aintain a relatively weak position for the yen. This policy was designed to spur exports and cause imports to be too expensive for Japanese consumers. Pressure from the other G-7 nations, however, led to a revision of that policy in the mid-1980s. Following the change in Japanese economic policy related to the value of the yen, the yen appreciated almost 50 percent from the mid-1980s through the mid-1990s. As Japan retained a trade surplus, the rising value of the yen was consistent with economic theory.
Other factors remaining unchanged, if the inflation rate in country "A" is greater than that in country "B", the value of country "A's" currency should decrease relative to country "B's" currency, and vice versa. An increase in real interest rates (nominal interest rates adjusted for inflation) in a country's economy tends to attract foreign capital, which, in turn, will cause the value of the country's currency to increase in foreign exchange. Conversely, a decrease in real interest rates tends to cause the value of a country's currency to decrease in international currency exchange markets (Salvatore, 1998).
During the late-1990s and in the early years of the 21st century interest rates in Japan fell to near zero. The Japanese economy was facing a number of serious problems which motivated the maintenance of the low interest rate. Japan, thus, was not attractive as a locus of investment. The policy of low interest rates was accompanied by a loss in the international currency value of the yen (from around -100:US$1 to around -120:US$1. Thus, again, the movement of the international currency exchange value of the yen was consistent with economic theory, and the outcome was driven by Japanese financial and economic policy.
Changes in foreign interest rates affect the foreign exchange value of a country's currency in a manner exactly opposite of the effect caused by changes in domestic interest rates. Positive changes...