One British pound exchanges for 1.6 U.S. dollars. One dollar exchanges for 81 Japanese yen, or for 6.2 Swedish krona. What is the exchange rate between the pound and the yen, between the pound and the krona, and between the krona and the yen?
Suppose that at the present time, 1 British pound exchanges for 1.4 U.S. dollars and 100 Japanese yen. Over the next decade, Japanese prices remain constant, while inflation doubles American prices, and quadruples British prices. What would the purchasing-power parity theory lead one to expect about the exchange rates between the three currencies 10 years hence?
Consider the following cases:
a) Draw a supply and demand diagram for the Japanese yen, showing an equilibrium exchange rate.
b) If the Japanese wished to have a lower exchange rate, would they run a balance of payments surplus or deficit? Would the Japanese central bank have to buy or sell foreign exchange to keep this low exchange rate? Show the effect of this central bank action on your diagram.
c) If the Japanese wished to have an exchange rate higher than the equilibrium, would they run a balance of payments surplus or deficit? Would the Japanese central bank have to buy or sell foreign exchange to keep this high exchange rate?
d) Are there constraints that might prevent the Japanese from pursuing either b) or c) above? Are the constraints equally strong in the two cases?