Japanese economists worry that changes in the U.S. inflation rate have too large an effect on the Japanese economy. What type of exchange-rate regime should Japan have if it does not want U.S. inflation changes to impact the Japanese internal economy? Explain, using relative purchasing power parity (PPP) in your explanation.

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: If a country wishes to isolate itself from external shocks, it should adopt a flexible exchange rate. The floating exchange rate adjusts to insulate the economy from foreign shocks. Under fixed exchange rates, inflation abroad would be imported. We can see the reasons using relative PPP, which states that (eventually, over a number of years) the percentage change in the nominal exchange rate value of a country's currency equals the difference between the foreign inflation rate and the country's inflation rate. If a fixed exchange is to be viable (zero change in the nominal exchange rate), then a country must, according to relative PPP, have the same inflation rate as the foreign country. For a fixed rate between the Japanese yen and U.S. dollar, Japan would have to accept having the same inflation as the United States has. If Japan wants to have a different inflation rate, Japan should have a floating exchange rate between the Japanese yen and the U.S. dollar, so exchange-rate changes can offset inflation rate differences.