Question

In: Economics

Sri Lanka and Kenya are trading partners, and capital flows occur between these two countries. Currently...

Sri Lanka and Kenya are trading partners, and capital flows occur between these two countries. Currently the nominal exchange rate is about 1.75 Sri Lankan rupees per Kenya shilling. Suppose that, ceteris paribus, the GDP deflator in Sri Lanka rises. Use this information to discuss the impact on the two foreign exchange markets - see parts A-F below. (Do not assume conditions outside of this question. Simply respond to the factor that is changing in the question, ceteris paribus.)

You are not required to draw graphs.

  1. In the Kenyan foreign exchange market, explain the impact (if any) on the demand for the Sri Lankan rupee.
  2. In the Kenyan foreign exchange market, explain the impact (if any) on the supply of the Sri Lankan rupee.
  3. In the Sri Lankan foreign exchange market, explain the impact (if any) on the demand for the Kenyan shilling.
  4. In the Sri Lankan foreign exchange market, explain the impact (if any) on the supply of the Kenyan shilling.
  5. Does the Sri Lankan rupee appreciate or depreciate? Provide an example of a new exchange rate.
  6. Does the Kenyan shilling appreciate or depreciate? Provide an example of a new exchange rate and make sure that you have mirrored the rate you have chosen in part (E) above.

Solutions

Expert Solution

(A)

Higher GDP Deflator in Sri Lanka increases inflation in Sri Lanka. This makes domestically made goods more expensive, and foreign goods cheaper, in Sri Lanka. Therefore, Sri Lanka will increase import, which will decrease the demand for Sri Lanka Rupee.

(B)

To pay for Kenyan imports, Sri Lanka will sell its Rupee to buy Shilling, therefore supply of Sri Lankan rupee will increase.

(C)

Sri Lanka will increase its demand for Kenyan Shilling in order to pay for imports from Kenya.

(D)

Since Sri Lanka will sell Rupee to buy Shilling, supply of Kenyan shilling will decrease.

(E)

Lower demand and higher supply will decrease the value of Sri Lanka Rupee, depreciating the Rupee. A new possible exchange rate is 1.5 Sri Lanka Rupee per Shilling.

(F)

Higher demand and lower supply will increase the value of Shilling, appreciating the shilling. The corresponding new possible exchange rate is (1/1.5) = 0.67 Shilling per Sri Lanka Rupee.

Rahul Sunny answered 1 year ago
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