Question

Kenya and South Africa are trading partners, and there are capital flows between the two countries. The currency in Kenya is the Kenyan shilling (Ksh.) and the currency in South Africa is the South African Rand (R). Assume that the equilibrium exchange rate is 0.14R per Kenya shilling. Now suppose that the opportunity cost of consumption falls in South Africa.  

Referring to the Kenyan foreign exchange market, explain how the equilibrium exchange rate might change.  You are not required to draw the graphs - all you need to do is explain in detail how the exchange rate could change. Remember to include both demand and supply shifts in your explanation, and indicate a possible new exchange rate in this market.

Referring to the South African foreign exchange market, explain how the equilibrium exchange rate might change.  You are not required to draw the graphs - all you need to do is explain in detail how the exchange rate could change. Remember to include both demand and supply shifts in your explanation, and indicate a possible new exchange rate in this market.

Answer 1

Opportunity cost of consumption is the interest rate (on saving). Therefore, interest rate falls in South Africa.

In Kenyan foreign exchange market, lower interest rate in South Africa will decrease the global investment in South Africa, and will decrease the global investment in Kenya. As a result, demand for Kenya's domestic currency will rise, shifting its demand curve rightward, increasing exchange rate and increasing quantity of Kenya's domestic currency. At the same time, supply for Kenya's domestic currency will fall, shifting its supply curve leftward, increasing exchange rate and decreasing quantity of Kenya's domestic currency. The net effect is a definite increase in exchange rate in Kenya.

In South African foreign exchange market, lower interest rate in South Africa will decrease the global investment in South Africa. As a result, demand for South Africa's domestic currency will fall, shifting its demand curve leftward, decreasing exchange rate and decreasing quantity of South Africa's domestic currency. At the same time, supply for South Africa's domestic currency will rise, shifting its supply curve rightward, decreasing exchange rate and increasing quantity of South Africa's domestic currency. The net effect is a definite decrease in exchange rate in South Africa.