Question

Which of the following would cause the U.S. dollar to depreciate against the Japanese yen? a. Greater popularity of U.S. exports in Japan b. A higher price level in Japan c. Higher real interest rates in the United States d. Higher incomes in the United States

Short answer

The correct answer is d. Higher incomes in the United States, as this will cause an increase in demand for foreign currencies like the Japanese yen due to increased imports, leading to depreciation of the U.S. dollar against the Japanese yen.

Step-by-step solution

Determine the direction of currency flow

To assess the causes behind currency depreciation, we need first to understand the direction of currency flow based on the options provided. A currency will depreciate (decrease in value) if its supply increases or demand decreases.

Analyze each option

Let's examine each choice to see which one would lead to depreciation of the U.S. dollar against the Japanese yen. a. Greater popularity of U.S. exports in Japan: In this case, the demand for U.S. dollars would increase in Japan because they would need more U.S. dollars to purchase American goods. This causes the U.S. dollar to appreciate (increase in value) against the Japanese yen, not depreciate. b. A higher price level in Japan: With a higher price level in Japan, Japanese goods become more expensive relative to U.S. goods. This causes a decrease in the demand for Japanese exports and an increase in demand for U.S. imports, leading to a higher demand for the U.S. dollar and causing it to appreciate, not depreciate. c. Higher real interest rates in the United States: When real interest rates in the U.S. are higher, foreign investors are more likely to invest in U.S. assets, increasing the demand for the U.S. dollar. As a result, the value of the dollar will appreciate, not depreciate, against the Japanese yen. d. Higher incomes in the United States: When U.S. incomes rise, U.S. consumers have more purchasing power and will typically demand more goods, including imports. This will increase the demand for foreign currencies like the Japanese yen because U.S. consumers will need yen to buy Japanese goods. This causes an increase in demand for the yen and a decrease in demand for the U.S. dollar, leading to depreciation of the U.S. dollar against the Japanese yen.

Identify the correct option

Upon analyzing each option, we find that option d (higher incomes in the United States) would cause the U.S. dollar to depreciate against the Japanese yen. Thus, the correct answer is: d. Higher incomes in the United States

Key concepts

Exchange Rates

Understanding exchange rates is crucial when examining how currencies interact with each other, particularly regarding depreciation or appreciation. Exchange rates determine the value of one currency in terms of another and are influenced by various economic factors. For instance, when looking at the U.S. dollar in comparison to the Japanese yen, a key focus is on what modifies the demand and supply for each currency.

As seen in the exercise, if there is greater demand for U.S. goods, theoretically, you'd expect the U.S. dollar to appreciate. However, this also demonstrates why high demand for a country's products doesn't always translate to currency appreciation. Currency markets are complex and are influenced by numerous factors simultaneously. Other influences such as interest rates, inflation, and economic indicators can override direct supply and demand dynamics from international trade.

Therefore, while the exercise points to an increase in demand for U.S. dollars when U.S. exports are popular, this is too isolated a view. It's important to examine a broader range of economic conditions to understand exchange rates fully.

International Trade

International trade significantly affects currency values. When a country like the United States experiences higher demand for its exports, its currency would generally be expected to appreciate as more foreign businesses and consumers are exchanging their currency for dollars to make purchases. However, it's not just exports that matter but the balance of trade—the difference between the value of a country's exports and imports.

When U.S. incomes rise (as outlined in option d of the exercise), American consumers may purchase more imported goods, thereby increasing the supply of dollars in international markets as they exchange dollars for foreign currencies. This can lead to the depreciation of the dollar because an excess supply of dollars in the exchange market pushes the price down. This example in the exercise is a classic case of how income levels and trade deficits are interconnected and can lead to currency depreciation.

Interest Rates

Interest rates serve as a primary magnet for international capital flows. Higher real interest rates in a country make it an attractive destination for foreign investors, as they can obtain a better return on investment. From the exercise, we learn that higher interest rates in the United States could attract more Japanese investors to hold their assets in dollars, therefore, increasing the demand for the U.S. dollar.

Nevertheless, it's crucial to note that real interest rates account for inflation. Hence, a high nominal interest rate might not entice foreign investment if inflation is also high, reducing the actual earning potential. When tackling exercises around currency depreciation, it is essential to differentiate between nominal and real interest rates to understand their impact accurately. In the context of the provided exercise, while higher U.S. interest rates might suggest an appreciating dollar, they are quite a one-dimensional indicator without considering inflation and other competing economic factors.