Question

Q.Briefly describes a flexible exchange rate system. Considering the current situation of Pakistan’s Economy, show graphically (separately) the impact of the decrease in the exchange rate on net exports, on total expenditure, and on total output?

Answer 1

A flexible exchange rate system is determined through the market demand and supply for dollars with respect to any country's currency.suppose pakistan trades with america that means pakistan exports some goods to america which america had to pay in pakistan currency on the other hand america export something to pakistan then pakistan also had to paid in dollars for those goods.so there is a market where pakistan ruppee exchange with dollars.now there may be imbalance in this market as pakistan imported more than export then pakistan had to paid more dollars than they earn.they what should pakistan do.as there is the excess demand for dollars then the exchange rate between dollar and pakistan ruppee should be higher.that means now pakistan have to spend more ruppee than before to get an one dollar.let it explain with a diagramin this diagram we measure demand and supply for dollars in the horizontal axis and exchange rate on the vertical axis.now the demand and supply for the dollars is like simple market demand supply.now if the exchange rate is or2 then there is excess supply for the dollar so the exchange rate has to fall that means we now get one dollar by spending less pakistani ruppee.on the other hand is exchange rate is or0 then there is excess demand for dollars.so the exchange rate goes up that means we have to spend more pakistani ruppee to get one dollar than before.in this way the stability will come at or1 where the demand and supply for dollar in respect to pakistani ruppee is equal so it is the exchange rate which is determined through market.

Now all the country has to bring balance in their net exports.net exports means total exports minus total imports.now the problem pakistan faces is it has a huge import bill which has to be paid in a finacial year but their export earning is very much low than the import bills so it impossible to cover up all import bills through exports.so to makeup the gap the pakistan government take the policy of devaluation of pakistani ruppee.that means for one dollar he has to paid more pakistani ruppee.it is to cover up the extra import bills.but here the main problem aries.with doing that the pakistani goods are more cheaper and the american products are more dearer.economist thought that it will decrease the import and increasing export so the exporting imbalance will reduce but it not occurs in real life.as import goods are very essential so they can't cut down those import bills and exports are not increasing that mucj which they expected so the export imbalance is now bigger and in this process it became worsen.to cope up with pakistan has to take loans to make up their export imbalance or huge import bills.and after taking such huge loans pakistan has to pay a huge amount of interest.and the budget amount gone to pay those interest so government can't spend other essential sectors.and also it is a capital outflow or leakage from the economy.now as leakage from the economy begins that means the net output has to fall and as net output falls export also falls.and when total.output falls then there should be increase in unemployment which may has a impact on total expecditure.as total expenditure falls the effective demand falls.and also net output falls.it is a vicious cycle in which the pakistan is trapped now.to overcome form this pakistan started to selling their public properties but it is not the solution.it has a huge amount of loans that country like china should overtook pakistan any day as they can't able to pay back those huge loans.