Draw the demand for and supply of the U.S. dollar in each of the following cases. Diagram and explain in words the effect of each of the following events in the short run. Make sure to properly label the axes

Question

In each case, assume the two countries under consideration are important trading partners. (a) There is an increase in the real interest rates in the United States relative to Japan. (b) Investment returns in the United States decrease relative to expected returns in Japan. (c) Inflation in Japan fell relative to the inflation rate in the United States. (d) The Japanese expect the value of the U.S. dollar to decline. (e) The Federal Reserve raised interest rates fearing the inflationary pressures of a booming U.S. economy.

Answer 1

(a) Both holders of yen and holders of U.S. dollars would now favor U.S. assets. This results in a shift of the demand curve for U.S. dollars to the right. The supply curve for U.S. dollars would likely shift to the left. Consequently, the U.S. dollar appreciates while the yen depreciates.
(b) Investment in the United States becomes relatively unattractive. As a result, both holders of yen and holders of dollars prefer yen denominated assets. This will increase the supply of U.S. dollars and decrease the demand for U.S. dollars. The dollar depreciates while the yen appreciates.
(c) This makes Japan's products more attractive so it will decrease the demand for U.S. dollars and increase the supply of U.S. dollars as more dollar holders seek Japanese goods. The dollar depreciates while the yen appreciates.
(d) The demand for U.S. dollars decreases, causing the yen to appreciate while the dollar depreciates.
(e) In the short run, the dollar may appreciate due to the higher interest rates, increasing the demand for U.S. dollars and decreasing the supply as people seek to earn these higher rates.