Floating Exchange Rates [ Biz/ed Virtual Developing Country ]

The Virtual Developing Country is a case study of Zambia. There are a series of field trips available looking at different issues connected with economic development. This tour is the trade tour, and this page looks at floating exchange rate systems and how they operate.

Theories

Floating Exchange Rates

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Since 1991 and the election of the government of President Chiluba and the adoption of macroeconomic stabilisation policies the value of Zambia's currency has been allowed to float. Exchange controls were dropped and the kwacha was made convertible. With a floating exchange rate the value of the foreign exchange is determined to a greater or lesser extent by the forces of supply and demand for the foreign exchange.

With a floating system the exchange rate between the local currency and a foreign currency is determined when the demand for and available supply of foreign currency is the same. When the economy is experiencing a balance of payments deficit and there is excess demand for the foreign currency the exchange rate of the local currency falls or depreciates. This may have the effect of automatically restoring equilibrium. In this case the foreign currency value of exports falls making them more attractive abroad and the local value of imports increases making them less attractive locally. Both could lead to an improvement in the balance of payments situation.

If however there is a balance of payments surplus and an excess supply of foreign currency the value of the local currency will rise, again restoring a balance in the foreign exchange market and the balance of payments.

Any changes in the conditions of demand and supply of foreign currency in Zambia such as a change in the demand for imports and exports or change in capital flows, such as foreign direct investment from multinationals, will bring about a change in the market exchange rate. This can be demonstrated in the diagram below. The price on the vertical axis is the number of Kwacha per unit of foreign currency.

Floating exchange rate - demand increase

If the demand for foreign currency increases, for example, if Zambian firms need to purchase more oil from abroad, the demand curve for foreign currency shifts to the right from D1 to D2. The effect of this will be for the value of the foreign currency to appreciate and consequently the value of the Kwacha to depreciate.

Balance of payments deficits caused by increases in the demand for foreign currency or reductions in the available supply of it will always lead to a depreciation of the value of the Kwacha. As the economy of Zambia has faced regular balance of payments deficits since it floated its currency the impact of a depreciation needs to be considered.

Next theory - Effects of a Floating Exchange Rate System >>


Related Glossary Items:
Balance of Payments
Floating Exchange Rate
Foreign Direct Investment
Current Account Deficit

Related Issues:
Zambia's Balance of Payments Situation
Zambia's Exports and Imports

Related Theories:
Exchange Rates:
Introduction to Exchange Rates
Fixed Exchange Rates
Floating Exchange Rates
Effects of a Floating Exchange Rate System
The Marshall-Lerner Condition
The Economic Effects of a Devaluation