Suppose that a trade agreement between Japan and the United States makes it less

Question

Suppose that a trade agreement between Japan and the United States makes it less expensive for U.S. residents to purchase Japanese goods. How does this affect the dollar-yen exchange rate? Drag the appropriate curve(s) to illustrate how this affects the market for Japanese yen.(equilibrum Price and quantity 3)

The exchange rate is the price of one country's currency in terms of another country's currency. In a system of floating exchange rates, the exchange rate is determined by the free market. The equilibrium market exchange rate is determined by the laws of supply and demand.

The following question focuses on the exchange rate for U.S. dollars and Japanese yen. The exchange rate is defined as the U.S. dollar amount one must pay for one yen.

Explanation / Answer

Let us start with the assumption that 1Yen =$2.75 though $ 0.0097 is the approximate current rate). Now assuming that a tarde agreement between Japan and United states makes it let expensive for the US residents to purchase the japanese goods implies that the demand for Japanese products in US will increase. This in turn would increase the demand for the Japanese yen in US to make payments for the increased imports in US consequent upon increased demand in US. This increased demand for Yen increases its value or appreciates the value of Yen. Let us see this in the graph below.

The initial equiloibrium is 1 yen =$2.75 in the free market where the forces of demand and supply determined the price. As the new agreement increased domestic demnad for Yen in US the demand curev for yen shifts upward towards to the right. Thus, the new equilibrium is now at 1Yen = $3.75. This, implies that despite the attempt to amke the Japanese goods cheaper in US the intention is compromised partailly by the increased excahnge rate as shown below.

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