Question

With the strengthening of the yen against the U.S. dollar in 2012 , Japan's central bank did not take any action. A Japanese politician called on the central bank to take actions to weaken the yen, saying it will help exporters in the short run and have no long-run effects. a. What is Japan's current exchange rate policy? b. What does the politician want the exchange rate policy to be in the short run? Why would such a policy have no effect on the exchange rate in the long run?

Short answer

Japan’s current policy is a floating exchange rate. The politician wants a weaker yen to help exporters in the short term. Long-term effects would be neutralized by market adjustments.

Step-by-step solution

Identify Japan's Current Exchange Rate Policy

Japan's current exchange rate policy can be identified by examining the fact that the central bank did not take any action when the yen strengthened against the U.S. dollar in 2012. This suggests that Japan is likely following a floating exchange rate policy where the value of the yen is determined by the market forces of supply and demand without direct intervention.

Understand the Politician's Proposed Policy for the Short Run

The politician wants the central bank to intervene to weaken the yen. This involves actions such as increasing the money supply by lowering interest rates or directly selling yen and buying foreign currencies to reduce its value. The reasoning is that a weaker yen makes Japanese exports cheaper and more competitive abroad, which can benefit exporters in the short run.

Explain Why the Policy Would Have No Long-Run Effects

In the long run, the effect of weakening the yen through intervention might be neutralized by market adjustments. Factors such as price levels, inflation, and economic output will adjust to reflect the fundamental value of the yen. Consequently, any short-term gains from a weaker yen may be offset by inflation or other counteracting economic forces, rendering the long-term effect on export competitiveness negligible.

Key concepts

Floating Exchange Rate

A floating exchange rate system is where the value of a currency is determined by the market forces of supply and demand. Japan's current exchange rate policy is a floating one, as indicated by the central bank's inaction when the yen strengthened against the U.S. dollar in 2012.

In a floating exchange rate, the currency's value can fluctuate due to various factors such as trade balances, interest rates, and overall economic performance. Countries like Japan allow their currencies to float because it enables the market to automatically adjust the currency's value based on economic conditions. This policy can often absorb economic shocks better than fixed exchange rate systems.

However, floating exchange rates can lead to volatility. Significant fluctuations impact international trade and investments. The stability offered by a fixed rate can sometimes be preferred, especially during economic uncertainty.

Currency Intervention

Currency intervention occurs when a country's central bank takes active measures to influence the value of its currency. The Japanese politician in the exercise suggests such intervention to weaken the yen.

Ways of intervening include:

• Buying and selling currencies: The central bank can sell its own currency and buy foreign currencies to decrease the value of its currency.
• Adjusting interest rates: Lowering interest rates can increase the money supply, leading to a weaker currency as it makes the currency less attractive for foreign investors.

Interventions are intended to control exchange rates to benefit the economy. For Japan, weakening the yen means that Japanese goods become cheaper for foreign buyers, boosting exports. However, repeated interventions can lead to market distrust and potential retaliatory measures from other countries.

Short-Term Economic Policy

Short-term economic policies are immediate actions taken to influence the economy over a brief period. The politician proposes a short-term intervention to weaken the yen to help Japanese exporters.

Such policies usually aim to:

• Boost exports: A weaker yen makes Japanese goods cheaper internationally.
• Stimulate domestic demand: Lower interest rates encourage borrowing and spending.
• Control inflation: Depending on the situation, policies may try to either increase or reduce inflation.

However, these policies often come with trade-offs, such as increased inflation risk. Short-term policies are not meant for sustaining long-term economic growth, as other factors will eventually equilibrate and offset initial gains.

Export Competitiveness

Export competitiveness is the ability of a country's goods to compete in the global market in terms of price and quality. Weakening the yen can improve this competitiveness in the short term by making Japanese goods cheaper abroad.

Factors influencing export competitiveness include:

• Exchange Rates: A weaker currency lowers the cost of goods for foreign buyers.
• Production Costs: Lower production costs increase competitiveness by allowing lower prices.
• Product Quality: High-quality goods are more competitive, regardless of price.

While short-term measures like currency weakening can provide an export boost, long-term competitiveness relies on sustainable practices such as innovation, improving production efficiency, and maintaining quality. Market adjustments usually neutralize temporary advantages as global prices and demand react accordingly.