Question

In early 1990, Japanese and German interest rates rose while U.S. rates fell. At the same time, the Japanese yen and German Mark, the currency of Germany before the introduction of Euro, fell against the U.S. dollar. What might explain the movement of Japanese yen and German Mark against U.S. dollar

Answer 1

According to the Fisher effect, the most likely cause for the rise in German and Japanese interestrates was higher expected inflation in those countries. At the same time, the fall in U.S. interest rates couldbe attributable to a decline in expected U.S. inflation. If so, then PPP would predict that the future value ofthe dollar should rise relative to what was previously expected. Since these expectations would beimmediately impounded in currency values, we would expect the dollar to rise relative to the yen and DM.This scenario is consistent with what actually happened.