INTERNATIONAL ECONOMICS
QUESTION ONE (Compulsory) (30 MARKS)
(a) Suppose you are a Kenyan importer who has ordered for 100 computers from the USA
at a price of US$ 1,000 each. The total payment of US$ 100,000 is due in 100 days’ time
after all the computers have been delivered in Kenya. Since the contract is written in
dollars, there is a possibility of a change in the Ksh exchange rate during the period. Using
this information demonstrate the concept of hedging by giving out two possible options the
Kenyan importer should consider. (4 Marks)
1. He can enter the spot foreign exchange market now and buy the required US$ 100,000 at the
current spot exchange rate and invest the dollars in USA to earn interest until payment is due at
the end of 100 days period (Balanced or closed position)
2. He can hold on to his Kenyan Shilling worth US$ 100,000 and invest them in CBK’s 91-day
Treasury Bills to earn interest. At the end of the 100 days, he enters the spot foreign exchange
market to buy the US$ 100,000 at the existing spot exchange rate (Short position)
(b) Given that Kenya is the domestic country and USA is the foreign country, clearly
demonstrate the relative form of purchasing power parity. Also explain what will happen
to Kenya’s currency in a situation whereby there is a 15 per cent increase in Kenya’s
overall price level and a 2 per cent increase in USA’s price level. (6 Marks)
This theory does not tell us about what determines the absolute level of exchange rate, moreover,
it tells what determines the change in the exchange rate over the given period. This theory
implies that the differential inflation rate is always identical to the change in spot rate. Hence
change in exchange rates is determined by the difference in the inflation rates of two countries,
i.e. any difference in the rates of inflation will be offset by a change in exchange rate.
If so then let, S0 be the current spot exchange rate at t0 [Rs./$]
E(St ) be the expected exchange rate in t periods
iqbe the inflation in quote currency [iRs]
ibbe the inflation rate in base currency[i$ ]
Now by definition,
[E(St )- S0 ]/ S0 =[iq-ib]
Solving this we get,
E(St )= S0 *[1+{ iq-ib}]
E(St )= S0 *(1+iq )/(1+ib )
Page 1 of 16
,The percentage change in the exchange rate between two currencies is approximately equal to
the difference in their respective countries’ rate of inflation.
Thus: %e = %pd - %pf
If, for example, Kenya’s overall price level rises faster than America’s overall price level, then
the Kenyan shilling must depreciate (lose value) vis a vis the US$ in order for Kenya’s goods
and services to remain competitive. Specifically, a 15 per cent increase in Kenya’s overall price
level and a 2 per cent increase in USA’s price level implies a 13 per cent depreciation of the Ksh
relative to the US$.
This means that Kenya residents will need 13 per cent more Ksh in order to buy one US$, that is,
% e = 15% - 2% =13%. Since the concept of PPP is derived from the law of one price, PPP is
subject to the same limitations of inflation rate, transport and other transaction costs as the law of
one price concept. An increase in e implies a depreciation of the Ksh. such that the Kenya
shilling price of imports rise, (and the foreign prices of Kenyan goods fall).
(c) In a free market economy with a flexible exchange rate regime, forces of demand for
and supply of foreign exchange determine the equilibrium position. Using a well labeled
diagram demonstrate the equilibrium condition in an economy with this kind of exchange
rate regime and explain what happens in case there is excess supply of foreign currency.
(8 Marks)
In figure above, the equilibrium exchange rate is eo, where at point A demand for and supply of
foreign exchange are equated. However, if market forces of demand and supply cause the
exchange rate to rise from e0 to e1, there will be a surplus of foreign exchange equal to BC. The
availability in the market of this BC foreign exchange surplus exerts pressure on the exchange
rate to fall towards e0, as shown by the arrow pointing downwards.
Page 2 of 16
, (d) Using the concept of Covered Interest Arbitrage, demonstrate when it is appropriate
to invest in Kenya Shilling denominated assets and when it is appropriate to invest in
dollar denominated assets. (4 Marks)
As long as the interest differential in favour of the Kenya shillings denominated assets is less
than the expected increase in the value of the foreign (dollar) denominated asset over the
investment period, there is an incentive to invest in foreign currency.
Algebraically, if:
{iksh – i$} < {(ee-e)/e} , invest in dollar denominated assets
where:
iKsh is the interest rate on short-term Kenya shilling denominated assets
i$ is the interest rate on short-term foreign(dollar) denominated assets
ee is the expected future spot rate at the expiry of the investment period
e is the current spot rate
On the other hand, if:
{iKsh -i$} > {(ee-e)/e} invest in Kenya shilling denominated assets
Numerical example, if:
{(8.42% -1.11%) = 7.3%} > {(Ksh 78/$ -Ksh 74/$) / (Ksh 74/$)= 5.4%}, invest in Kenya
shilling denominated assets.
In this case the interest differential {iKsh -i$} in favor of Ksh - denominated assets is large
enough to compensate for the expected loss in reconverting dollars into Ksh.
(e) The economy of the United Kingdom can be characterized by the following set of
equations:
Y =2400
MD
=1470+0.4 Y −10000 ( r + π e ) ( π e =0.03) (Real Money Demand)
P
MS
=2000 (Real Money Supply)
P
C d=388+ 0.6 ( 1−t ) Y −50000 r (t = 0.4) (Desired consumption)
d
I =600−12000 r (Desired savings)
NX =300−0.2Y + 0.01Y for +10000( r−r for ) (Net Exports)
r for = 0.02 (Foreign real interest rate)
Y for = 12000 (Foreign real output)
G = 900 (Government spending)
T R = 200 (Government transfers)
Page 3 of 16
QUESTION ONE (Compulsory) (30 MARKS)
(a) Suppose you are a Kenyan importer who has ordered for 100 computers from the USA
at a price of US$ 1,000 each. The total payment of US$ 100,000 is due in 100 days’ time
after all the computers have been delivered in Kenya. Since the contract is written in
dollars, there is a possibility of a change in the Ksh exchange rate during the period. Using
this information demonstrate the concept of hedging by giving out two possible options the
Kenyan importer should consider. (4 Marks)
1. He can enter the spot foreign exchange market now and buy the required US$ 100,000 at the
current spot exchange rate and invest the dollars in USA to earn interest until payment is due at
the end of 100 days period (Balanced or closed position)
2. He can hold on to his Kenyan Shilling worth US$ 100,000 and invest them in CBK’s 91-day
Treasury Bills to earn interest. At the end of the 100 days, he enters the spot foreign exchange
market to buy the US$ 100,000 at the existing spot exchange rate (Short position)
(b) Given that Kenya is the domestic country and USA is the foreign country, clearly
demonstrate the relative form of purchasing power parity. Also explain what will happen
to Kenya’s currency in a situation whereby there is a 15 per cent increase in Kenya’s
overall price level and a 2 per cent increase in USA’s price level. (6 Marks)
This theory does not tell us about what determines the absolute level of exchange rate, moreover,
it tells what determines the change in the exchange rate over the given period. This theory
implies that the differential inflation rate is always identical to the change in spot rate. Hence
change in exchange rates is determined by the difference in the inflation rates of two countries,
i.e. any difference in the rates of inflation will be offset by a change in exchange rate.
If so then let, S0 be the current spot exchange rate at t0 [Rs./$]
E(St ) be the expected exchange rate in t periods
iqbe the inflation in quote currency [iRs]
ibbe the inflation rate in base currency[i$ ]
Now by definition,
[E(St )- S0 ]/ S0 =[iq-ib]
Solving this we get,
E(St )= S0 *[1+{ iq-ib}]
E(St )= S0 *(1+iq )/(1+ib )
Page 1 of 16
,The percentage change in the exchange rate between two currencies is approximately equal to
the difference in their respective countries’ rate of inflation.
Thus: %e = %pd - %pf
If, for example, Kenya’s overall price level rises faster than America’s overall price level, then
the Kenyan shilling must depreciate (lose value) vis a vis the US$ in order for Kenya’s goods
and services to remain competitive. Specifically, a 15 per cent increase in Kenya’s overall price
level and a 2 per cent increase in USA’s price level implies a 13 per cent depreciation of the Ksh
relative to the US$.
This means that Kenya residents will need 13 per cent more Ksh in order to buy one US$, that is,
% e = 15% - 2% =13%. Since the concept of PPP is derived from the law of one price, PPP is
subject to the same limitations of inflation rate, transport and other transaction costs as the law of
one price concept. An increase in e implies a depreciation of the Ksh. such that the Kenya
shilling price of imports rise, (and the foreign prices of Kenyan goods fall).
(c) In a free market economy with a flexible exchange rate regime, forces of demand for
and supply of foreign exchange determine the equilibrium position. Using a well labeled
diagram demonstrate the equilibrium condition in an economy with this kind of exchange
rate regime and explain what happens in case there is excess supply of foreign currency.
(8 Marks)
In figure above, the equilibrium exchange rate is eo, where at point A demand for and supply of
foreign exchange are equated. However, if market forces of demand and supply cause the
exchange rate to rise from e0 to e1, there will be a surplus of foreign exchange equal to BC. The
availability in the market of this BC foreign exchange surplus exerts pressure on the exchange
rate to fall towards e0, as shown by the arrow pointing downwards.
Page 2 of 16
, (d) Using the concept of Covered Interest Arbitrage, demonstrate when it is appropriate
to invest in Kenya Shilling denominated assets and when it is appropriate to invest in
dollar denominated assets. (4 Marks)
As long as the interest differential in favour of the Kenya shillings denominated assets is less
than the expected increase in the value of the foreign (dollar) denominated asset over the
investment period, there is an incentive to invest in foreign currency.
Algebraically, if:
{iksh – i$} < {(ee-e)/e} , invest in dollar denominated assets
where:
iKsh is the interest rate on short-term Kenya shilling denominated assets
i$ is the interest rate on short-term foreign(dollar) denominated assets
ee is the expected future spot rate at the expiry of the investment period
e is the current spot rate
On the other hand, if:
{iKsh -i$} > {(ee-e)/e} invest in Kenya shilling denominated assets
Numerical example, if:
{(8.42% -1.11%) = 7.3%} > {(Ksh 78/$ -Ksh 74/$) / (Ksh 74/$)= 5.4%}, invest in Kenya
shilling denominated assets.
In this case the interest differential {iKsh -i$} in favor of Ksh - denominated assets is large
enough to compensate for the expected loss in reconverting dollars into Ksh.
(e) The economy of the United Kingdom can be characterized by the following set of
equations:
Y =2400
MD
=1470+0.4 Y −10000 ( r + π e ) ( π e =0.03) (Real Money Demand)
P
MS
=2000 (Real Money Supply)
P
C d=388+ 0.6 ( 1−t ) Y −50000 r (t = 0.4) (Desired consumption)
d
I =600−12000 r (Desired savings)
NX =300−0.2Y + 0.01Y for +10000( r−r for ) (Net Exports)
r for = 0.02 (Foreign real interest rate)
Y for = 12000 (Foreign real output)
G = 900 (Government spending)
T R = 200 (Government transfers)
Page 3 of 16
