Q3. Exchange rates and the AD/AS model (10 points) Japan has a large stock of government debt and has been at the zero lower bound many years. Suppose that, for whatever reason, international investors become less willing to hold Japanese government bonds and other yen-denominated assets. In other words, suppose there is an autonomous decrease in the demand for yen-denominated assets. Analyze the effects of this change on the Japanese economy, using the following steps. i) In the graph below, draw the supply and demand curves for assets denominated in Japanese yen (hint: follow the textbook, how does the supply curve look like?). The variable E is the exchange rate from the Japanese point of view, that is, the number of US dollars that you can buy with one Japanese yen. Label these curves S and D, respectively. Label the equilibrium as point 1 in this graph. (Use the blue lines to draw S and D) Exchange rate, E yen Quantity of yen- denominated assets i) What changes in the graph above when there is an autonomous decrease in the demand for yen-denominated assets? Shift one or more curves in the graph above to show the effect of this change and label the new equilibrium as point 2. iii) Does the Japanese yen appreciate or depreciate as a result of this change? Write your answer (appreciate or depreciate) here:iv) Now consider the effects of the change in E within the AD/AS model (hint: follow slides). Before the change in the exchange rate, the Japanese economy is at point 2 in the figure below. What happens in this diagram as a result of the change in the exchange rate from your answer in part (iii) above? Shift one or more curves in the graph below to show the effect of this change. Suppose the new equilibrium is still in zero lower bound regime, and you do not need to consider policy response. Label this new equilibrium as point 3. LRAS " TAD AS 2 N 2 Y v) Which of the following statements best describes the behavior of real output in Japan as the economy moves from point 2 to point 3 in your graphs above? (choose one answer) A. output increases because of increased exports and a lower real interest rate B. output increases because of increased exports and a higher real interest rate C. output decreases because of decreased exports and a lower real interest rate D. output decreases because of decreased exports and a higher real interest rate E. output decreases even though exports increase because of a higher real interest rate