Question

Kenya and the UK are trading partners. The currency in Kenya is the Kenyan shilling (Ksh.). Assume that the equilibrium exchange rate in Kenya is 113 Ksh. per British pound (£). Now suppose that inflation rises in the UK.

(a) Using TWO separate graphs of the Kenyan foreign exchange market, with each graph showing a different possible shift that could occur in that particular forex market, show how the equilibrium exchange rate might change. Label your graphs fully and explain the reason for your shifts.

(b) Now mirror your explanation using TWO separate graphs of the British foreign exchange market, with each graph showing a different possible shift that could occur in that particular forex market, show how the equilibrium exchange rate might change. Label your graphs fully and explain the reason for your shifts.

Answer 1

A).

As inflation rises in Britain ,the goods in Britain become relatively expensive than Kenyan goods. Britain people start buying more kenyan goods(increase in exports) ,for which they need ksh whcih increases demand of ksh (shown by rightward shift of demand). And exchange rate increases.

As Britain goods become expensive ,then kenyan people will start reducing their imports and start buying domestic product for which they will exchange pound for ksh and it will decrease supply of ksh for foreigners and exchange rate increases.

B).

As for inflation increases Kenyan demand for Britain goods falls(exports decrease). Which leads to decrease in demand for pound and exchange rate decreases.

As inflation increases in Britain , Britain people start more import,for which they need to exchange pound for ksh which increase supply for pound and exchange rate decreases