Question

Japan is the country of Macroville's largest trading partner. Macroville's currency is the dollar. Japan uses the Yen currency. Recently, the Japanese central bank raised interest rates.

a) Using a correctly labeled graph of the foreign exchange market for Macroville, show the impact of the Japanese central bank decision.

b) Given your answer in part (a), what will happen to Marcoville’s exports and imports to and from Japan? Explain.

c) Identify what will happen to the Macroville dollar, as a result of the Japanese central banking decision.

d) Given your answer in part (c), draw a correctly labeled graph of aggregate demand and aggregate supply, showing what will happen to Macroville’s real output and price level.

e) As a result of your graph in part (d), identify an appropriate response for the Macroville central bank to take.

f) Draw a correctly labeled graph of the money market and show how your answer to part (e) would affect nominal interest rates in Macroville.

Answer 1

a) Below is a labelled graph of the foreign exchange market for Macroville, where the supply and demand of dollars is shown. As a result of Japanese central bank decision, there will be an outflow of capital from Macroville to Japan which implies increased demand of Yen and increased supply of dollars as more and more investors now convert dollars in yen. Increase supply reduces the value of dollar and so dollar is depreciated against yen.

b) Given the answer in part (a), Marcoville’s exports will increase and imports will decrease that are traded to and from Japan. This is because Yen is now expensive to purchase with a given amount of dollars and so imports are now expensive due to yen appreciation and relative dollar depreciation. Similarly, Japanese can purchase more dollars with a given amount of yen so that exports from Macroville will increase.

c) As mentioned, Macroville dollar will depreciate as a result of the Japanese central banking decision.

d) Below is a labelled graph of aggregate demand and aggregate supply, showing that Macroville’s real output and price level are increased. This happens because increased exports and reduced imports have increased net exports and so AD has increased and shifted to the right. This shift is responsible for the increase in price and quantity

e) As a result of our graph in part (d), an appropriate response for the Macroville central bank to take is to increase the rate of interest in the domestic economy to bring back the capital that is gone to Japan. This can be done by raising the target for federal funds rate and increasing reserve requirements, conducting open market sales of treasury securities or using any other monetary policy tool to implement contractionary monetary policy and depress the aggregate demand. This reduction in the money supply will increase domestic interest rate and appreciate the dollar which reduces net exports and shift AD back to its original level.

f) Below is labelled graph of the money market where money supply has reduced. This would increase the nominal interest rates in Macroville.