◄UNIT 4:BALANCE OF PAYMENT (BOP).UNIT 6: ECONOMIC INTEGRATION►

UNIT 5:EXCHANGE RATES.

  • UNIT 5:EXCHANGE RATES.

    Key unit Competency: 

    Analyse the various forms of exchange rate determination and their impact 

    on economic development.

    Introductory activity.

    The table below shows different countries, their currencies and symbols 

     and exchange rate.

    Study the data in the table above. Make research and fill the table.

    i) In your own view, who determines the exchange rate between the 

    Rwandan franc and other currencies?

    ii) Considering the exchange rate between Rwf and Kenyan Shilling 
    given in the table above, how much Kenyan Shillings can one get 

    from 100,000Rwf?

    iii) Supposing the Rwf gained more value against a Ksh, shall the above 

    value in the exchange rate (8.964534) go above or below? 

    iv) What do you think shall happen to the price in Rwf of goods Rwanda 

    imports from Kenya if the Ksh gains more value against the Rwf?

    v) Supposing Rwanda imports goods with inelastic demand from 
    Kenya. What do you think shall happen to their quantity demanded 

    in Rwanda if the Ksh gains more value against the Rwf?

    5.1. Exchange rates

    5.1.1: Meaning of Foreign Exchange 

    Activity 5.1.

    Agasaro is a Rwandan Import and export trader. She buys handcraft products 
    from Rwandan Women Cooperative Society and exports them to Chinese 
    consumers in China. On her way back from China, she buys Kitchen Ware from 

    Dubai which she sells to Super market in Kigali, Rwanda.

    vi) Which currency do you think Agasaro uses to buy the handcraft 

    products from Rwanda Women Cooperative society?

    vii)In which currency do you think she is paid when she sells her 

    products in China?

    viii) Which currency do you think Agasaro uses to pay for the 

    Kitchenware in Dubai markets and how does she get it?

    Activity 5.1.

    Countries in international trade use currencies other than their own. This is 
    because not every currency is acceptable in the world market. Payment of 
    transactions among countries is carried out in hard or convertible currencies 

    like US dollars, Japanese Yen, pound starlings etc.

    Foreign exchange is the conversion of one currency into another currency. 
    Foreign exchange market refers to the global market where currencies are traded 
    virtually around the clock. The term foreign exchange is usually abbreviated as 

    “forex” and occasionally as “FX.”

    Foreign exchange transactions encompass everything from the conversion of 
    currencies by a traveler at an airport kiosk to billion-dollar payments made by 
    corporations, financial institutions and governments. Increasing globalisation 
    has led to a massive increase in the number of foreign exchange transactions in 

    recent decades.

    5.1.2: Terms used in foreign exchange.

    Activity 5.2.

    Make research and find the meaning of the following terms used in foreign 

    exchange markets.

    Foreign exchange rate; Exchange rate regime; Floating exchange rate; 
    Fixed exchange rate; Pegged float exchange rate; Spot Market; Floating 
    currency; Forward Market; International Currency Exchange; Currency 
    Pairs; Foreign Exchange Market; Foreign Exchange Reserves; Foreign 

    Exchange Risk. 


    The foreign exchange market has a number of basic terms used some of which 

    include the following:

    - Foreign exchange rate. The rate/price at which given currencies are 

    exchanged for each other in the foreign exchange market

    - Exchange rate regime: This is way in which an authority manages its 

    currency in relation to other currencies in the foreign exchange market.

    - Floating exchange rate: This is a system where the value of currency in 
    relation to others is freely determined by the market forces of demand and 

    supply for the currency.

    - Fixed exchange rate: This is a system where a currency’s value is tied 
    to the value of another single currency, to a basket of other currencies, or 

    to another measure of value, such as gold.

    - Pegged float exchange rate: A currency system that fixes an exchange 
    rate around a certain value, but still allows fluctuations, usually within 

    certain values, to occur.

    - Spot Market. This is where the price of a currency is established on the 

    trade date but money is exchanged on the value date. 

    - Floating currency. This is a currency that uses a floating exchange rate

    - Forward Market. A forward market/ trade is any trade that settles further 

    in the future than spot.

    - International Currency Exchange. This is a rate at which two currencies 

    in the market can be exchanged. 

    - Currency Pairs. These are two currencies with exchange rates that are 

    traded in the retail market.

    - Foreign Exchange Market. This is a market where participants buy, 

    sell, and exchange currencies daily.

    - Foreign Exchange Reserves: These are reserves assets in foreign 

    exchange that are held by a central bank.

    - Foreign Exchange Risk: Foreign exchange risk is the chance that an 
    investment’s value will decrease due to changes in currency exchange 

    rates. 

    Sources of Foreign Exchange
    - Export of goods and services
    - Transfer payments e.g. grants and aid
    - Remittances and transfers of nationals working abroad
    - Selling of public assets abroad
    - Capital inflow through direct and foreign investments
    - Profits, dividends and interests repatriated from investments abroad
    - Funds from charitable organizations e.g. UNICEF 
    - Private foreign bank deposits in the local banks

    - Borrowing from international countries, companies and individuals.

    5.1.3: Forms/ types of exchange rates/ exchange rate 

    systems/ regimes

    Activity 5.3.

    In line with a liberalized current and capital account of the balance of 
    payments, NBR pursues a flexible exchange rate policy regime. In this 
    regime, the price of Rwandan francs vis-a-vis the US dollar and other 
    foreign currencies is determined by the market forces of demand and 
    supply. NBR’s involvement in the foreign exchange market is limited to 
    occasional interventions (purchase or sale of US dollars) only to dampen 
    excessive volatility in the exchange rate. Stable exchange rate movements 
    in either direction (appreciation or depreciation), enable proper planning 
    by all market players. NBR does not sell and/or purchase foreign exchange 
    in the retail market. Intervention involves the process of purchasing and/
    or selling foreign exchange to the Foreign Exchange Interbank Market to 
    stem the volatility of the currency when the Rwandan francs is appreciating 
    and/or depreciating, respectively. It is done through the foreign exchange 

    interbank market that comprises mainly commercial banks.

    From the above case study,

    (i) What do you think is meant by 

    (a) Flexible exchange rate policy?

    (b) Foreign exchange interbank market? 

    (ii) What do you think will happen to the price/value of a Rwandan franc 

    when NBR sells more of it on the foreign exchange interbank market?

    (iii) Apart from flexible exchange rate system, what do you think are the 

    other types of foreign exchange rate systems?

    Some of the major types of foreign exchange rates are as follows:

    1. The gold standard exchange rate system

    2. Fixed Exchange Rate System (Pegged Exchange Rate System).

    3. Flexible Exchange Rate System (Floating Exchange Rate System).

    4. Managed Floating Rate System.

    5.1.3.1. The gold standard

    Under the gold standard, a country’s government declares that it will exchange 
    its currency for a certain weight in gold. In a pure gold standard, a country’s 
    government declares that it will freely exchange currency for actual gold at the 
    designated exchange rate. This “rule of exchange” allows anyone to go the 
    central bank and exchange coins or currency for pure gold or vice versa. The 
    gold standard works on the assumption that there are no restrictions on capital 

    movements or export of gold by private citizens across countries.

    Because the central bank must always be prepared to give out gold in exchange 
    for coin and currency upon demand, it must maintain gold reserves. Thus, this 
    system ensures that the exchange rate between currencies remains fixed. The 
    main argument in favor of the gold standard is that it ties the world price level 
    to the world supply of gold, thus preventing inflation unless there is a gold 

    discovery.

    a) Advantages of the gold standard

    - It solves the BOP problems automatically because of the automatic 

    adjustment mechanism.

    - There is neither currency appreciation nor currency depreciation since 

    every unit of currency is tied to gold.

    - There is economic stability because of a stable exchange rate system.

    - Liquidity problem is easily solved because of free flow of gold.

    - There is smooth international trade because gold is used as a medium of 

    exchange.

    b) Disadvantages of the gold standard exchange rate system

    - It is difficult for the central bank to control money supply.

    - When gold is in excess supply, it loses exchange value.

    - It does not favour economic growth in countries with small quantities of 

    gold.

    5.1.3.2. Fixed Exchange Rate System:

    Activity 5.4.

    Make research and discuss the view that the foreign exchange rate should be 
    fixed by the forces of demand and supply of the currency and not the central 

    bank.

    Fixed exchange rate system refers to a system in which exchange rate for 
    a currency is fixed by the government at a specific rate in relation to a specific 
    foreign currency for a period of time. Once this rate is fixed, it becomes illegal 

    to exchange a currency at a parallel rate.

    The basic purpose of adopting this system is to ensure stability in foreign trade 
    and capital movements. To achieve stability, government undertakes to buy 
    foreign currency when the exchange rate becomes weaker and sell foreign 
    currency when the rate of exchange gets stronger. For this, government has to 
    maintain large reserves of foreign currencies to maintain the exchange rate at 

    the level fixed by it. 

    Under this system, each country keeps value of its currency fixed in terms 
    of some ‘External Standard’. This external standard can be gold, silver, other 
    precious metal, another country’s currency or even some internationally agreed 
    unit of account. When value of domestic currency is tied to the value of another 

    currency, it is known as ‘Pegging’. 

    The fixed exchange rate may be undervalued or overvalued i.e. undervalued 
    exchange rate i    s where the exchange rate is fixed below the market or 
    equilibrium value of the currency. For example, if the equilibrium rate is 600frw 
    for a dollar and the rate is fixed at 300frw for a dollar, this leads to cheap imports 

    and expensive exports hence BOP deficits.

    Overvalued exchange rate is where the exchange rate is fixed above the 
    market or equilibrium value of the currency. This leads to undervalued local 
    currency which makes exports cheap and imports expensive hence improved 

    BOP position.

     In a fixed exchange rate system when the external value of the currency is 
    increased, we refer to this as revaluation (increase in the value of domestic 
    currency by the government) and when the external value of the currency is 
    reduced, we refer to this as devaluation (reduction in the value of domestic 

    currency by the government)

    Countries can either choose a single currency to peg to, or a “basket” consisting 

    of the currencies of the country’s major trading partners.

    The pegged float exchange rate can be; 

    - Crawling bands. The market value of a national currency is permitted 
    to fluctuate within a range specified by a band of fluctuation. This band 
    is determined by international agreements or by unilateral decision by the 
    central bank. Generally, the bands are adjusted in response to economic 

    circumstances and indicators.

    - Crawling pegs. This is an exchange rate regime, usually seen as part 
    of a fixed exchange rate regime that allows gradual depreciation or 
    appreciation in an exchange rate. The system is a method to fully utilize 
    the peg under the fixed exchange regimes as well as the flexibility under 

    the floating exchange rate regime.

    - It is designed to peg at a certain value but, at the same time, to “glide” in 

    response to external market uncertainties.

    - Pegged with horizontal bands: This system is similar to crawling 
    bands, but the currency is allowed to fluctuate within a larger band of 

    greater than one percent of the currency’s value.

    a) Advantages of fixed exchange rate system

    - It encourages international trade by ensuring certainty and predictability of 

    prices with goods involved in international trade

    - It ensures stability in foreign exchange markets by avoiding constant 
    appreciation and depreciation with in the currency which ensures confidence 

    in the domestic market 

    - It minimizes speculation in the economy by both goods and foreign exchange 

    markets and it is negative effects

    - It reduces exploitation and cheating of foreign exchange buyers and holders 

    by money markets and foreign exchange markets.

    - It facilitates planning since income in form of foreign exchange assessed 

    and predicted according to the rate of exchange.

    - The government can easily use foreign exchange rate to minimize BOP 
    deficits i.e. by rising the exchange rate and devaluing the domestic currency 
    which makes exports cheap and imports expensive hence improvement in 

    the BOP position

    - Encourages long term capital inflows in an orderly manner thus encouraging 

    investment

    - Fixed exchange rates impose a price discipline on nations with higher 
    inflation rates than the rest of the world, as such a nation is likely to face 

    persistent deficits in its balance of payments and loss of reserves.

    b) Disadvantages of fixed exchange rate system

    -It is expensive to maintain because it requires a lot of foreign exchange 

    reserves.

    -It requires strict monitoring of the economy which is affected by insufficient 

    personnel.

    -It may lead to inflation if it is fixed above the market price or deflation if it is 

    fixed below the market price.

    -It reduces speculation which reduces business profitability. 

    -It discourages competition in foreign exchange markets which leads to 

    inefficiency.

    -The announced exchange rate may not coincide with the market equilibrium 

    exchange rate, thus leading to excess demand or excess supply.

    -The central bank needs to hold stocks of both foreign and domestic currencies 
    at all times in order to adjust and maintain exchange rates and absorb the 

    excess demand or supply.

    -The cost of government intervention is imposed upon the foreign exchange 

    market.

    -It fails to identify the degree of comparative advantage or disadvantage of the 

    nation and may lead to inefficient allocation of resources throughout the world.

    -Fixed exchange rate does not allow for automatic correction of imbalances 
    in the nation’s balance of payments since the currency cannot appreciate/
    depreciate as dictated by the market. It is too rigid so that the exchange rate 
    system cannot respond to the changes in the economy. For example, when 

    there is BOP surplus or deficit

    -There exists the possibility of policy delays and mistakes in achieving external 

    balance

    5.1.3.3. Flexible /floating/free/market/ fluctuating Exchange Rate 

    System: 

    Flexible exchange rate system refers to a system in which exchange rate 
    is determined by forces of demand and supply of different currencies in the 
    foreign exchange market. The value of currency is allowed to fluctuate freely 
    according to changes in demand and supply of foreign exchange. There is no 

    official (Government) intervention in the foreign exchange market.

    The exchange rate is determined by the market, i.e. through interactions of 
    thousands of banks, firms and other institutions seeking to buy and sell currency 

    for purposes of making transactions in foreign exchange.

    When the supply of foreign exchange is equal to the demand for it, then 

    equilibrium exchange rate is determined.

    Figure 2: Exchange rate Equilibrium


    From the figure above, forex equilibrium is obtained when import spending 
    is equal to export revenue. i.e. at point ‘e’ in the above diagram. This means 
    that the demand for forex is equal to its supply. Fe is equilibrium currency rate 
    while Qe is equilibrium quantity demanded and supplied of currencies. Below 
    or above Fe, the demand for and supply of currencies isn’t equal thus causing 

    disequilibrium in the forex market (forex shortages or excess).

    In a floating exchange rate system, when the external value of the currency 
    increases, then this is called currency appreciation (low exchange rate) and 
    when the external value declines, this is called currency depreciation (high 

    exchange rate)

    a) Advantages of flexible exchange rate

    - The system is automatic and therefore does not need a lot of government 

    involvement and expenditure on foreign exchange rate monitoring

    - Trade imbalances i.e. surpluses and deficits are corrected automatically 

    by the forces of demand supply

    - It responds to the rapid economic changes quickly since it is automatic

    - It encourages proper resource utilization into their optimal use

    - It increases the volume of international trade because of the freedom in 

    the foreign exchange markets

    - It encourages efficiency and competition in the money market

    b) Disadvantages of the flexible exchange rate

    - It creates uncertainty as it fluctuates and discourages international trade 

    and capital movements

    - It creates instabilities in the foreign exchange rate thus affecting planning 

    and hence discouraging economic growth and development

    - It encourages speculation in the foreign exchange where foreign exchange 

    buyers may be cheated

    - It is inefficient in correcting BOP deficits as the domestic demand for 

    exports and imports remain inelastic

    - It leads to fluctuations in export earnings which affects budgeting of the 

    government

    - It discourages long term contracts between borrowers and lenders which 

    may discourage investments and economic growth and development

    - In case there is no understanding between governments about manipulation 
    of exchange rates, it may result into war of exchange rates with each 

    country trying to establish favourable rates with other countries

    c) Causes of Currency depreciation in LDCs

    - Decline in the volume and value of exports (primary products)

    - Decline in foreign exchange inflow due to political instabilities

    - Decline in international payments in the domestic banks 

    - Reduction in the volume of grants, aid and loans

    - Increase in demand for imports especially capital inputs and essential 

    consumer goods

    - Increase in foreign exchange expenditure e.g. on embassies, official trips 

    abroad etc.

    - Government policy of devaluation

    - High rates of inflation which reduces domestic production

    d) Effects of currency depreciation

    Positive effects

    - It increases the volume of exports hence foreign exchange earnings

    - It encourages export promotion and import substitution industrialization 

    which reduces foreign exchange expenditure

    - It encourages domestic investments because the cost of production is 

    low at home if inputs are not imported.

    - It reduces the BOP problems because the expenditure on imports reduces

    - It increases capital inflow and foreign investments

    - It encourages exploitation of domestic resources because it is cheap to 

    produce at home

    Negative effects

    - It reduces the volume of imports which might lead to scarcity of goods and 

    services in the economy

    - It makes projected planning difficult and distorted

    - It increases the cost of production at home because of expensive imported 

    inputs

    - It increases the country’s indebtedness abroad

    - It worsens BOP problems since imports become expensive than exports

    - It leads to loss of confidence in the local currency

    - It may lead to over exploitation of resources since it is cheaper to produce 

    at home.

    5.1.3.4. Mixed/multiple/Managed/ Dirty Floating Rate System:

    This refers to a system in which foreign exchange rate is determined by market 
    forces and central bank influences the exchange rate through intervention in the 
    foreign exchange market. It is a hybrid of a fixed exchange rate and a flexible 

    exchange rate system.

    In this system, central bank intervenes in the foreign exchange market to restrict 
    the fluctuations in the exchange rate within certain limits. The aim is to keep 
    exchange rate close to desired target values. For this, central bank maintains 
    reserves of foreign exchange to ensure that the exchange rate stays within the 

    targeted value.

    When the exchange rate rises above the upper limit, the central bank intervenes 
    and buys off the surplus or excess foreign exchange. When the exchange rate 
    falls below the lower limit, the central bank supplies the needed foreign exchange. 

    However, this depends on the purpose on which the foreign exchange is needed

    a) Advantages of the managed floating exchange rate system

    - It helps a country to export and import commodities of national priority

    - Government can reduce unfair competition of foreign currencies over 

    domestic currencies

    - It reduces excessive foreign exchange fluctuations in the foreign exchange 

    market

    - It reduces speculation hence reducing hoarding and scarcity of foreign 

    exchange

    b) Disadvantages of the managed floating exchange rate system

    - It is expensive for the government to supervise and maintain maximum and 

    minimum margins

    - It limits free convertibility of currencies hence limiting the flow of exports 

    and imports

    - It doesn’t allow free exchange of currencies to determine the real value 

    - It might lead to malpractices such as over invoicing imports and under 

    invoicing exports.

    Application activity 5.1.

    From your knowledge of exchange rates, carry out research on the factors that 
    determine the exchange rate in a foreign exchange market and make class 

    presentations.

    5.2. Devaluation.

    5.2.1. Meaning and reasons for devaluation.

    Activity 5.5.

    Make research and find the meaning of the following terms.
    Currency devaluation. Currency depreciation. Currency appreciation. 
    Given the following as the exchange rate between a Rwf and US $ is such that 
    US $ 1 is equal to 900 Rwf, the price of a car from an Auto market in Japan is 
    1000 US $ while the price of Made in Rwanda Cotton fabric is 27000Rwf per 

    metre.

    Determine 

    i) The price of the same car from the Auto market in Japan in Rwf? 

    ii) The price of Made in Rwanda cotton fabric in US$?

    Because of changes in demand and supply of a dollar and Rwf, the dollar 
    gains more value against the Rwf such that the exchange rate changes 

    and US$ 1 is equal to 1200Rwf.

    Basing on the new exchange rate, determine

    (i) The price of the above car in Rwf.

    (iI) The price of the Made in Rwanda cotton fabric in US$.

    Compare the prices above before and after the changes. Derive a suitable 

    conclusion.

    Devaluation refers to deliberate government policy of reducing the value of 
    domestic currency in the terms of other currencies i.e. the domestic currency 
    becomes cheaper in relation to other countries’ currencies.
    Devaluation is only possible under the fixed exchange rate system. It takes 
    place when there is fundamental disequilibrium in the balance of payment. The 

    devaluating country has no supply rigidities but it is facing marketing difficulties.

    LDCs devalue their currencies due to the following reasons;

    - To make exports cheap and hence lead to more export, there by leading to 

    increase in foreign exchange earnings.

    - To collect balance payment problems by reducing imports by making them 
    expensive. This is because importers need more of the local currency in 
    order to obtain foreign exchange they thus either have to import less or 

    charge high prices hence low quantity demanded for them.

    - To attract foreign and domestic investors as it becomes cheaper to invest 
    in the economy as little foreign exchange can be exchanged for a lot of the 
    local currency. Again due to devaluation there is export promotion leading 

    to increased market for output produced by investors.

    - To protect domestic infant industries from competition by cheap imports 

    by making similar imports expensive.

    - To promote self-sufficiency by encouraging import substitution industries 

    and reduce dependency on imports from other countries.

    - To conserve foreign exchange as it discourages imports and minimizes 
    foreign exchange out flow and therefore can reduce on the problem of 

    trade shortage.

    - To increase on the level of productivity and thus domestic resource 

    utilization this calls for employment of idle resource.

    - To increase on employment opportunities at home through increased 

    domestic production.

    - Some LDCs undertake devaluation in order to fulfill IMF conditionalities in 

    order to receive loans.

    - To check on imported inflation because after devaluation, the inflation hit 

    imports are too expensive and this discourages importers. 

    - To increase the nominal income of the producers of primary products that 

    are exported

    5.2.2 Conditions necessary for devaluation to be 

    successful

    Activity 5.6

    Make research and find the factors that can make devaluation succeed or fail.

    A number of conditions have to be made for devaluation to be successful 

    - The demand for exports must be price elastic. That is, a small price 
    reduction resulting from devaluation will lead to a proportionately large 

    increase in their purchase and more foreign exchange will be earned.

    Devaluation and foreign exchange earnings.

    - The demand for imports should be price elastic so that imports appear to 
    be expensive after devaluation and less of them are demanded hence less 

    foreign exchange expenditure.

    Devaluation and foreign exchange expenditure.

    - The supply of export in the devaluating country should be elastic such that 
    as demand for export increases then more quantity of exports should be 

    supplied

    - The supply of imports should be price elastic in that when there is 
    devaluation and there is a decrease in demand for imports, the quantity 

    supplied for them should be able to reduce greatly.

    - There should be no inflation in devaluing country so that after devaluation 
    exports will be cheap and attractive to foreign importers hence more will 

    be imported.

    - There should be no restrictions on exports from the devaluing countries 

    otherwise this would limit exports and hence earnings from exports.

    - There should be no counter devaluation or other countries should not 
    retaliate by devaluing their currency because this will neutralize the 

    intention of devaluing countries.

    - There should not be trade union to put pressure on wages and increase 

    the cost of production.

    - There should be excess capacity in devaluing country such that as exports 
    are produced, imports are discouraged and more output is produced to 

    substitute import.

    - The marginal propensity to import in devaluing country should be low.

    - The devaluing country should be able to compete favorably in the world 

    market

    - The devaluing country should be politically stable so as to ensure stable 

    production

    - There should be stability in the exchange rate system i.e. fixed exchange 

    rate regime. 

    5.2.3: Effects of devaluation.

    Activity 5.7

    Make research and discuss the view that developing economies should use 

    devaluation as a tool to bring out economic growth and development.

    Positive effects

    - It increases the volume of exports by making them cheap.

    - It increases the volume of foreign exchange earnings by increasing on 

    the volume of exports.

    - It increases the capital inflow e.g. through foreign investment because it 

    becomes cheaper to produce in the devaluing country. 

    - It improves balance of payment position due to increased foreign 

    exchange earnings and reduced foreign exchange expenditure on import.

    - Increase in domestic investments which increase exploitation of idle 

    resources.

    - It increases employment opportunities at home, e.g. through export 

    promotion and import substitution industries.

    - It leads to development of domestic infant industries by making similar 

    imports expensive.

    - It promotes self-sufficiency by encouraging exports and reducing the 

    volume of imports.

    Negative effects

    - It worsens the balance of payment position because external market for 

    products from developing economies is poor.

    - It leads to imported inflation since devaluation increases prices of imports 

    yet imports in developing economies have inelastic demand.

    - It leads to capital flight by nationals because they will tend to invest 

    outside to earn high value foreign currency.

    - Due to inflation that may result from devaluation imported inputs become 
    expensive which discourages production yet developing economies 

    heavily depend on imported capital.

    - It increases borrowing rate and debt servicing burdens by developing 
    economies since they need a lot of income in terms of domestic 

    currencies in form the foreign resources.

    - It leads to persistent government budgetary deficit as a result of increased 
    expenditure on imports which increases expenditure due to devaluation 

    that makes import expensive.

    - Saving levels can decline in economy because of liquidity preference to 

    meet high price of imported commodities thus causing inflation.

    - It affects fixed income earners because where as prices are increasing 

    due to devaluation their income remains constant hence low real incomes.

    - If it is common, it may discourage investors who lose confidence in the 

    local currency.

    - It may reduce the standards of living of people due to shortage of 
    commodities in the economy as a result of restricting imports yet 

    developing economies heavily depend on imports.

    - 11. It also discourages competition by protecting infant industries which 
    may provide low quality commodities yet charging high prices.12. It 
    may hinder technological transfer because of the increase in the cost of 

    imported commodities and inputs.

    5.2.4: Success of devaluation policy in LDCs.

    Activity 5.8.

    Analyse the statements below and answer the questions that follow;

    1. Under AGOA arrangement, African products have an opportunity to access 
    American markets without strict tariff restrictions. And this implies that African 
    producers would reap highly from this arrangement since their currencies have 
    lower value in comparison to the US dollar. However, most African countries 

    have not enjoyed maximum benefit from this?

    2. Most developing countries import commodities that are price and income 
    inelastic, for instance medicine. Even the supply of their products is also inelastic 

    because of supply rigidities. 

    In reference to the above statements, discuss why devaluing currencies in 

    developing countries may not easily benefit them.

    Most developing economies which have tried devaluation as a measure to solve 

    their BOP problems have not succeeded due to the following reasons

    - Domestic elasticity of demand of their imports is low because of high 

    population growth rate

    - Developing economies import commodities that are price and income 

    inelastic because they are mainly essential commodities

    - There is protectionism by developed economies on products from 

    developing economies so as to increase employment in MDCs.

    - The elasticity of supply of products from developing economies is low 

    because of domestic supply rigidities.

    - Developing economies have competitive supply i.e. supply of similar 

    commodities; they therefore tend to carry out competitive devaluation.

    - Developing economies have inadequate co-operant factors especially 

    capital and entrepreneur hence low production for exports.

    - Most developing economies experience high rates of inflation which 

    discourage export due to high costs of production

    - Developing economies pursue unfavorable economic policies like trade 

    legalization which increase the inflow of imports.

    - There is high degree of malpractice for example smuggling because 
    of inefficient administrative machinery hence increasing the volume of 

    imports.

    - Political instability and insecurity in developing economies discourage 

    domestic production and foreign investment.

    - There is counter devaluation among developing economies i.e. other 

    countries retaliate by devaluing their currency. 

    - There is high marginal propensity to import due to the desire for essential 

    capital input and imported raw materials.

    - Developing economies exports are limited by low export quotas in the 

    international commodity Agreement (ICA)

    - There are weak export promotion institutions in developing economies 

    which reduce the benefits of devaluation.

    - Developing economies face foreign exchange instabilities because of 

    adapting liberal exchange rate systems.

    Application activity 5.2.

    The Kenyan shilling has a relatively higher value than the Rwandan franc. 

    Assess the impact of this on the trade between Rwanda and Kenya.

    End unit assesment

    1. a) When and why is devaluation carried out?

    b) How is devaluation of a currency supposed to address an economy’s 

    balance of payments current account deficit?

    2. Under what circumstances may devaluation fail to achieve its intended 

    objectives in an economy?

    3. Explain the merits and demerits of floating exchange rate system.

    ◄UNIT 4:BALANCE OF PAYMENT (BOP).UNIT 6: ECONOMIC INTEGRATION►