Question

Question 4: Suppose the current exchange rate for the Japanese Yen against the dollar is $1 = 120 yen. Answer the following questions using the long run model of the exchange rate developed in class.

a.           If you expect Japanese monetary growth to be a total of 25% larger than the US monetary growth rate over the next ten years, what is your best guess as to the exchange rate ten years from now? Be as precise as possible. What theory underlies your prediction given you have no other information?

b.           In addition to the higher money growth rate in Japan mentioned above, you are now told that output growth will be higher in Japan as compared to the US by 30% over the next ten years. What is your best guess as to the exchange rate ten years from now?

c.           Given the information in a. and b. where do expect inflation to be higher, the US or Japan?   Where do you expect interest rates to be higher? Where do you expect real interest rates to be higher? Be as precise as possible and explain the assumptions that you make at each step.

Answer 1

a. Money supply equals money demand—or real money supply equals real money demand—at the equilibrium interest rate in the money market.

Short run scenario: increasing the money supply lowers the domestic interest rate, as well as the exchange rate because lower interest rates do not attract foreign capital and thus there is decrease in demand for foreign currency leading to its depreciation. Also lower interest rate stimulate AD. The rise in domestic GDP will tend to increase the demand for imports. The increase in imports will cause the current account to deteriorate. The increase in imports purchased will increase the need to convert domestic to foreign currency. As a result, the exchange rate of the domestic currency will decrease.

b. If GDP growth rates are also higher in Japan along with the increasing money supply then The rise in domestic GDP will tend to increase the demand for imports. The increase in imports will cause the current account to deteriorate. The increase in imports purchased will increase the need to convert domestic to foreign currency. As a result, the exchange rate of the domestic currency will decrease.