Fixed 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 fixed exchange rate systems and how Zambia''s fixed exchange rate operated.

Theories

Fixed Exchange Rates

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Prior to 1991 Zambia operated a fixed exchange rate system. With a fixed exchange rate system the government, often acting through its agent the Central Bank, fixes or pegs the value of the currency to another currency such as the US dollar. Official exchange rates are then usually quoted in terms of US dollars. It shows the value of US dollars in terms of Zambian Kwacha and vice versa.

If the pegged value coincides with the equilibrium price for foreign exchange and consequently the balance of payments equilibrium then there is no need for the government to act. The problem arises when the balance of payments and foreign exchange market go into disequilibrium. Consider the effect of a fall in the value of exports of copper. The balance of payments of Zambia will go into deficit. The earnings of foreign currency and thus the available supply to Zambia will be less than the demand for foreign currency. The official exchange rate is consequently overvalued.

Where excess demand for foreign currency exists the central banks of LDCs have three options open to them if the official exchange rate is to be maintained:

  • They can accommodate the shortage by using up reserves of foreign currency or borrowing foreign currency from overseas incurring foreign debt.
  • They can deal with the balance of payments deficit through reducing the demand for imports such as operating protectionist measures such as tariffs, quotas and licences.
  • They can attempt to ration the amount of foreign exchange made available to those people they consider should have it through exchange controls.
Exchange controls

The diagram above illustrates how a system of exchange controls operates. Under free market conditions the equilibrium price of foreign currency in Zambia would be P0 with Q0 units of foreign currency supplied and demanded. If the government maintains an artificially low valued foreign currency P1 (i.e. an overvalued domestic currency) Q2 will be demanded and Q1 will be supplied. There will be an excess demand equal to Q2-Q1. As with many attempts to implement a maximum price, the government often steps in to ration the item in short supply. This is the essence of exchange controls.

Why was an overvalued fixed exchange rate maintained?

The government of President Kaunda was following a policy of import substitution and industrialisation. An overvalued kwacha would keep the price of imported goods such as oil and capital items for the copper industry artificially low.

However the impact of an overvalued exchange rate on the balance of payments should be considered.

The foreign currency price of Zambian exports is raised hence making them less attractive abroad and the local price for imported foreign goods is lowered making them more attractive in Zambia. Both of these, in the absence of any form of effective protection such as export subsidies or barriers to imports, would lead to a worsening of the balance of payments and debt situation.

In such a situation a parallel, dual or black market for foreign exchange usually develops. Foreign currency will be bought illegally at an exchange rate far in excess of the official exchange rate.

The IMF usually requires those countries seeking assistance to either allow their currency to depreciate if it is floating exchange rate or to devalued it if it is a fixed exchange rate. In either case the value of foreign currency increases and reduces export prices and raises import prices.

Next theory - Floating Exchange Rates >>


Related Glossary Items:
Import Substitution
IMF
Dual Exchange Rate
Exchange Control
Fixed Exchange Rate
Official Exchange Rate
Devaluation
Revaluation
Tariff
Quotas
Subsidy
Protectionism
Balance of Payments

Related Issues:
Zambia's Balance of Payments Situation
Zambia's Trade Policy
Protectionist Policies of Zambia

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
The Imposition of Quotas
The Imposition of Tariffs and Welfare Loss