Question

Assume that Japan and the US are trading partners.

a..Draw a model showing the foreign exchange for the US dollar(compared with the yen)

b. Draw another model showing the foreign exchange rate for the yen(compared to the US dollar)

c. Now assume that the US federal reserve institutes a policy that raises interest rates in the United States relative to interest rates in Japan. Is this a fiscal or monetary policy?

d. Show what happens on both models - based on this new Federal Reserve policy

e. Has the dollar appreciated or depreciated

f. Has the yen appreciated or depreciated.

g. As a result of the changing value of the US dollar:

i. will US exports increased or decreased? why?

ii. Will us imports increased or decreased? why?

iii. Will the US aggregate demand shift left or right?

Answer 1

a) The exchange rate of one national currency is determined by the number of foreign currency demanded and number of domestic currency supplied against the foreign currency. For example the exchange rate of US dollar in terms of Yen is determined by the quantity of Yen demanded and the quantity of U.S dollar supplied against the Yen in the foreign exchange market. Similarly the exchange rate of Yen is determined by the number of dollar demanded and the number of Yen supplied against the US dollar. Yen per dollar ¥ 110- 1 2 3 4 5 6 Quantity of dollar traded for Yen (billions) The vertical axis shows the exchange rate of US dollar in terms of Yen. The horizontal axis shows the quantity of US dollar being traded in the foreign exchange market against Yen. The demand for U. S dollar made by Japanese citizen is equal to the supply of dollar made by the U.S citizen equals at the point E where the exchange rate is $1=¥110. The total quantity of U.S dollar traded in the forex market is equal to $4 billion. b) Dollar per Yen 1 2 3 4 5 6 Quantity of Yen traded for dollar (billions) The vertical axis measures the exchange rate of Yen in terms of dollar. The horizontal axis represents the quantity of Yen traded in the market against U.S dollar. The demand for Yen made by the U.S citizen is equal to the supply made by Japanese citizens is cqual at the point El where ¥110 - SI. The quantity of Yen traded against US dollar is equal to 5 billion. c)The fiscal policy is more effective to attain the balance of payment stability and monetary policy is less effective under fixed exchange rate. The monetary policy is more effective to attain the balance of payment stability and fiscal policy is less effective under flexible exchange rate. The US is following a flexible exchange system under which the Federal Reserve takes monetary measures to correct the exchange rate fluctuation. The policy adopted by the Fed to raise the interest rate is a contractionary monetary policy.

d) The rise in interest rate in U.S cause more flow of Yen into U S economy in order to get higher returns. This will increase the demand for dollar and the value of dollar appreciates. The value of dollar will appreciate as shown in the following figure. Yen per dollar ¥120 ¥ 110 - \DD1 1 2 3 4 5 6 Quantity of dollar traded for Yen (billions) In the US foreign exchange market there will be more demand for US dollar since the increased interest rate leads to more conversion of Yen into dollars. The demand curve shift up to the right to Di and the exchange rate of US dollar appreciatc from $1 ¥110 to $1 ¥120. Dollar per Yen $1 $0.92 1 2 3 4 5 6 Quantity of Yen traded for dollar (billions) The increased conversion of Yen into dollar increases the supply of Yen in the Japanese foreign exchange market. Thus the supply curve shifts to the right to Sl. The value of Yen depreciate from the earlier $1= ¥I 10 into $0.92 = ¥110. e) The Fed policy causes the appreciation in the value of US dollar in terms of Yen. f) The value of Yen depreciates in terms of U.S dollar. h) i) The appreciation in the value of US dollar makes cxport costly. This will reduce cxport from US to Japan. U.S export will decrease. ii) The depreciation of the value of Yen creates a situation where importing from Japan is cheaper. The US import from Japan increase. iii) AD C+I+G+Nx. The increased import and decreased cxport reduce the net export. The aggregate demand in US shifts to the left.