Effects of a Floating Exchange System [ 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 the effects of a floating exchange rate system.

Theories

Effects of a Floating Exchange Rate System

Next theory - The Marshall-Lerner Condition >>

On taking power in 1991 the government of President Chiluba made a number of trade reforms. Perhaps the most important was the floating of the Zambian currency - the Kwacha. Two questions should be considered

  1. Why were the government of President Chiluba and the multilateral agencies assisting Zambia's economic reforms such as the IMF such keen advocates of a freely floating exchange rate system?
  2. What are the potential hazards of such a exchange rate regime?

Arguments in favour of floating exchange rates for LDCs

  1. Balance of Payments on current account disequilibrium will automatically be restored to equilibrium.

    A balance of payments deficit caused by a decrease in the demand for Zambian exports would lead to a shortage of foreign currency as the amount of foreign currency available falls - shown by a shift to the left of the supply curve for foreign currency. This would push up its price from P1 to P2 and hence lead to a depreciation of the Kwacha. This is shown below.

    The fall in the value of Kwacha causes the price of Zambian exports to decrease and the price of foreign imports to increase. Consequently the demand for Zambian exports increases and the demand for foreign imports decreases. The deficit shrinks and the balance of payments returns to equilibrium assuming the Marshall Lerner Condition is satisfactorily met.

    Thus, in theory, governments need not worry about having to manage their balance of payments situation. If the exchange rate is allowed to fluctuate freely any disequilibrium will automatically be restored to equilibrium. The need to resort to overseas borrowing to finance balance of payments deficits (adding to the burden of Zambia's existing debt) is therefore less. The attention of government can then be focused on achieving other government objectives such as inflation, unemployment, economic growth and poverty reduction.
Floating exchange rate - supply decrease
  1. Reduces inflationary pressures and international uncompetitiveness

    One argument is that a floating exchange rate will reduce the level of inflation. Zambia has suffered from high levels of inflation. Allowing the exchange rate to float freely should ensure that Zambian exports do not become uncompetitive. This is embodied in the Purchasing Power Parity theory. A high rate of inflation in Zambia would tend to make Zambian exports uncompetitive. Their demand would fall and the foreign exchange flowing into the country would also fall. The supply curve of available foreign currency would in turn shift to the left causing its value to increase and the corresponding value of the Kwacha to depreciate. This would, assuming the Marshall Lerner condition was met, lower the price of Zambian exports making them more competitive.

Arguments against floating exchange rates

  1. The Marshall Lerner Condition is not necessarily met

    The problem for countries such as Zambia and many other LDCs is that the link between the exchange rate adjustment and the balance of payments improvement is not as straight forward as the above would suggest. Some economists would argue with the idea that balance of payments deficits would automatically be returned to equilibrium under a floating exchange rate system. They argue that the Marshall Lerner conditions are not met.
  1. Abolition of exchange controls causes capital flight

    The introduction of a floating exchange rate and the abolition of exchange controls lead to substantial capital flight as wealthy Zambians and Zambian firms attempted to move their finances abroad and convert their savings of Kwacha into hard currencies held in overseas banks. This leads to purchasing of foreign currencies reducing the amount available, pushing up its value, and leading to a substantial depreciation of the Kwacha.
  1. Cost Push Inflationary Pressures

    A depreciating currency will help a country's exporting sector. However, the cost of imports will invariably rise leading to cost push inflationary pressures. Those people whose livelihoods rely on the consumption of goods with a high import content will experience hardship.
  1. Uncertainty

    A wildly fluctuating exchange rate at the mercy of national and international currency speculators introduces considerable uncertainty to export and import prices and consequently to economic development.

Next theory - The Marshall-Lerner Condition >>


Related Glossary Items:
Cost Push Inflation
Capital Flight
Floating Exchange rate
Exchange Control
Purchasing Power Parity

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

Related Theories:
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
Terms of Trade