Exchange rate intervention and economic stabilization policies between U.S. and Japan

Monetary Policies

A meeting between heads of state: President Obama of the United States and Naoto Kan of Japan has just concluded. The focus of the discussion was the exchange rate between the U.S. dollar and the Japanese yen. The president and prime minister along with the respective central bank heads agree that the current market exchange rate of 120 Yen to the dollar is too high, and as a result the respective governments will take steps to drive the value of the yen lower concomitant with an increase in the value of the dollar. To achieve this end government and central bank directives manifest themselves in several policy options.

Exchange Rates

Many policy advisors and officials contend that currency manipulation has no significant impact on exchange rates because annual official foreign exchange purchases of 40 billion to 70 billion per year by countries such as Japan and China pale in comparison with a trillion dollars or more per day of financial transactions. The error in this assessment is to compare net and gross financial flows (Preeg, E. 2003).

The reality of government intervention in the currency markets is that there can be a profound effect on exchange rates. Government action in the area of currency valuation takes on two predominant forms: interest rate adjustments and one- way purchases of foreign currencies. In the case of the ostensible goal of a devaluation of the Yen from 120 to 130 per U.S. dollar the U.S. Federal Reserve could raise the target fed funds rate through open market operations by selling bonds, as well as hike the discount rate, and as a result treasury rates would increase (See Appendix 1- Contractionary Policies). The purpose of this interest rate increase is that "higher interest rates offer lenders in an economy a higher return relative to other countries; therefore, higher interest rates attract foreign capital and cause the exchange rate to rise" (Bergen, J.N.D.). The Bank of Japan could likewise reduce their key interest rates which would "tend to decrease exchange rates" (Bergen, J.N.D.).

The second method of moving the exchange rate between the yen and dollar is the one-way purchases of the dollar via the U.S. And Japanese central banks (See Appendix I- Direct Currency Purchases). An increase in the demand for the dollar will cause its value to rise relative to the yen; likewise the sale of yen in the open market will lead to a devaluation of the yen in relation to the dollar. It is important to remember that the context for these policy actions is to allow the Japanese yen to depreciate, which will have the effect of making their exports less expensive to foreigners and as such exports will increase. Second a devalued yen relative to the dollar will be an inflationary pressure on the Japanese economy which has suffered from extensive deflation over the past two decades.