Economics

Key unit competence: Learners will be able to analyse the various forms of exchange rate determination and their impact in economic development.

My goals

By the end of this unit, I will be able to:

⦿ Identify the various forms of exchange rate systems.

⦿ Examine the factors influencing exchange rate.

⦿ Explain the impact of each exchange rate system on the economy.

⦿ Explain the reasons and necessary conditions for successful devaluation.

⦿ Identify the effects and limitations of successful devaluation in LDCs.

⦿ Make comparison of the various exchange rate systems.

⦿ Analyse the effects of exchange rate on the prices of commodities on the market in Rwanda.

⦿ Use the conditions for devaluation to achieve economic stability.

⦿ Justify the choice of the appropriate exchange rate system in economic development.

⦿ Appreciate the exchange rate of Rwandan currency in terms of other currencies.

⦿ Advocate for devaluation to increase the level of economic activities.

Activity 1
(a) Use the library, the internet or any other economics source, make more research on international trade and use your understanding and analysis to match the following currencies
with their countries.
Country                                                    Currency
Rwanda                                                    Dollars
Uganda                                                    Rwanda Francs
Japan                                                      Shillings
USA                                                         Yen
South Africa                                           Pound sterling
Britain                                                     Rand
Denmark                                                 Euro
European                                              Union Krone

(b) In your own view, what do you think foreign exchange is?

(c) Akaliza was going to visit her relatives in Canada for her December holiday, she was forced to exchange her Francs into Dollars to facilitate her travel to Canada. Why do you
think she never used Rwandan francs for her travel?

(d) What ways can we may earn currencies from other countries?

(e) Carefully look at photo a, b, c, d and e. Mention the countries in which these currencies are used.

Facts

5.1 Meaning of Foreign Exchange

Foreign exchange is the exchange of one currency for another or the  conversion of one currency into another currency. Foreign exchange also 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.” 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 transactions encompass everything from the conversion of currencies by a traveller at an airport kiosk to billion-dollar payments made by corporations, financial institutions and governments. Transactions range from imports and exports to speculative positions with no underlying
goods or services. Increasing globalisation has led to a massive increase in the number of foreign exchange transactions in recent decades.

The global foreign exchange market is the largest financial market in the world, with average daily volumes in the trillions of dollars. Foreign exchange transactions can be done for spot or forward delivery. There is no centralised market for foreign exchange transactions, which are executed
over the counter and around the clock.

5.1.1 Terms used in forex

• Foreign exchange rate: The rate/price at which given currencies are exchanged for each other in the foreign exchange market.

• Exchange rate regime: The way in which an authority manages its currency in relation to other currencies in the foreign exchange market.

• Floating exchange rate: A system where the value of currency in relation to others is allowed to freely fluctuate subject to market forces.

• Fixed exchange rate: 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.

• Nominal exchange rate: This is the rate at which a currency is traded for another.

• Real exchange rate: This is the purchasing power of different currencies i.e. how much goods and services in the domestic country that can be exchanged for goods and services in the foreign countries.

• 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: The rate at which two currencies in the market can be exchanged.

• Currency exchange: A business that allows customers to exchange one currency for another.

• Currency pairs: Two currencies with exchange rates that are traded in the retail.

• Foreign exchange market: The foreign exchange market is a market where participants buy, sell, and exchange trillions of dollars’ worth of currencies daily.

• Foreign exchange reserves: Foreign exchange reserves are reserve assets 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.

5.1.2 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 organisations e.g. UNICEF.

• Private foreign bank deposits in the local banks.

• Borrowing from international countries, companies and individuals.

5.1.3 Factors that Influence foreign exchange rates

Activity 2

Using the library, the internet or any other economics source, research and share in your class discussion; what you think could be the factors that determine the strength of a currency over other countries’ currencies in a forex market.

Facts

The foreign exchange rates, just like other financial assets, fluctuate every day as the demand and supply of different currencies changes. These changes in exchange rates affect everyone either directly or indirectly. Some of the important factors that influence the exchange rates include the following:

• Inflation rates: A country with low inflation rate compared to another country will see its currency appreciate compared to the other country. This is because, in the country where the inflation rate is low, the prices of goods and services are increasing at a slower rate. That country’s exports will become more competitive thereby increasing the demand for that currency. At the same time, the foreign goods in
that country will become less competitive and imports will reduce, thereby decreasing the demand for the foreign currency.

• Interest rates: A higher interest rate causes the country’s currency to appreciate. This is because the country with higher interest rates can offer better rates to lenders thereby attracting more foreign capital,
which causes the exchange rates to rise.

• Balance of payments: Changes in current accounts also impact the
value of currency. A current account deficit indicates that the country’s
value of imports is more than the value of exports. Therefore, to balance
the trade, it requires more foreign currency than it receives through
exports. The country will therefore borrow foreign capital which will
increase the demand for foreign currency and the domestic currency
will depreciate. This can be changed only by either increasing exports
by making the goods more attractive/competitive or by reducing
imports.

• Public debt: A country with huge public debt attracts less foreign capital. This is because, high public debt leads to increase in inflation which erodes the country’s currency value. Additionally, if there is a
risk of default by the country, investors will sell their bond holding in the open market. This leads to a depreciation of the currency value.

• Political uncertainty and economic instability: This again is related to how foreign investors percieve the prospects of the country. If the country has high political uncertainty or economic instability, it will
attract less foreign capital compared to a country that offers high stability to investors.

• Government intervention: Sometimes even the governments can intervene to artificially maintain a currency value at a certain level. For example, China has kept its currency undervalued by buying dollars
so that its exports are attractive.

• Speculation: The movement in exchange rates is also influenced by the current sentiment in the market. For example; if the general sentiment is that the Euro will rise in value, the speculator will start buying Euro to make a profit causing the value of Euro to rise. Similarly, if there is speculation that a country’s interest rates will rise, it will cause a lot of speculative activity in the foreign exchange market leading to the rise in currency value.

5.1.4 Forms/ types of exchange rates/ exchange rate systems/ regimes (factors influencing each)

Activity 3

There are different forms of exchange rates that may be adopted by different countries or in the same country. Visit the library, the internet or any other economics source, research and;

(a) Analyse the different types of exchange rate an economy can adopt.

(b) Explain the forms you think are adopted in Rwanda’s exchange market and their likely advantages  and disadvantages.

Facts

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

1. The gold standard exchange rate system.

2. Fixed exchange rate system (or Pegged exchange rate system).

3. Flexible exchange rate system (or Floating exchange rate system).

4. Managed floating rate system.

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 to 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 favour 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.

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.

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.

2. Fixed exchange rate system

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 the value of a domestic currency is tied to

the value of another currency, it is known as ‘Pegging’. When the value of
a currency is fixed in terms of some other currency or in terms of gold, it is known as ‘Parity value’ of currency’. The fixed exchange rate may be undervalued or overvalued. i.e. undervalued
exchange rate is 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, it 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 regimes that allows gradual depreciation or appreciation in an exchange rate. The system is a method to fully utilise 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.

Advantages of a fixed exchange rate system

1. It encourages international trade by ensuring certainty and predictability of prices with goods involved in international trade.

2. It ensures stability in foreign exchange markets by avoiding constant appreciation and depreciation within the currency which ensures confidence in the domestic market.

3. It minimises speculation in the economy by both goods and foreign exchange markets and it’s negative effects.

4. It reduces exploitation and cheating of foreign exchange buyers and holders by money markets and foreign exchange markets.

5. It facilitates planning since income in form of foreign exchange is assessed and predicted according to the rate of exchange.

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

7. It encourages long term capital inflows in an orderly manner thus encouraging investment.

8. Central banks can acquire credibility by fixing their country’s currency to that of a more disciplined nation.

9. 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.

10. Fixed exchange rate prevent debt monetisation, or fiscal spending financed by debt that the monetary authority buys up. This prevents high inflation.

11. On a micro-economic level, a country with poorly developed or illiquid money markets may fix their exchange rates to provide its residents with a synthetic money market with the liquidity of the markets of
 the country that provides the vehicle currency.

Disadvantages of a fixed exchange rate system

1. It is expensive to maintain because it requires a lot of foreign exchange reserves.

2. It requires strict monitoring of the economy which is affected by insufficient personnel.

3. It may lead to inflation if it is fixed above the market price or deflation if it is fixed below the market price.

4. It reduces speculation and hence reduces business profitability.

5. It discourages competition in foreign exchange markets and this leads to inefficiency.

6. The announced exchange rate may not coincide with the market equilibrium exchange rate, thus leading to excess demand or excess supply.

7. A 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.

8. The cost of government intervention is imposed upon the foreignexchange market.

9. 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.

10. Fixed exchange rate does not allow 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.

11. There exists a possibility of policy delays and mistakes in achieving external balance.

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.

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).

From the above figure, when the exchange rate is high e.g. at f1, exports of the country will be cheap leading to more exports and hence leading to more supply of foreign exchange. This will lead
to foreign exchange rate to fall e.g. to f2 and as it falls, exports will become expensive hence few exports and less supply of foreign exchange leading to scarcity of foreign exchange. This
will force foreign exchange rate to rise until it reaches equilibrium foreign exchange rate where the supply of and demand for foreign exchange are equal, hence the exchange rate will be determined
automatically.

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)

Advantages of a flexible exchange rate system

• 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 and supply.

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

• It encourages proper resource utilisation 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.

Disadvantages of a flexible exchange rate system

• 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.

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.

Effects of currency depreciation

Positive effects

• It increases the volume of exports hence foreign exchange earnings.

• It encourages export promotion and import substitution industrialisation which reduces foreign exchange expenditure.

• It encourages domestic investments because the cost of production is low at home.

• 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 cheaper 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 more 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.

4. Managed/Dirty/Floating exchange rate system

Traditionally, International monetary economists focused their attention on the framework of either Fixed or a Flexible exchange rate system. With the end of Bretton Woods’s system, many countries have adopted the method of Managed Floating Exchange Rates.

It 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.

Advantages of the managed dirty 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.

Disadvantages of the managed dirty 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.

5.2 Foreign Exchange Liberalisation

Activity 4

Suppose you are called upon to advise, as a person who has studied economics on the issue that; Rwanda wants to liberalise her foreign exchange market, how would you do it?

Facts

Foreign exchange liberalisation is the lessening of government regulations and restrictions in an economy in exchange for greater participation by private entities in foreign exchange market. Forex liberalisation offers the opportunity for the private sector to compete internationally, contributing
to GDP growth and generating foreign exchange

Advantages of foreign exchange liberalisation

• It reduces bureaucracy and corruption hence making it easier for investors to obtain foreign exchange.

• It encourages forex inflow because of free movement of currencies.

• It increases employment opportunities from several forex bureaus.

• Forex bureaus facilitate customers in forex transfer to and from abroad.

• It reduces over valuation and under valuation of currencies.

• It reduces government expenditure in managing the exchange rates.

• It eliminates black marketing in the forex market.

• It encourages competition in the forex market which improves service delivery.

• Forex bureaus give technical advice to customers with regard to investment and bureau dealings.

Disadvantages of foreign exchange liberalisation

• It undermines the local currency because citizens tend to prefer foreign currencies to domestic currencies.

• It results into capital outflow in form of profit repatriation in case forex bureaus are owned and operated by foreigners.

• It encourages speculation which leads to hoarding and shortages of forex.

• It leads to forex instability because of excessive competition in the forex market.

• Government loses full control over forex which may worsen BOP problems.

• It leads to misallocation of resources e.g. if scarce forex is used to import luxuries.

5.3 Foreign Exchange Reserves

Activity 5

Using the knowledge and understanding from Activity 1 of this unit on the sources of forex in an economy, discuss and share with the rest of the class what you think about the following:

(i) Forex reserves.

(ii) The importance of forex reserves in an economy.

(iii) The causes of forex shortages in Rwanda.

Facts

5.3.1 Meaning of foreign exchange reserves

Foreign exchange reserves refer to the money or claims in foreign exchange, gold or Special Drawing Rights (SDRs) kept in the central bank and other international financial institutions.

5.3.2 Importance of foreign exchange reserves

• They help in stabilising exchange rates e.g. buying of excess domestic currency.

• They are used in making international payments such as national obligations abroad debt servicing.

• They are used to back the issue of local currency.

• They can be used in periods of economic hardships such as disasters, wars etc.

• They can be used to upset the BOP deficit.

• They can be used to finance foreign investments and diplomatic missions abroad.

• They can be used to purchase essential inputs or commodities.

• They are used to show the country’s economic strength in international market.

5.3.3 Causes of foreign exchange shortages in LDCs

The following are the causes of foreign exchange shortages in LDCs:

• Exportation of low value primary products which fetch little foreign exchange.

• Importation of expensive commodities such as capital equipment and oil from oligopolies and monopolies.

• High marginal propensity to import due to demonstration effect.

• High foreign debt problems hence high debt servicing ratio.

• Capital outflow by multinational corporations and profit repatriation by foreign investors.

• LDCs have few investments abroad.

• Excessive employment of expatriates who are paid highly in foreign currencies.

• High population growth rates which reduce the quantity of export and increase the volume of imports.

• A large subsistence sector which doesn’t contribute to export revenue.

• Political instability and insecurity which discourage capital inflow.

• Poor government policies such as a large public sector which drains foreign exchange.

• High rates of inflation which discourages production and export.

• Protectionist policies of MDCs against LDCs products which reduces export earnings.

• Weak capital markets which do not encourage capital inflow.

• Depletion of foreign exchange reserves to finance persistent budget deficit.

• Low absorptive capacity which attracts little aid.

5.3.4 Foreign exchange control

Activity 6

The government of Rwanda, through the Central Bank of Rwanda and its monetary policy instruments, has always controlled forex in the country. From your own analysis, what do you think could be the
rationale behind your government’s control of foreign exchange and what are the likely effects?

Facts

Foreign exchange control means the control over the factors that determine the rate of exchange in a free and independent atmosphere. It is the state regulation excluding the free play of economic forces from the foreign exchange market. The government of a country can adopt a number of measures to control fluctuations in the rate of exchange. These measures include:

1. The establishment of official rates of exchange for the sale and purchase of foreign currencies.

2. The enforcement of regulations relating to the surrender to the government whatever foreign exchange people of a country possess.

3. Allocation of foreign exchange between people requiring it.

4. Restricting the use of domestic currency by foreigners and entering into agreement with other governments to make payments according to specified procedures for example, exchange clearing agreements.

A complete exchange control system implies subjecting all international payments to control by the government. To check the evasion of exchange control provisions, export licenses are issued to be presented to the customs officials before shipment of exports is permitted.

The term exchange control is used in two senses, namely the narrow and wide contexts. In its narrow sense, it refers to all those measures which restrict foreign exchange business; In the wide sense, it refers to all those activities of the government which influence the rate of exchange or the transactions
involving payments or receipt of foreign exchange. These can be:

1. Imposition of controls on the exchange rate, on the movements of capital,

2. The management of exchange equalisation accounts, and

3. Trade and payments agreements with other countries.

Exchange control can either be full or partial. When the exchange control is full, i.e. complete, it implies that the government restricts the sale and
purchase of all foreign currencies. Under the partial exchange control, the government restricts the sale and purchase of either a single currency or a few selected foreign currencies. Generally, exchange control in practice is only partial in character.

5.3.5 Rationale for exchange control

Exchange control measures may be adopted for the following reasons:
• Stabilisation: This is the most important objective of exchange control. It is geared towards ironing out temporary fluctuations in the rates of exchange. The objective should be to prevent those fluctuations of the free market rate which are purely adventitious or temporary without intervening with changes of rates which correspond to real alterations in the respective values of different currencies.

• Checking capital flight: An important objective of exchange control is to check the flight of capital from a country. Capital flight means the action of the holders of securities and bank deposits in a country
to convert their cash holding into foreign exchange. If this is allowed to continue unabated, it may lead to total exhaustion of a country’s scarce foreign exchange reserves.

• Ensuring availability of foreign exchange: Exchange control is also adopted to ensure the availability of foreign exchange to enable the government to import essential commodities.

• Acquiring foreign exchange to service debt: Exchange control measures are also adopted by countries to acquire foreign exchange for debt servicing and repayment of foreign loans.

• Protecting home industries: Countries also adopt exchange control measures with the objective of protecting home industries against foreign competition. In this connection, the government restricts the
imports and thus provides an opportunity to the domestic industries to grow and develop without the trouble of foreign competition.

• Raising government revenue: This is done by purchasing foreign exchange at lower rates and selling it at high rates.

• Increasing economic confidence so as to attract aid and grants from international financial institutions.

• To conserve forex which can be used for strategic projects in future.

• Reducing dependence on external economies by making exchange rates for imports expensive.

5.3.6 Advantages of exchange control

The following are some of the advantages of exchange control:

• Exchange control helps in preventing erratic capital outflows.

• It helps in correcting the disequilibrium in the balance of payments by restricting imports.

• It makes the imports of essential capital goods possible by making available the needed foreign exchange.

• It helps in the prevention of imports of non-essential consumer goods.

• It aids in controlling the multiplication of foreign companies and also in regulating their operations in national interest.

• It helps in protecting domestic industries from foreign competition.

• It maintains exchange rate stability.

• It controls speculative activities in foreign exchange.

• It improves the capacity of the government to repay its external loans.

• It acts as a source of revenue for the government.

• It conserves foreign exchange which can be used to meet strategic, defense and planning needs of the country.

• It acts as an instrument of anti-deflationary policy.

5.3.7 Disadvantages of exchange control

Exchange control is associated with the following disadvantages among
others:

• Exchange control reduces the volume as well as the value of international trade by restricting imports and by the restriction of exports owing to the retaliation by other countries.

• It creates inefficiency, red tape and corruption among people connected with its administration.

• It entails huge expenses because many people have to be employed for its smooth functioning.

• It leads to inequities because in some cases the restrictions are very low from which some countries gain more while in other cases the restrictions are heavy, resulting in smaller gains for some countries.

• It gives rise to smuggling and the creation of ‘black markets’ in foreign exchange.

5.4 Devaluation

Activity 7

Different countries’ currencies have different values in the forex market. At times this is done intentionally by the government to make her country’s currency lose value in respect to other countries’ currencies
based on different reasons. Using the library, the internet or any other economics source, research and share about the following in your whole class discussions:

(a) What economic term is given to an act by the government of making her country’s currency lose value in respect to other countries’ currencies?

(b) The conditions necessary for the success of such action by the government.

(c) When and why should countries do so?

(d) Effects of such an act by the government on an economy.

Facts

5.4.1 Meaning of devaluation

Devaluation refers to deliberate government policy of reducing the value of domestic currency in the face of external country’s currency 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.

5.4.2 Why LDCs devalue their currencies

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 of payment problems by reducing imports by making them expensive. This is because importers need more of the local currency in order to obtain forex. Thus they either have to import less
or charge high prices so that low quantity is demanded.

• To attract foreign and domestic investors as it becomes cheaper to invest in the economy as little forex 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 minimises foreign exchange outflow and therefore can reduce on the problem of trade shortage.

• To increase on the level of productivity and thus domestic resource utilisation. This calls for employment of idle resources.

• 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, inflation hit imports and they become too expensive. This discourages importers.

• To increase the nominal income of the producers of primary products that are exported.

5.4.3 Conditions necessary for devaluation to be successful

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 proportionate large increase in their purchase and more forex will be earned.

From the figure above, before devaluation forex earning from exports are OQ1aP₁ and after devaluation forex earnings increase to OQ2bP₂. Rectangle OQ₂bP₂ is bigger than rectangle OQ1aP₁
meaning that more forex earnings are as a result of a fall in the price from OP₁ to OP₂ which increased quantity exported from OQ₁ to OQ₂.

• 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 forex expenditure.

From the figure above, before devaluation, the price for imports was OP₁ and the quantity imported was OQ₁. After devaluation, the price for imports increased from OP₁ to OP₂ and the quantity
demanded of imports fell from OQ₁ to OQ₂ thereby reducing the

forex expenditure from OP₁aQ₁ to OP2bQ². Rectangle OQ₂bP₂
is smaller than rectangle OQ₁aP₁.

• The supply of export in the devaluating country should be elastic such that as demand for exports increases, 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 neutralise 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.

5.4.4 The Marshall-Lerner devaluation condition

The M-L condition examines the price elasticities of demand for exports and imports of a particular country, for example Rwanda experiences a depreciation of its currency, If foreigners’ demand for exports from Rwanda is relatively elastic, then a slightly weaker franc should cause a dramatic increase in foreign demand for Rwandan output, causing export income in Rwanda to rise dramatically. On the other hand, if Rwanda’s demand for

imports is highly price elastic, then a slightly weaker franc should likewise cause Rwanda’s demand for imports to decrease drastically, reducing greatly Rwanda’s expenditures on imports. If the combined elasticities of demand for exports and imports is elastic (i.e. the co-efficient is greater than 1), then
a depreciation of a nation’s currency will shift its current account towards surplus. This is the Marshall-Lerner Condition.

Marshall-Lerner Condition: If PEDx + PEDm > 1, then depreciation
or a devaluation of a nation’s currency will shift the balance on its current account towards surplus.

What if the Marshall Lerner Condition is not met? Demand for exports and imports may not always be so responsive to changes in exchange rates. Imagine a scenario where a weaker Franc does little to change foreign demand for Rwanda’s output. In this case income from exports may actually decline (in real terms, since the Franc is weaker) as the Franc depreciates. Likewise, if Rwanda’s demand for imports is highly inelastic, then more expensive imports will only minimally affect Rwanda’s demand for imported
goods, in which case expenditures on imports may actually rise as they become more expensive. In this case, where the elasticities of demand for exports and imports are highly inelastic, a depreciation of the currency will actually worsen a trade deficit. Rwanda’s import expenditures will go up
while export income from abroad will decline shifting the current account further into deficit.

5.4.5 Effects of devaluation

Positive effects

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

2. It increases the volume of foreign exchange earnings by increasing on the volume of exports.

3. It increases the capital inflow e.g. through foreign investment because it becomes cheaper to produce in the devaluing country.

4. It improves balance of payment position due to increased forex earning and reduced forex expenditure on import.

5. It leads to an increase in domestic investments which increase exploitation of idle resources.

6. It increases employment opportunities at home, e.g. through export promotion and import substitution industries.

7. It leads to development of domestic infant industries by making similar imports expensive.

8. It promotes self-sufficiency by encouraging exports and reducing the volume of imports.

Negative effects

1. It worsens the balance of payment position because external market
for LDCs products is poor.

2. It leads to imported inflation since devaluation increases prices of imports yet imports in LDCs have inelastic demand.

3. It leads to capital flight by nationals because they will tend to invest outside to earn high value foreign currency.

4. Due to inflation that may result from devaluation imported inputs become expensive which discourages production yet LDCs heavily depend on imported capital.

5. It increases borrowing rate and debt servicing burdens by LDCs since
they need a lot of income in terms of domestic currencies in form of
foreign resources.
6. 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.

7. Saving levels can decline in economy because liquidity preference to meet high price of imported commodities thus causing inflation.

8. It affects fixed income earners because where as prices are increasing due to devaluation their income remains constant hence low real incomes.

9. If it is common, it may discourage investors who lose confidence in the local currency.

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

LDCs 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.

5.4.6 Success of devaluation policy in LDCs

Most LDCs 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.

• LDCs export commodities are price and income inelastic because they are mainly essential commodities.

• There is protectionism of LDCs products by MDCs so as to increase employment in MDCs.

• The elasticity of supply of LDCs products is low because of domestic supply rigidities.

• LDCs have competitive supply i.e. supply of similar commodities; they therefore tend to carry out competitive devaluation.

• LDCs have inadequate co-operant factors especially capital and entrepreneur hence low production for exports.

• Most LDCs experience high rates of inflation which discourage export due to high costs of production.

• LDCs pursue unfavourable economic policies like trade legalisation which increases 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 LDCs discourage domestic production and foreign investment.

• There is counter devaluation among LDCs 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..

• LDCs exports are limited by low export quotas in the international commodity agreement (ICA).

• There are weak export promotion institutions in LDCs which reduce the benefits of devaluation.

• LDCs face foreign exchange instabilities because of adapting liberal exchange rate systems.

Unit assessment

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

  (b) How is devaluation of a currency supposed to cure an economy’s balance of payments current account deficit?

2. (a) Given that exchange rate is 1US $=850 Rwf. Calculate the new exchange rate after devaluation of the francs by 20%.

(b) Under what circumstances may devaluation fail to solve the balance of payments problem in an economy?

3. Explain how fluctuations in exchange rates can effect an economy.

Glossary

ཀྵཀྵ Appreciation: An increase in the value of a currency against other currencies under a floating exchange rate system.

ཀྵཀྵ Bureau de change: A business whose customers exchange one
currency for another.

ཀྵཀྵ Competitive devaluation: A situation where several countries devalue their currencies in an attempt to gain a competitive advantage over one another.

ཀྵཀྵ Currency pair: The quotation of the relative value of a currency unit against the unit of another currency in the foreign
exchange market.

ཀྵཀྵ Digital currency exchange: Market makers which exchange fiat currency for electronic money.

ཀྵཀྵ Depreciation: Capital consumption wearing out of capital stock during production. It is the cost of replacing equipment wornout in production.

ཀྵཀྵ Devaluation: Reduction in the official exchange rate, which results into the reduction of the price of domestic currency to the foreign countries and increase in the price of the foreign
currency.

ཀྵཀྵ Exchange control: Government regulations relating to the buying and selling of foreign exchange. It is normally in order to prevent a worsening balance of payments position.

ཀྵཀྵ Exchange rate: A price of one national currency in terms of
another.

ཀྵཀྵ Fixed exchange rates: System in which exchange rates between trading countries are pegged at a certain rate. It is maintained through reserve flow, action by the central banks, and
domestic inflation or deflation.

ཀྵཀྵ Floating exchange rate: Flexible exchange rate; a situation in which a country’s foreign exchange rate is determined entirely by the market of the forces of supply and demand for currencies, without intervention by central banks or governments. The result is usually much greater fluctuations
in exchange rates than under a fixed exchange rate.

ཀྵཀྵ Foreign exchange: These are claims on a country by another country. Foreign exchange system enables one currency to be exchanged for another. Or a transaction involving exchange
of one currency for another at a specified exchange rate.

ཀྵཀྵ Foreign exchange company: A broker that offers currency exchange and international payments.

ཀྵཀྵ Foreign exchange controls: Controls imposed by a government on the purchase/sale of foreign currencies.

ཀྵཀྵ Foreign exchange market: This is a market where foreign currencies are traded at a price that is expressed by the
exchange rate.

ཀྵཀྵ Foreign exchange rate: The rate, or price, at which one country’s currency is exchanged for the currency of another country. A country has a fixed exchange rate if it ‘pegs’ its currency at a
constant, predetermined exchange rate, and then stands ready to defend that rate. An exchange rate which is not fixed is said to ‘float’.

ཀྵཀྵ Foreign reserves: Stock of foreign currencies and Special Drawing Rights (SDRs) held by the county’s Central Bank as both reserve and a fund from which international payments
can be made.

ཀྵཀྵ Foreign exchange risks: These are risks that arise from the change in price of one currency against another.

ཀྵཀྵ Gold standard: Is when and where the currency of a country is completely backed by gold.

ཀྵཀྵ Gold standard currencies: These are defined in terms of a given weight of gold. Exchange rates remain fixed.

ཀྵཀྵ Managed floating exchange rates: Determination of foreign exchange rates by the interaction of supply and demand modified on occasion by government intervention for
domestic, political and economic progress.

ཀྵཀྵ Par exchange rate: This is a price of one country’s currency in terms of another by IMF.

ཀྵཀྵ Parallel exchange rate: This occurs when the official exchange rate does not reflect the true market rate, such that unofficial exchange rate tends to operate side by side with the official
one.

ཀྵཀྵ Purchasing power parity: A situation when the exchange rate between two currencies is such that the equivalent amounts of the currencies have the same purchasing power in their
respective countries.

ཀྵཀྵ Retail foreign exchange platform: Speculative trading of foreign exchange by individuals using electronic trading platforms.

ཀྵཀྵ Revaluation: It is the increase in the official exchange rate. It has the effect of increasing the price of the domestic currency to the foreigner and decreasing the price of foreign currency.

Unit summary

• Exchange rate

• Meaning

• Terms used

• Forms of exchange rate

• Factors influencing exchange rate

• Advantages and disadvantages of each exchange rate system

• Exchange rate regime (floating vs fixed exchange rate)

• Devaluation

• Meaning

• Reasons for devaluation

• Conditions for successful devaluation

• The Marshall-Lerner devaluation condition

• Effects of devaluation

• Success of devaluation in LDCs