Trade - Worksheet - Exchange Rates [ Biz/ed Virtual Developing Country ]

Introduction

The exchange rate of a country measures the external value of the currency. To a country such as Zambia the market for foreign exchange is very important. Its own currency, the kwacha is not a hard currency and thus not universally accepted in payment of debt. Zambia relies on generating foreign currency from selling exports to enable it to finance imports. The macroeconomic situation such as the balance of payments position, employment and inflation are all influenced by a country's exchange rate. Hence it becomes a key economic policy variable.

Step 1

Use the glossary and the trade theory sections to check up on your understanding of the terms below. Write a short definition of each.

  • Exchange rate
  • Fixed exchange rate
  • Floating exchange rate

1. Use the data in the resources section and a spreadsheet to plot the value of the kwacha measured in terms of the US$ between:

1965 and 1980 and
1990 and 1998

2. Which particular exchange rate regime predominated in period 1 and which in period 2?

3. Would you describe the change in the exchange rate of the kwacha between 1980 and 1995 as an appreciation or a depreciation? What is your reason for thinking this?


Review the theory sections of the trade tour on fixed exchange rate and floating exchange rate regimes.

4. Why did the government of Zambia want to maintain a fixed exchange rate for the kwacha?

5. Explain using supply and demand analysis how a government could fix the value of the currency at an official exchange rate.


During much of the period from Independence there has been a black market for dollars in Zambia.

6. Would you expect a black market for dollars to develop in Zambia during a floating or fixed exchange rate regime? Why?

7. Using the data in the resources section calculate the % difference between the official exchange rate and the black market exchange rate and complete the table below. In which year is the % greatest? Why do you think this might be?

  1970 1980 1991 1998
Official Exchange Rate        
Black Market Exchange Rate        
% difference        

Step 2

In 1992 when the government of President Chiluba introduced a floating exchange rate and abolished exchange controls there was considerable capital flight out of Zambia.

1. Explain what is meant by capital flight

2. Using supply and demand analysis illustrate and explain the impact of capital flight on the value of the kwacha against the dollar.

3. When a currency depreciates the fear is that it may lead to inflation. Why is this?

4. Using a spreadsheet and the data in the resources section plot the values of the exchange rate and the inflation rate between 1980 and 1998. Describe and explain the relationship between the two sets of data. Does it support the idea that a depreciation could contribute to causing inflation?

Step 3

A fall in the value of a currency will bring about a change in the prices of exports and imports. Changes in export and import prices will in turn cause changes in the quantity of exports and imports demanded and consequently the balance of payments of current account.

1. Using the data in the resources section and a spreadsheet plot the data for the exchange rate of the kwacha and the current account balance. Can you find any evidence to support either of the following:

a) the idea that a devaluation leads to an improvement in the balance of payments situation?

b) the Marshall Lerner condition?

2. Explain, using the concept of price elasticity of demand, how the exchange rate changing affects the balance of payments of current account.

Step 4

Suppose the members of the COMESA decided to form an economic union and introduce a single currency. You may find it helpful to review the COMESA case study in the trade tour and also look at the theory on the formation of Trading Blocs.

1. Prepare two paragraphs, one outlining the advantages for a single regional currency and one outlining the disadvantages of such a currency to the economy of Zambia.

2. Could there ever be a world currency? Give the reasoning for your decision.