Question

Suppose we observe a strengthening of the Japanese economy which increases Japanese investment activity and raises Japanese interest rates. Given this shift in economic fundamentals, predict the likely effect on a) the Japanese trade surplus, b) the foreign exchange value of the Japanese Yen, and c) U.S. Treasury bond prices. Briefly explain your reasoning.

Answer 1

(a) Strengthening in Japanese economy will increase income in Japan, which will increase Japan's import demand. This will decrease net exports (= exports - imports), thus decreasing trade surplus.

(b) Higher interest rate in Japan will increase foreign investment in Japan, which will increase the demand for Yen. So Yen will appreciate.

(c) As interest rate in Japan increases, global investors will demand more Japanese bonds and less US bonds. So demand for US Treasury bond will decrease, shifting its demand curve leftward and decreasing price of such bonds.