Suppose the foreign exchange market is in equilibrium. Then, the U.S. government increases borrowing, causing American interest rates to increase. What will happen to the price of the Japanese yen? Why?

What will be an ideal response?

The higher U.S. interest rates induce foreign residents, including Japanese residents, to increase their demand for U.S. securities, which causes the demand for dollars to increase. This is equivalent to an increase in the supply of yen. Holding the demand for yen constant, an increase in supply implies the dollar price of the yen falls and the quantity demanded increases. The Japanese yen is now relatively cheaper, and U.S. residents buy more of them.