Question

Draw the demand and supply curves and provide brief explanations about the exchange rate and the value of the domestic currency in each case. Note: you just need to state whether the dollar has appreciated or depreciated and whether the exchange rates (R) goes up or down) (after drawing the graphs). Note: be sure to use the currency of the foreign country implied in each question!

a) An increase in the growth rate of U.S., real GDP relative to Japan (assume Japan and the U.S. are important trading partners).

b) Americans become more bullish on the Japanese economy.

c) Inflation in the U.S. edged up relative to the one in Japan.

Answer 1

In each graph, Exchange rate (P) and Quantity of domestic currency (i.e. US Dollar) (Q) are measured vertically and horizontally respectively. D0 & S0 are initial demand & supply curves for US Dollar, intersecting at point A with initial exchange rate P0 and quantity of dollar Q0.

(a) Higher growth rate in US will increase US demand for Japanese goods, which will increase the demand for Japanese Yen and decrease the demand for US dollars. Demand curve for dollars will shift left, depreciating dollar, decreasing exchange rate and increasing quantity of dollars. In following graph, D0 shifts leftward to D1, intersecting S0 at point B with lower exchange rate P1 and lower quantity of dollars Q1.

(b) When Americans become bullish on Japanese economy, they invest less in US and more in Japan. This will increase the demand for Japanese Yen and decrease the demand for US dollars. Demand curve for dollars will shift left, depreciating dollar, decreasing exchange rate and increasing quantity of dollars. In following graph, D0 shifts leftward to D1, intersecting S0 at point B with lower exchange rate P1 and lower quantity of dollars Q1.

(c) Higher inflation in US will increase US demand for Japanese imports, leading to higher demand for Japanese Yen and lower demand for US dollar. Demand curve for dollars will shift left, depreciating dollar, decreasing exchange rate and increasing quantity of dollars. In following graph, D0 shifts leftward to D1, intersecting S0 at point B with lower exchange rate P1 and lower quantity of dollars Q1.