Scenario: Japan and the United States
Suppose that the interest rate in the United States is 4%, in Japan it is 7%, and financial assets in the two countries are equal in risk.

-(Scenario: Japan and the United States) Refer to the scenario Japan and the United States. The implication is that:

Question

Scenario: Japan and the United States
Suppose that the interest rate in the United States is 4%, in Japan it is 7%, and financial assets in the two countries are equal in risk.

-(Scenario: Japan and the United States) Refer to the scenario Japan and the United States. The implication is that:

Quizplus · Accepted Answer

The difference in interest rates between the two countries will encourage investors to transfer their capital to the country with the higher interest rate, in this case, Japan. This will increase the demand for Japanese currency, causing its value to rise and the demand for US dollars to fall, causing its value to decline. As a result, Japanese exports to the United States will become more expensive, and US exports to Japan will become cheaper, leading to a reduction in the US trade deficit and an increase in Japan's trade surplus. These changes, in turn, will gradually cause the interest rates in the two countries to converge. Therefore, the capital flow between Japan and the United States eventually will render the interest rates equal.