Realignment of the yen-dollar exchange rate: aspects of the adjustment process in Japan

The paper first surveys recent estimates of the appropriate yen dollar exchange rate that have been proposed in the literature. Most of the more careful estimates suggest that the yen was substantially undervalued against the dollar in early 1985 when it began its steep ascent and some of the estimates suggest that further appreciation from today's strong level is warranted. ; We then turn to the adjustment process. First, we present evidence that a narrowing of Japan's record trade surplus has already started to occur, particularly in real terms. Next, we show that external adjustment has been slower than would have been predicted by a simple econometric model, if Japanese trade. We then explore several possible explanations for this predictive failure in the recent period, including the slower pass-through of exchange rate changes to Japanese export prices than in the past, and the slow pass-through of terms-of-trade gains to consumer prices. Evidence is also presented that Japanese exporters adjust prices asymmetrically in response to yen depreciations and appreciations. ; Next, we use a simple model to analyze the oft-stated claim that too much yen appreciation in a short period of time may actually be counter-productive. The model shows that this outcome is possible, but we argue that for an economy with Japan's structure it is unlikely. ; Finally, we analyze what role fiscal policy can play in the adjustment process. MCM simulation results suggest that a Japanese fiscal expansion would be much less effective in fostering a reduction in both the U.S. and Japanese trade imbalances than would a U.S. fiscal contraction. However, a Japanese fiscal expansion could have an important impact on domestic demand in Japan and on trade with the developing countries.