Assume that the U.S. interest rate on 1-year deposits is 2% and the Japanese interest rate on 1-year deposits is 2%. i.e. R$= R= 0.02. The expected exchange rate between the yen and the USD one year from now is Ee/$ = 115.70.

1. If FX markets are in equilibrium (i.e. UIP holds), what is the current yen/USD spot exchange rate (E/$)?
2. Suppose the Bank of Japan temporarily raises the interest rate from 2% to 3% (assume exchange rate expectations remain constant). How does this affect the equilibrium yen/USD spot rate? Calculate the new yen/USD spot rate. Show your results graphically using a foreign exchange market equilibrium diagram.