Question

If the Bank of Japan sees the need to fight deflation and as a result it carries out a series of temporary quantitative easing policies aimed at boosting money supply, what will this do to (i) the Japanese short run interest rates, and (ii) the spot Yen exchange rate with other currencies for countries that Japan trades with, assuming that no action happens to any key variables in those other countries? Explain.

Answer 1

I) In order to fight deflation, the Japanese short run interest rates will have to fall so that this induces people to save less in bank accounts and hold more cash in their hands. This will induce increased consumption, thereby reducing deflation.

I I) The spot exchange rate with other trading countries will increase. This is because incrreased cash holding by Japanese would mean increased demand for foreign goods as well. Thus an increased demand for foreign goods in turn means increased demand for foreign currency, thereby devaluation of yen and thus increased spot exchange rate.