Question

The U.S. economy is growing faster than that of Japan. The faster growth rate in the U.S. should cause the value of the dollar to depreciate against the yen, everything else being equal. Explain. (essay)

Answer 1

Following factors affect the currency exchange rate:

- interest rates

- rate of growth

- Inflation rate

- Balance of Trade

A higher economic growth in the US improves the balance of trade through increase in exports and reduction in imports. Higher level of exports attracts more foreign capital into the domestic economy. On the contrary, lower growth in the Japan would make its exports expensive and imports cheaper. This would result in the currency appreciation in Japan and depreciation in US.

Also, US $ will depreciation due to disparity in the US and foreign interest rates. Due to higher growth and demand, the interest rate falls. Domestic interest rate < foreign interest rates. Seeing this, the investors find it beneficial to invest in Japan and this leads to capital outflow from US. As a result, the US $ depreciates and Japan Yen appreciates.