2015 AP Macroeconomics FRQ #3

FOREX

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2015 AP Macroeconomics FRQ #3

(a)

     (i) If Japan's deficit increases then the Japanese Government spends more than it takes in in tax revenue.

It must borrow to make up the deficit. It borrows by selling bonds. It sells bonds to the public/banks and therefore the money supply decreases. People pay for the bonds with cash, so cash leaves the banks and people's pockets and flows to the government. Money supply decreases.

Less money in the banks means the supply of loanable funds have decreased. 

If the government has the cash,, the banks cannot loan it out. Supply of loanable funds decreases.

From the Fiscal Policy Cheat Sheet

Less money in the banks means that the demand for loanable funds will increase.

Both, supply decreasing and demand increasing raises the RIR (real interest rate).

If demand increases then the banks raise interest rates to deal with the increased demand.

Answer -  (a) i

(a)

   (ii) If there is an increase in Japan's deficit, again,, they must borrow funds from the public. This lowers the supply of loanable funds and because the government has borrowed funds from the public demand increases. Real Interest Rates increase, with higher rates of interest less people can afford to invest.

From the Fiscal Policy Cheat Sheet

Answer (a) ii

If the Real Interest Rate increases due to the borrowing by the government then what happens to the supply of Euros and the price of Yen to Euro.

Ok, so if the RIR (real interest rate) increases in Japan, people from the Euro Zone will want to deposit money into the Japanese banks to take advantage of the high interest rates.

So the supply of Euros (money)  traveling to Japan will increase as people are searching for a higher return on their investment.

From the FOREX Cheat Sheet

If the RIR in Japan increases there will be a rush by Euro zone citizens to deposit money and buy financial assets in Japanese banks to gain the higher interest rates. That means that the supply of Euros in the FOREX market will increase. A larger supply will decrease the value of the Euro relative to the Yen.  The value of the Euro compared to the Yen will start to decrease in value as there is a larger and larger supply in the FOREX market.

Supply increases, value decreases

The opposite happens with the Yen,

As more and more Euros flow into the FOREX market to purchase the Yen  needed to buy these financial products the Yen will become relatively more valuable.  As the Yen becomes more valuable it will take less and less Yen to buy a Euro.

Again, as the supply of Euros increases, the value of the Euro decreases,,, as more people need to buy Japanese financial products they have to exchange their Euros for Yen increasing the demand for Yen, driving up the value of the Yen.

The graph above shows that as the Euro's supply increases it takes less and less Yen to buy a Euro.

If the European Central bank buys the Euro it will reduce the supply of Euros in the FOREX market increasing the value of the Euro relative to the Yen.