Let S^N ($/¥) denotes the nominal exchange rate between the U.S. dollar and Japa

Question

Let S^N ($/¥) denotes the nominal exchange rate between the U.S. dollar and Japanese yen. Show that an increase in the Japan’s real exchange rate ,(S^real ($/¥)), (say over one year time period) will make Japan less competitive in international trade with U.S. and lowers the cost of U.S. goods for Japanese. Use a numerical example to support your answers. (Hint: Assume a constant nominal exchange rate in two periods, assume CPIs 0f 100 for both counties at initial time, assume different CPIs for terminal period).

Explanation / Answer

Let the current exchange rate be 0.009 $ / Y (data sourced from google finance)

The initial CPI values in both countries are assumed to be 100 each. Let the CPI (Japan) value be 102 after a year and the CPI(US) value be 108

Inflation Rate in US = (108-100) / 100 = 8 % and Inflation Rate in Japan = (102-100) / 100 = 2 %

Expected Exchange Rate after-one year = 0.009 x (1.08/1.02) = 0.00953 $ / Y

As is observable, 1 Y would be able to buy 0.00953 Yens as compared to 0.009 Yens today. This implies that Japanese goods are becoming more expensive for the US, thereby harming Japan's competitiveness in exports and hence the international trade. Conversely. 1 Yen could purchase goods worth 0.009 $ today and $ 0.00953 a year later, implying that US cost of goods is going down for the Japanese.

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