South-Western College Publishing - Economics  

A Yen for Devaluation
Subject Foreign Exchange Rates and Markets
Topic International Finance
Key Words Currency Devaluation, Exchange Rate, Foreign Exchange
News Story What determines the value of a currency? In the world’s financial markets currencies are just like any other commodity – their price determined by supply and demand. Some demand arises because buyers actually need the currency they are purchasing in order to purchase goods and services or to be a tourist in that country. Others have purely speculative motives, that is, they hope to profit from changes in the value of a currency. The addition of the speculative motive is often the cause of dramatic swings in the price of a currency.

For example, in 1995, the U.S. economy was relatively weak, and Japanese investors were wary of continuing to put money into U.S. investments. The economic situation in Japan also contributed to the decline in the demand for dollars. Japanese firms had sustained large losses on a number of their investments in Japan. In order to cover those losses, dollar investments were exchanged for yen. The combination of the weakness in the U.S. economy and the need to repatriate yen resulted in a strong flow of money out of dollars and into yen, pushing the exchange rate of yen for dollars to a record high.

In 1998, the strength of the U.S. economy, record levels of the U.S. stock market and high yields in the U.S. bond market, coupled with a weakness in Japan’s economy, has reversed capital flows. Japan’s economy is in a recession. Real estate values have been falling for a number of years, the banking system is struggling with bad debts, and interest rates are at record low levels. With all of these problems, Japan does not appear to be a promising place for investment and the yen has fallen accordingly.

The U.S. and Japanese governments could intervene in the currency market to halt the yen’s slide. But interventions without change in the underlying policy or economy is unlikely to permanently halt or reverse a currency’s slide. A shift in relative interest rates between Japan and the U.S. could improve the exchange rate; however, Japan cannot raise interest rates because of its recession and the U.S. cannot lower its because of inflationary fears. Japan can stimulate its economy through tax cuts and U.S. officials are apparently urging Japan to do so. What is the future course of the yen? According to Mickey Levy, chief financial economist at NationsBank in New York, "Until Japanese policymakers take credible steps toward not just fiscal reform but massive structural reform of their financial institutions, the yen will likely test its recent lows and go through them."
(Updated August 12, 1998)

Questions
  1. What are some of the determinants of the supply of foreign exchange?
  2. What are some of the determinants of the demand for foreign exchange?
  3. How is the exchange rate determined?
  4. Describe how the central bank of Japan could intervene to maintain an exchange rate.
Source John M. Berry, “How to Make a Silk Purse out of a Sour Currency,” TheWashington Post, June 18, 1998

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