Question 1

i) Increased demand for imports in a country will lead to increased demand for foreign currency to

make payments for the imports. Consequently, the demand curve shifts upwards causing a rise in

the exchange rate.

Increased demand for imports in a country will lead to a deficit in the balance of payment hence

exerting a downward pressure on a country’s currency.

ii) Discovery of massive oil deposits exceeding domestic consumption/needs will lead to a fall in

the domestic prices and cost of production of oil products. This will lead to increased domestic

exports and a simultaneous increase in the foreign demand for domestic currency leading to a

rise in the price of the domestic currency. This causes a fall in the exchange rate.

Consequently, increased domestic exports in a country will lead to a surplus in the balance of

payment hence exerting an upward pressure on the country’s currency.

iii) Increased GDP and the incomes of the people in the main export market would tend to increase

the domestic exports and a simultaneous increase in the foreign demand for the domestic

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Exchange rate

(kshs. per $)

P2

P1

Q1 Q2

Dollars demanded per time unit

S

P’

P

D

D

S’

D1

D2

currency leading to a rise in the price of the domestic currency. This causes a fall in the exchange

rate.

Consequently, increased domestic exports in a country will lead to a surplus in the balance of

payment hence exerting an upward pressure on the country’s currency.

iv) Political turmoil in the domestic economy, causing capital flight would tend to decrease demand

by foreign investors to invest in the domestic economy and a simultaneous decrease in the

foreign demand for the domestic currency leading to a fall the price of the domestic currency.

This causes a rise in the exchange rate.

Consequently, as capital flight, the supply of domestic goods and services to the foreign market

will decrease hence less domestic exports leading to a deficit in the balance of payment.

v) Tightening of the domestic monetary policy will mean reduced money supply in the domestic

economy leading to increased interest rates and a corresponding decrease in domestic borrowing.

This will in turn decrease demand for foreign goods and investments in the foreign countries and

a simultaneous decrease in demand for the foreign currency leading to an appreciation of the

exchange rate.

Consequently, decreased demand for foreign currency will mean decreased demand for imports

leading to a surplus in the balance of payments.

vi) Tightening of the monetary policy in the main export market will mean reduced supply of the

foreign currency and a corresponding increased domestic demand for the foreign currency

leading to a decrease in the exchange rate.

Consequently, increased domestic demand for foreign currency will mean increased demand for

imports leading to a deficit in the balance of payments.

Question 2

i) Factors determining change in quantity demanded of foreign exchange:

These are those factors which explain the inverse/negative relationship between the price and quantity

demanded of foreign exchange. They include:

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a) Purchase of imports

The domestic importers buy/demand the foreign currency (and sell/supply the domestic currency) to

pay for foreign goods and services (i.e. the imports).

If the foreign exchange price increases (i.e. the domestic currency depreciates, the foreign currency

appreciates), the foreign currency will become more expensive relative to the domestic currency.

Therefore, the domestic price of imports increases leading to a decrease in the quantity of imports

demanded and a simultaneous decrease in the quantity demanded of foreign exchange, and vice versa.

b) Purchase of foreign assets

The domestic investors in foreign countries buy/demand the foreign currency (and sell/supply the

domestic currency) to purchase foreign assets (i.e. shares, property in foreign countries).

If the foreign exchange price increases (i.e. the domestic currency depreciates, the foreign currency

appreciates), the foreign currency will become more expensive relative to the domestic currency.

Consequently, the foreign assets become expensive and the more likely the domestic currency will

appreciate in future, giving capital losses on foreign held assets. Therefore, there will be a decrease in

the quantity demanded of foreign currency and assets and a simultaneous decrease in the quantity

demanded of foreign exchange, and vice versa.

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E2

E1 a

b

D

Exchange rate

Quantity demanded of foreign exchangeQd1 Qd2

ii) Factors determining change in quantity supplied of foreign exchange:

These are those factors which explain the positive relationship between the price and quantity supplied

of foreign exchange. They include:

a) Sale of exports

Foreigners buy/demand the domestic currency (and sell/supply the foreign currency) to pay for

domestic goods and services (i.e. exports)

If the foreign exchange price increases (i.e. the domestic currency depreciates, the foreign currency

appreciates), the domestic currency will become cheap relative to the foreign currency. Therefore, the

domestic goods and services become cheap leading to increased demand for exports and a

simultaneous increase in the quantity demanded of foreign exchange.

b) Sale of domestic assets to foreigners

Foreign investors in the domestic country buy/demand the domestic currency (and sell/supply the

foreign currency) to purchase domestic assets (i.e. shares, property in the domestic countries)

If the foreign exchange price increases (i.e. the domestic currency depreciates, the foreign currency

appreciates), the domestic currency will become cheap relative to the foreign currency. Consequently,

the domestic assets become cheap and the more likely the domestic currency will appreciate in future,

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E1

E2

a

b

SExchange rate

Quantity supplied of foreign exchangeQs1 Qs2

giving capital gain on assets held in the domestic country. Therefore, there will be an increase in

demand for domestic currency and assets and a simultaneous increase in the quantity demanded of

foreign exchange, and vice versa.

iii) Factors determining change in demand for foreign exchange:

Change in demand is a shift either to the right or left of the demand curve. This can be due to the

following factors:

a) Domestic real GDP

Increase in domestic real GDP will lead to an increase in households’ consumption and a simultaneous

increase in imports. Therefore, the demand for foreign exchange increases (capital outflow out of the

domestic country) causing a shift to the right in the demand curve for foreign exchange.

b) Domestic prices relative to foreign prices

Increase in prices for domestic goods and services will imply a relative decrease in prices for foreign

goods and services. Therefore, imports will increase with a simultaneous increase in demand for

foreign exchange causing a shift to the right in the demand curve for foreign exchange.

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S

e’

e

D

D

S’

D1

D2

Exchange rate

Demand for foreign exchange

E1

E2

Q1 Q2

c) Interest rate differential

If the rate of interest in the foreign countries increases in relation to the rate of interest in the domestic

economy, the foreign assets seem to give better return. Therefore, demand for foreign assets increases

with a simultaneous increase in domestic demand for foreign currency. Consequently, demand for

foreign exchange increases causing a shift to the right in the demand curve for foreign exchange.

d) Expected future value of domestic currency

If the domestic currency is expected to depreciate, then the foreign currency/ assets will give better

return to investors. Therefore, demand for foreign currency/ assets will increase leading to a

simultaneous increase in demand for the foreign exchange. The demand curve for foreign exchange

will shift to the right.

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S

e’

e

D

D

S’

D1

D2

Exchange rate

Demand for foreign exchange

E1

E2

Q1 Q2

S

e’

e

D

D

S’

D1

D2

Exchange rate

Demand for foreign exchange

E1

E2

Q1 Q2

iv) Factors determining change in supply of foreign exchange:

Change in supply is a shift either to the right or left of the supply curve. This can be due to the

following factors:

a) Foreign real GDP

Increase in foreign real GDP will lead to an increase in foreign consumption and a simultaneous

increase in exports from domestic countries. Therefore, supply of foreign exchange increases (capital

inflows into the domestic country) causing a shift to the right in the supply curve for foreign exchange.

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S

e’

e

D

D

S’

D1

D2

Exchange rate

Demand for foreign exchange

E1

E2

Q1 Q2

D

S2

S1

Exchange rate

Supply of foreign exchange

E2

E1

Q1 Q2

e’

e

b) Domestic prices relative to foreign prices

Decrease in prices for domestic goods and services will imply a relative increase in prices for foreign

goods and services. Therefore, domestic exports will increase with a simultaneous increase in supply

of foreign exchange causing a shift to the right in the supply curve for foreign exchange.

c) Interest rate differential

If the domestic rate of interest increases in relation to the rate of interest in foreign countries, the

domestic assets will give better return. Therefore, demand for domestic assets increases with a

simultaneous increase in demand for the domestic currency. Consequently, supply of foreign exchange

increases causing a shift to the right of the supply curve for foreign exchange.

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D

S2

S1

Exchange rate

Supply of foreign exchange

E2

E1

Q1 Q2

e’

e

D

S2

S1

Exchange rate

Supply of foreign exchange

E2

E1

Q1 Q2

e’

e

d) Expected future value of domestic currency

If the domestic currency is expected to appreciate in value, then the domestic currency/ assets will give

better return to investors. Therefore, demand for domestic currency/ assets will increase leading to a

simultaneous increase in supply of the foreign exchange. The supply curve for foreign exchange will

shift to the right.

Question 3

a) Difference between monetary policy and fiscal policy

Monetary policy

Monetary policy is usually carried out by the Central Bank / Monetary authorities and involves:

Setting base interest rates (e.g. Bank of England in UK and Federal Reserve in US)

Influencing the supply of money. e.g. Policy of quantitative easing to increase the supply of

money

In general, a stimulative monetary policy is expected to improve the economy’s rate of growth of

output (measured by Gross Domestic Product or GDP) in the quarters ahead; tight or restrictive

monetary policy is designed to slow the economy in the future to offset inflationary pressures.

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D

S2

S1

Exchange rate

Supply of foreign exchange

E2

E1

Q1 Q2

e’

e

Fiscal Policy

Fiscal Policy is carried out by the government and involves changing:

Level of government spending

Taxation

and hence  this influences the level of government borrowing.

In general, a stimulative fiscal policies, tax cuts, and spending increases are normally expected to

stimulate economic growth in the short run, while tax increases and spending cuts tend to slow the rate

of future economic expansion.

b) Application of monetary policy and fiscal policy to help any economy move from a severe

recessionary trend

Application of monetary policy

i) Attainment of full employment

Monetary policy can raise the level of employment by discouraging credit to capital-intensive sectors,

while at the same time, directing investment to labour-intensive sectors like rural agriculture and light

industries like those dealing with textiles through selective lending. In addition a policy that lowers the

rate of interest constitutes expansionary monetary policy and is likely to lead to increased investment

and hence more job opportunities.

ii) Achievement of price stability

Price stability can be maintained by regulating money supply through the tools of the central bank

such as discount rate, minimum reserve requirements and open market operations.

iii) Attainment of economic growth

This is the process whereby real GNP per capital increases over a period of time. Monetary policy can

contribute to this end by providing investment funds through cheaper credit and by mobilizing savings

which can then be used for investment. The flow of funds can be institutionalized so that investment

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funds are allocated to those sectors with the highest rates of return. This better allocation of resources

brings about increased output.

iv) Maintain equilibrium in the balance of payments

Monetary policy can be used in such a way that credit is selectively directed to the export sector and

away from the import sector. At the same time capital inflow can be encouraged and outflow

discouraged through exchange controls.

v) Monetary policy can be used to create sound banking and financial institutions to mobilize

savings for capital formation. For instance, by encouraging branch banking in rural and urban

areas.

Application of fiscal policy

The government can use fiscal policy to intervene in the economy during a period of severe economic

decline in the following ways:

i) By spending more money and financing this expenditure through borrowing

ii) By cutting taxes

Either way, incomes would rise, people would spend more, and the economy could start growing

again. As government spending surges, people’s incomes rise, factories start operating at full capacity,

and the hardships of the depression fades.

Question 4

i) Demand pull inflation

Demand pull inflation occurs when the aggregate demand increases much more rapidly than aggregate

supply. The following measures can be implemented to combat demand-pull inflation:

Monetary policy

This could take the form of contractionary monetary policy aimed at regulating/ controlling the money

supply and excess credit expansion. This can be done through the following instruments:

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The restriction of direct lending to the government by the central bank beyond a legally

permitted limit

The increase of cash or liquidity ratio requirements on commercial banks and financial

institutions thereby reducing their ability to create credit

Raising the interest rates or the cost of borrowing through the sale of treasury bills in open

market operations

The Central Bank can ensure punitive interest rates for overnight borrowing

Fiscal policy

This will be in the form of contractionary fiscal policy which involves raising taxes in order to cut

customers’ income and hence their level of spending. The government can also lower its expenditure.

A vital factor is lowering government borrowing to finance budget deficits. The ideal situation is to

maintain a balanced budget whereby expenditures match revenue.

In the event of a manageable budget deficit the best option is to finance the deficit from the financial

markets since borrowing from the Central Bank is effectively ‘printing money’.

ii) Cost push inflation

Cost-push inflation is seen as being caused mainly by an increase in the costs of production, which

occur independently of the level of aggregate demand, and which firms pass on to consumers in the

form of higher prices. The following measures can be implemented to combat cost-push inflation:

Where the increase in prices results from higher wages, steps may be taken to encourage

greater productivity in industry and to apply controls over wage and price increases. Also

increase government spending. As government spending surges, people’s incomes rise,

factories start operating at full capacity hence high return on sales

In case where cost-push inflation is caused by an increase in the prices of imports, steps can be

taken to reduce the quantities of such imports probably by looking for alternative sources of

supply. Also by allowing exchange rate appreciation which decreases the price of imported raw

materials.

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Question 5

Reasons for doing capital budgeting and investment evaluations in any investment decisions

The capital budgeting decisions are important, crucial and critical business decisions due to following

reasons:

i) Substantial expenditure: Capital budgeting decisions involves the investment of substantial

amount of funds. It is therefore necessary for a firm to make such decisions after a thoughtful

consideration so as to result in the profitable use of its scarce resources.

The hasty and incorrect decisions would not only result into huge losses but may also account

for the failure of the firm.

ii) Long time period: The capital budgeting decision has its effect over a long period of time.

These decisions not only affect the future benefits and costs of the firm but also influence the

rate and direction of growth of the firm.

iii) Irreversibility: Most of the investment decisions are irreversible. Once they are taken, the firm

may not be in a position to reverse them back. This is because, as it is difficult to find a buyer

for the second-hand capital items.

iv) Complex decision: The capital investment decisions involve an assessment of future events,

which in fact is difficult to predict. Further it is quite difficult to estimate in quantitative terms

all the benefits or the costs relating to a particular investment decision.

v) Capital budgeting is the main tool of financial management

vi) All types of capital budgeting decisions are exposed to risk and uncertainty.

vii) Capital rationing gives sufficient scope for the financial manager to evaluate different

proposals and only viable project must be taken up for investments.

viii) It helps the management to avoid over investment and under investments.

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REFERENCES

Dwivedi, D. N (2008). Managerial Economics. New Delhi: Vikas Publishing House PVT Limited.

Jhingan M L (2003). Macro-Economic Theory, 11th revised edition. Delhi: Vrinda Publications (P)

Limited.

Ison, S and Wall, S (2007). Economics, 4th edition. England: Pearson education Limited

Mudida, R (2003). Modern Economics. Nairobi: Focus Publications Limited

Saleemi N A and Bogongo J B (2007). Economics Simplified (Revised and Updated). Nairobi: Saleemi

Publications Limited.

Thomas C R and Maurice S C (2008). Managerial Economics. New York: McGraw-Hill

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