Exchange rate

Exchange rate

Is the price of a country's currency expressed in terms of another country's currency.

Types of exchange rate

Floating / free exchange rate

This is an exchange rate that is determined by market forces, i.e. demand and supply. The forces of demand and supply make exchange rate flow upward and downward.

Advantages of a floating exchange rate

1. No government intervention The exchange rate is determined by the market, so there is no need for the government to interfere.
2. Helps manage the deficit in the balance of payment A currency depreciation can help make exports cheaper and more competitive, improving the balance of payments.
3. Indicates the strength of the currency The exchange rate gives a clear signal about the strength or weakness of a country's currency based on market conditions.
4. Fair pricing of domestic currency The value of the currency is determined by supply and demand, making it more transparent and fair compared to a fixed system.
5. Reduces competitive exchange rate depreciation among countries Countries do not engage in competitive devaluations because the market sets the rate.

Disadvantages of a floating exchange rate

1. It causes uncertainty for businessmen Frequent changes in the exchange rate make it difficult for businesses to predict costs and revenues, adding uncertainty to international trade.
2. Government intervention may still occur In some cases, governments intervene to stabilize or influence the exchange rate, which can lead to market distortions.
3. Leads to inflation, particularly imported inflation A depreciating currency can make imports more expensive, driving up imported inflation.
4. Leads to misallocation of resources Volatile exchange rates may cause inefficient allocation of resources, as businesses might avoid foreign trade or investment due to uncertainty.
5. Speculative effects on businessmen Speculators may engage in currency trading, which can cause artificial volatility and disturb the economy.

Fixed exchange rate

It is a system whereby countries fix the value of their currency in terms of another country's currency, or it is an exchange rate which the government sets and maintains through the central bank.

Advantages of a fixed exchange rate

1. It helps to remove uncertainties With a fixed rate, businesses and traders know the exact exchange rate, reducing the uncertainty associated with currency fluctuations.
2. It discourages speculation among businessmen A stable exchange rate reduces the potential for speculative attacks on the currency, as there is less volatility.
3. It reduces inflation, especially imported inflation A stable currency helps keep import prices constant, reducing inflationary pressures from fluctuating exchange rates.
4. It is easier to predict future prices Predicting prices in foreign trade becomes simpler because the exchange rate does not change, helping businesses plan and budget effectively.
5. It enables economic integration among different countries A fixed exchange rate can encourage regional cooperation and integration by providing a common, stable currency base for trade agreements.
6. It enables the government to plan and implement its responsibilities easily Governments can easily plan budgets and manage fiscal policies when the exchange rate is stable and predictable.

Disadvantages of a fixed exchange rate

1. It imposes a burden on the government and central bank Maintaining a fixed exchange rate requires the government to intervene regularly in the foreign exchange market to buy or sell currency, which can be resource-intensive.
2. It affects the balance of payments equilibrium by:
   • Overvaluing the currency The currency may be artificially valued higher, leading to a trade deficit as exports become more expensive.
   • Undervaluing the currency Conversely, a currency may be kept undervalued, which can boost exports but result in higher import costs.
3. It may lead to inflation If the central bank needs to inject more money into the economy to maintain the fixed exchange rate, it can increase the money supply, leading to inflation.
4. It makes it difficult to control a deficit in balance of payment A persistent deficit in the balance of payments may require continuous intervention to maintain the fixed rate, which can deplete foreign exchange reserves.

Multiple exchange rates

Is an exchange rate system where a given foreign currency is purchased at different rates for a local currency. The exchange rate depends on government intervention in controlling importation—for example, basic needs are given at a lower exchange rate while luxury goods are given a higher exchange rate.

Pegged exchange rate

Is a system where the price of a particular domestic currency is fixed in relation to a given foreign currency, for example, TSH and dollar, where all the prices of goods and services in Tanzania are determined by the dollar.

International institutions used in international trade

• I.M.F: International Monetary Fund
• I.B.R.D: International Bank for Reconstruction and Development (World Bank)
• I.F.C: International Finance Corporation