Tsunamis destroy factories in Japan, increasing the price of Japanese-made goods.

Question

Draw correctly labeled side-by-side graphs for the British pound and the Japanese yen showing how the increasing price of goods in Japan will affect the 2 countries’ currencies. What is the effect on the international value of the Yen and the Pound?

Answer 1

Hi Richard - this is based on a few assumptions that you need to make about the foreign currency markets. It's a multi-step process.

1) Economic Shock in Japan.

In the (closed) Japanese Production: Supply Decreases -> Prices Go up (e ceterus paribus). These prices go up whether Japanese or British people are buying. But when it's outside the closed market, now you have to consider the impacts on currency exchange. This is one of the reasons why stable exchange rates are so meaningful to stable international trade and open economies.

2) Rising Prices have impacted the foreign markets. In this example, the UK sees the higher prices and will import fewer goods from Japan (e.c.p).

3) when two economies interact, one action in one economy has a corresponding action in another (like physics). So if something happens and impacts goods and the Yen, then there is a corresponding impact on any other economy or currency that interacts with the Japanese market.

Here's the link to FX:

2a) Graph 1 - The Market for Yen (in UK).

Y-Axis: Price of Pound /Yen

X-axis: Quantity Yen

1. Higher prices mean fewer Japanese Goods demanded in the UK. Demand for Yen goes down relative to the Pound. (D curve Shift left, Quantity falls)
2. Equilibrium Price of Yen on the Fx market Goes Down (Y-Axis)
3. Deflation of the Yen occurs relative to the British Pound.
4. That is, the price of the Pound in YEN has gone down. (say Equilibrium was 1 pound =1 yen, it is now .5 pound/1 Yen). The currency market is the lower of the two numbers, and is the base number).

2b) Graph 2 - The Market for Pounds (in Japan).

Y-Axis: Price of Yen/Pound

X-Axis:Q Pounds

1. Correspondingly, the Supply of the Pound Decreases ( S Curve Shifts left, and Quantity drops) because fewer foreign currency (pounds) is needed to buy the fewer Japanese goods.
2. Equilibrium Price on the Fx Market of the Pound goes up, and sees inflation compared to the Yen.
3. That is, the price of the Pound has increased relative to the Yen (Y-Axis)

Labeling the graphs and understanding the markets is the easiest part to misunderstand.

The price of the "object" is the currency itself. Remember, money and prices are two different things. You should be able to draw it from this.