The video is the first time in which the man believed to be Jihadi John has publicly asked for a ransom. Previous hostage videos and executions have been billed as retaliation to the US-led campaign against Isil.
The Japanese prime minister Shinzo Abe is currently touring Israel and the Palestinian territories.
He called on the Islamic State group to immediately release the hostages. "I strongly demand that they not be harmed and that they be immediately released," he said at a news conference during a visit to Jerusalem. "I am extremely indignant at such an act."
"Their lives are the top priority," Mr Abe said. "Extremism and Islam are completely different things."
He added: "The international community will not give in to terrorism and we have to make sure that we work together."
Chief cabinet secretary Yoshihide Suga told journalists in Tokyo that his country would not give into terrorism. "Our country's stance - contributing to the fight against terrorism without giving in - remains unchanged," he said.
It is believed that Japan may have secretly paid out ransoms for hostages in the past – including in Iraq – but the figure of $200m is well beyond what might considered a realistically negotiable sum. Similar demands were made in private for other Western hostages but turned down.
While Japan has not got troops involved in the campaign against Isil, it has pledged financial support. On a visit to Cairo on January 17, Japanese Prime Minister Shinzo Abe pledged about $200 million in non-military assistance for countries battling the jihadist group, such as Iraq.
The two hostages' identities have not been officially confirmed, but one is believed to be Haruna Yukawa, a private military contractor in his early 40s who was kidnapped in Syria last August, and the other is thought to be Kenji Goto, a Japanese freelance journalist who went to report on Syria's civil war last year.
The man identified as Jihadi John has appeared in the beheading videos of British aid workers David Haines and Alan Henning. He also appeared in similar videos featuring US journalists James Foley and Steven Sotloff, and Peter Kassig, an American aid worker.
British intelligence officials, who have been tasked by David Cameron with hunting Jihadi John down, are also examining the video for clues as to where it was shot.
A spokeswoman from the Foreign Office said: "We are aware of the video and we are studying the content."
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