Question

Use supply-and-demand diagrams to analyze the effect of the following actions on the exchange rate between the dollar and the yen: a. Japan opens its domestic markets to more foreign competition. b. Investors come to believe that values on the Tokyo stock market will fall. c. The Federal Reserve cuts interest rates in the United States. d. The U.S. government, to help settle the problems of the Middle East, gives huge amounts of foreign aid to Israel and her Arab neighbors. e. The United States has a recession while Japan booms. f. Inflation in the United States exceeds that in Japan.

Short answer

Answer: The increased foreign competition in Japan's domestic markets will lead to an increased demand for yen, as more yen is required to purchase foreign goods. This will result in a higher exchange rate between the US dollar and the Japanese yen.

Step-by-step solution

As Japan opens its domestic markets to more foreign competition, there will be an increased supply of foreign goods in Japan, which will require more yen to purchase those goods. This will increase the demand for yen, which, in turn, increases its exchange rate with the dollar. On the supply and demand diagram, this will lead to an outward shift of the demand curve, resulting in a higher exchange rate. #b. Investors come to believe that values on the Tokyo stock market will fall.#

If investors expect that Tokyo's stock market values will fall, they will likely sell Japanese stocks and shift their investments to other markets, such as the US. This will lead to an increase in the supply of yen in the market, which will reduce its exchange rate with the dollar. The supply and demand diagram will show an outward shift of the supply curve, resulting in a lower exchange rate. #c. The Federal Reserve cuts interest rates in the United States.#

When the Federal Reserve cuts interest rates in the United States, this means that US investments become less attractive to foreign investors, including those in Japan. Consequently, Japanese investors would require fewer US dollars, decreasing the demand for dollars. A lower demand for dollars weakens the currency and leads to a depreciation of the US dollar against the Japanese yen, indicating a lower exchange rate. #d. The U.S. government, to help settle the problems of the Middle East, gives huge amounts of foreign aid to Israel and her Arab neighbors.#

The US government giving foreign aid to Middle Eastern countries will require the US to obtain more foreign currencies, increasing the supply of US dollars in the foreign exchange market. As a result, the value of the dollar may depreciate, leading to a lower exchange rate between the dollar and the yen. The supply and demand diagram will show an outward shift of the supply curve for dollars, resulting in a lower exchange rate. #e. The United States has a recession while Japan booms.#

When the United States faces a recession while Japan experiences economic growth, Japanese investors may shift their investments from the US to their home country. This will increase the supply of dollars in the foreign exchange market, causing the dollar to depreciate against the yen. Additionally, a booming Japanese economy will likely increase the demand for yen, which will appreciate its value against the dollar. Both these factors will result in a lower exchange rate. #f. Inflation in the United States exceeds that in Japan.#

If inflation in the US is higher than in Japan, US goods will become relatively more expensive compared to Japanese goods. As a result, the demand for US products decreases while the demand for Japanese products increases. This will lead to an increased demand for yen and a decreased demand for dollars. Consequently, the exchange rate between the dollar and the yen will decrease, as the yen appreciates and the dollar depreciates.

Key concepts

Supply and Demand Diagrams

Supply and demand diagrams are key tools in understanding currency exchange rates. They visually represent how the quantity of currency demanded and supplied changes with the exchange rate. In the context of currency trading, the demand curve shows how much of a currency is desired at different price levels, while the supply curve illustrates how much of it is available. When an event causes a shift in either curve, the exchange rate adjusts accordingly.
For example, if Japan opens its markets to more foreign competition, the demand for yen increases. This event is shown as a rightward shift of the demand curve in a supply and demand diagram, resulting in a higher exchange rate for the yen against the dollar. Alternatively, if investors expect a depreciation in Tokyo stock market values, they may sell off yen, causing a rightward shift of the supply curve, thus decreasing the exchange rate of yen against the dollar.

Foreign Exchange Market

The foreign exchange market is where currencies are traded. It operates 24/7, facilitating the buying and selling of currencies on a global scale. It's vital for determining currency values since it is driven by supply and demand forces.
When the Federal Reserve in the US cuts interest rates, the foreign exchange market reacts as many investors might seek more attractive investments elsewhere. This leads to a reduced demand for US dollars, translating to a depreciation of the dollar's rating compared to other currencies, such as the yen.
In instances where the US government allocates foreign aid that requires other currencies, the foreign exchange market sees an increased supply of US dollars. This can often reduce the exchange rate of the dollar, illustrating how interconnected global events and policies are with currency values.

Currency Depreciation

Currency depreciation occurs when a currency loses value compared to others. This can be caused by several factors, such as macroeconomic changes, political events, or market speculations.
If the US enters a recession while Japan experiences growth, the value of the US dollar may depreciate relative to the yen. This means each US dollar would buy fewer yen than before. Increased economic strength in Japan may lead investors to repatriate their investments, increasing the yen's value and depreciating the dollar during this period.
The depreciation of a currency makes exports cheaper and imports more expensive for the depreciating country. This can lead to shifts in trade balances and influence ongoing economic strategies.

Economic Recession

An economic recession is a period of economic decline, typically identified by a fall in GDP in successive quarters. During a recession, consumer confidence tends to wane, leading to reduced spending and investment.
In a foreign exchange context, when a country like the US undergoes a recession, foreign currencies might become more attractive. In contrast, the local currency weakens. Japanese investors might pull out their investments from the US to take advantage of better opportunities at home, increasing the supply of US dollars in the market and further depreciating the US currency against the yen.
Recessions can have widespread impacts, influencing unemployment rates, wage levels, and stimulating policy responses to stabilize the economy.

Inflation Comparison

Inflation comparison between countries can drastically influence currency exchange rates. Inflation refers to how the general price level of goods and services increases over time, reducing purchasing power.
When inflation in the US surpasses Japan’s inflation rate, American goods become more expensive compared to Japanese counterparts. This change typically results in a decreased demand for US goods and an increased demand for Japanese goods, boosting the yen's value against the dollar.
This inflation disparity leads to currency appreciation for Japan as investors and businesses might prefer to hold a more stable currency. Thus, monitoring inflation rates is crucial for policymakers and investors to predict currency movements and make informed economic decisions.