs to their consumers or go out of business.

  In addition to QDII expansion, China could consider other actions to help prevent the worsening of the U.S. economic slowdown and disruption of the financial sector. For example, China can consider investing $100-200 billion of its foreign exchange reserve into blue chip stocks in the U.S. market. This would help boost confidence in the U.S. stock market, and also redirect the liquidity back to the U.S., further reducing the pressure on excess liquidity faced by China.

  The current situation presents an opportunity for truly constructive policy cooperation across the Pacific, and China can play the leading role. The right policy measures can help the U.S. to deal with its current economic crisis while tackling the root cause of inflation in China.

Mr. Jin is associate professor of finance at the Harvard Business School. Mr. Li is the vice chairman of the China Overseas-Educated Scholars Development Foundation and former CEO of Bank of China International.