Download Impact of Carry Trade on Japanese Yen and Australian Dollar: A Case Study - Prof. Patrick and more Assignments International Economic Relations in PDF only on Docsity! Economics 460 Suggested Answers Case 2: The Danger of the Falling Yen 1. What is the impact of the carry trade on the spot and forward exchange rates of Japanese yen in terms of Australian dollars? On the spot market, the desire to borrow in Japan and lend in Australia leads to an excess demand for Australian dollars and a depreciation of the yen relative to where it would be without this. On the forward market with the Australian dollar, the trades supporting covered interest parity will cause an appreciation today to offset the spot depreciation. If the carry trade is seen as a increasing volume on the financial markets, we might anticipate that both spot and forward exchange rates will depreciate through time, but this will depend upon this increasing volume relative to other transactions on the foreign exchange market. 2. Why is Secretary Paulson unconcerned about this phenomenon? What do you think does he see as the benefits of it continuing? Do you agree? Secretary Paulson indicates in his testimony that he is only concerned about exchange-rate activity that is triggered by central-bank intervention. Since the weakened yen is due to private financial activity (the carry trade), he believes that it is a reflection of efficient market forces. He also sees the value to the world economy of having a growing Japanese economy, and the weakened yen provides for export growth in that economy. You can agree or not. If so, you might speak of the value to the world economy of reallocating Japanese saving to foreign countries. If not, you might discuss the threat of a 1998-style financial meltdown due to unwinding financial positions should the yen sharply reverse course. 3. If the Japanese introduce an expansionary fiscal policy at this time, what will be the impact on national income, interest rate, exchange rate and current account balance? Will there be added impacts due to the carry trade? Explain. The impact of expansionary fiscal policy will be to increase autonomous expenditure in the goods market and thus drive up national income and the interest rate. These changes will trigger an appreciation of the Japanese spot exchange rate. This reduces the positive impact on national income, but in the end leads to a worsened current account (smaller surplus). The carry trade will be adversely affected by this switch. The rising interest rate in Japan will make the carry trade less attractive. This will lead to reduced capital outflows and a further appreciation, and this appreciation will further reduce national income and worsen the current account. The unwinding of carry trade positions thus may lead in the short run to larger appreciation and less expansion of national income than was anticipated from the policy.
