Question

1. Suppose that 1 US$ = 1.5 South African Rand. Also, suppose that the representative good, peanut butter, is $3 per jar in the US and 4 Rand per jar in SA. How will this situation affect the exchange market for U.S. dollars? Explain/show the effect(s) of these prices. Include the initial effect(s), the market adjustment(s), and the final result(s) on equilibrium. (9 pts.)

Answer 1

Ans. Price of 1 Jar of Peanut butter in USA = $3

Dollar-Rand exchange rate = 1.5 Rand / $

=> Price of 1 Jar of Peanut butter in South Africa denominated in $ = 4/1.5 = $2.67

Thus, the price of 1 jar of butter is cheaper in South Africa, this will increase demand for peanut butter from South Africa increasing demand for Rand and decreasing demand for dollar shifting the demand curve leftwards from D to D'. This decrease in demand for US$ will lead to surplus of dollars in the market leading to decrease in Rand/$ exchange rate to E (calculated below) from initial 1.5Rand / $and decreasing the equilibrium quantity of US$ from initial L to L'.

Also, as price is not same in both the countries, so,

New Exchange rate, E = Price in South Africa / Price in USA = 2.67/3 = 0.89 Rand/$

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