Question

Impacts of an Exchange rate adjustment

Assume the US Dollar experiences a major real and nominal appreciation. Given this scenario, you are to discuss how 2 export-driven African economies will be impacted by this dollar Appreciation.

You should identify the key export and import items for each of these countries as well as their pattern of trade. One of the countries of your choice should operate under floating (flexible) exchange rates system and the other under fixed exchange rates system.

Answer 1

Exchange rate measures the value of one currency in terms of the currency of another country. It simply gives the amount of money required for the home country to buy one unit of foreign currency. Currency appreciation is the increase in the value of one currency in relation to the value of another currency. If the currency of the home country appreciates, it essentially means that fewer units of the home currency will be required to buy one unit of the foreign currency. There can be fluctuations in the exchange rate due to various reasons like government policies, external shocks, and instability, trade deficits, etc.

For our analysis, consider 2 African economies –Kenya and Botswana. Let us call Kenya and Botswana the Home country (HC) and the US – the foreign country (FC). Then the exchange rate of Kenya is (HC/FC). The exchange rate adjusted for the price level of the respective countries is the Real exchange rate.

We make the following assumptions for our analysis –

1. The US is the only trading partner of both Kenya and Botswana.
2. The price level in all three countries is assumed to be constant so that the nominal and real changes in the exchange rate are the same.

In figure 1 and 2, the demand and supply curves of foreign exchange are plotted against the exchange rate e. Since the US dollar has appreciated, more units of home currency will be required to buy 1 dollar. So, the HC will depreciate which is the same as a higher exchange rate. If the exchange rate is higher, then –

1. The cost of imports will increase and so the demand for foreign exchange will reduce.
2. The dollar cost of exports is lower and so the supply of foreign exchange will increase. Now more dollars will be sold in the market to get a higher amount of home currency to pay for higher imports from Kenya.

So, the supply curve will slope upwards and the demand curve will slope downwards.

Since the value of exports for both the home countries will decrease, there will be a huge boost in exports. There will be a trade surplus in both countries. The balance of Payments will be in surplus. The countries being export-oriented, will experience a higher rate of growth. Let us see the impacts on the countries individually.

Interaction with country 1 – Kenya

Let us assume that Kenya operates under flexible exchange rate. The key export of Kenya is Tea and the key import is refined petroleum. Under floating exchange rate, the value of currency changes constantly depending on the nature of demand and supply. Here, the Central Bank does not intervene in the market. Demand and supply of foreign exchange in the market naturally adjust to reach the equilibrium. So, as the exchange rate of US dollar appreciates, imports from the US will decrease and exports from Kenya will increase. This will lead to a surplus in trade account for Kenya. Since the exchange rate here is free to adjust, the home currency will depreciate and a new equilibrium will be reached. This is shown in figure 1. At this new equilibrium, BOP will balance, but the value of the home currency will depreciate and exports will be higher. Kenya, assumed to be an export-oriented country, will see a period of growth.  Growth in the export sector will cause the export industry to expand. The demand for workers in the Tea industry will increase and in the short run, unemployment may decrease. However, the imports of refined petroleum will become very costly.

Interaction with country 2 - Botswana

Let us assume that Botswana operates under fixed exchange rate. Key export of Botswana is precious stones and the key import is oil and minerals. Here, the Central Bank of the country pegs the value of the exchange rate. In this case, any increase (or decrease) in the value of the currency is carried out by the Central Bank and is known as devaluation (or revaluation).

Suppose, due to appreciation of the dollar, the exchange rate moves from the initial position of e₁ to e₂. But the Central Bank is unwilling to adjust the exchange rate to e₂. At e₁, the home currency is overvalued. The price of the dollar is being forcefully kept at e₁. At e ₁, the demand for foreign exchange will exceed the supply and the BOP will be in deficit. To maintain equilibrium, the central bank must buy dollars from the market in exchange for reserves to neutralise the increasing pressure of devaluation. The Central Bank should have sufficient foreign reserves to maintain its overvalued currency. If the foreign reserves are exhausted, the Central Bank will have no other option than to devaluate the currency. On the other hand, if the Central Bank adjusts e according to its market forces and fixes e at e₂, then the BOP will balance and the HC will devaluate. This will boost exports of precious stones and the country will experience higher growth. Growth in the export sector will cause the export industry to expand. The demand for workers in the diamond industry will increase and in the short run, unemployment may decrease. However, the imports of oil and minerals will take a hit.