Question

a) Suppose that the future dollar-yen exchange rate increases. How does this affect the IS curve? Explain fully.

b) If the Bank of Japan decides to decrease their money supply, how would that affect the Japanese LM curve? Explain fully.

Answer 1

a. With the rise in the future dollar-yen exchange rate or say the appreciation of yen (more dollars in future per yen), the demand for the yen will rise, which will shift the demand curve for the yen to the right. At the same time, those who are holding the yen with themselves will also be reluctant to sell their yen because of the higher future value of yen which will cause the supply curve of yen to shift left. The rightward shift of demand and leftward shift of supply of yen will increase the exchange rate of the dollar per yen.

When the dollar depreciates, the goods of US will become cheaper thus there will be a rise in the demand for the US goods or the net exports of US, which will then shift the IS curve to the right. LM being the same will thus the interest rates in the United States. Similarly, the appreciation of Yen will reduce the net exports of Japan, so the IS curve will shift to the left which further when met with the given LM curve lead to a decline in the interest rate in Japan.

b. When the bank of Japan decides to decrease the money supply in the economy, the LM curve will shift to the left, which will cause a rise in the interest rates in Japan, because of more money demand as compared to the money supply. If the LM curve will be vertical, there will not be any change in the output of the economy which will reduce had the LM curve be upward sloping.