The graph below shows the foreign exchange market between the United States and

Question

The graph below shows the foreign exchange market between the United States and Japan before and after an increase in the demand for Japanese goods by U.S. consumers.

A. If the exchange rate was free-floating prior to the change in demand for Japanese goods, what was its value in yen per dollar?

B. After the change in demand, assuming a free-floating exchange rate, what is the new exchange rate in yen per dollar?

C. If the Japanese central bank wanted to keep the exchange rate fixed at its initial value, how many dollars would it have to buy?

Explanation / Answer

A. The value of yen per dollar was 125. This is shown by the interaction of demand curve and the old supply curve.

B. The new value of yen per dollar is 100. This is shown by the interaction of demand curve and the new supply curve.

C. If the Japanese central bank wanted to keep the exchange rate fixed at its initial value, the demand curve for dollars needs to shift towards the right to a position that the new demand and supply curve intersects at the point of 125 yen /dollar. Currently, the demand curve intersects the new supply curve at 100 yen per dollar. The current demand for the dollar is 1,190 and the demand for dollar needs to be 1,270 for the yen value of the dollar to be 125. So, the Japanese central bank needs to buy 1,270 - 1,190 = 80 dollars.

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