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Wednesday, September 24, 2008

A question on Foreign Exchange Rates


I just came a cross a seemingly simple question, but a very interesting one from Issa Michuzi's Website. In the post, a visitor who goes by the alias David Villa asks, are foreign exchange rates true indicators of economic standards? He goes on to explain that say you have country A whose economic level is in all respects higher than country B, should the exchange rate of A's currency compared to B's currency be higher?

None of the visitors to that post could adequately answer that querry, and I thought it would make for an interesting discussion topic here. Would economists and particularly experts in monetary policy, international trade, development economics, etc. help us out with this?
  • What determines the exchange rate of a given currency?

  • What is the measure of economic level and/or growth?

  • What is the relationship between economic level and forex rate (if any)?

8 comments:

David Villa said...

Posted another small querry on michuzi website,just connected to that.Currently I am leaving in a country whose currency 'beats' ours by 2.5 times.When I am changing 5USD here I am getting ~2750 local currency equivalent to ~5700TZS.Whereas with 5USD in Tanzania I can afford to buy about 4Kg of Sugar,here I can only afford to buy 1 Kg of sugar!(Same 5USD).I am asking myself how comes that this currency beats our?

Nalitolela, P. S. said...

one thing I can say n regards to that is that the country you are in, the standard of living is high. This is typical with countries with high economic level. And usually (though not always); high economic level means high exchange rate.
I will give you anotother example, I live in Canada, and the CAN $ is almost at par with the USD; the house I live in, rent is $1140 per month (and it's not a fancy house... it's a simple house with all the tenants being students); where as in Tanzania; for a house of this caliber I would only pay $300 at most.
So the fact that the currency of the country you are in beats the TZS could possibly mean their economy is higher than ours and as such, the living standards are high too. You see that happening in Tanzania too; everytime salaries go up, commodity prices go up too. The important this is that for the economy to grow, the prices should not increase faster than the income growth. ie, in economic lingo, the Consumer Price Index (and consequently the inflation) should grow much slower than the Per-Capita-Gross-Domestic-Product

That is why when comparing two different countries, Economists consider the Purchasing-Power-Parity (PPP). i.e, the compate not just the purchasing power (PP); but they are adjust the PP by scaling it according to the exchange rate.

Anonymous said...

What determines the exchange rate of a given currency?
Lets first see what does exchange rate mean
In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specifies how much one currency is worth in terms of the other. For example an exchange rate of Tshs 1,130 (TAS) to the United States dollar (USD $) means that TAS 1,130 is worth the same as USD 1. In other words exchange rate is the price of acquiring other currency. This means the price of acquiring one unit of US $ is Tshs. 1,130.
The price of any currency, like any other commodity, is determined by demand and supply of that currency.
We need/demand a certain currency in order to buy things denominated in it (goods, services, or assets), to hold interest-bearing accounts in that currency. These are reffered to as price determinatnts o f demand for foreign currency. Non-price Determinants of demand include increased (decreased) demand for foreign G&S, increased (decreased) domestic income, lower (higher) relative price levels for G&S denominated in currency and increased (decreased) relative return on assets denominated in foreign currency.
If you are a Tanzania company, you want to be paid in Tshs. So when a US company buys your goods, it needs to take its dollars, exchange them for Tshs and complete the purchase. When a country imports goods, it supplies its currency and demands another. Exports are the reverse. Tanzania imports more than what it exports. This means, it needs more foreign currency ( dollar) to pay for American traders, hence demand for dollar is high. Since it exports less to the rest of the world, supply of dollar is low. From the law of demand and supply, holding supply constant, the price of a good will rise when there is more demand for it, and fall when there is less. So you see, price is positively correlated to demand and negatively correlated to supply. In other words, exports increase the value of a domestic currency, and imports decrease it.

What is the measure of economic level and/or growth?
Economists often tend to use economic development and economic growth interchangeably, as they appear to be synonymous with each other.

The economic development of a country is defined as the development of the economic wealth of the country. Economic development is aimed at the overall well-being of the citizens of a country, as they are the ultimate beneficiaries of the development of the economy of their country.

Economic development is a sustainable boost in the standards of living of the people of a country. It implies an increase in the per capita income of every citizen. It also leads to the creation of more opportunities in the sectors of education, healthcare, employment and the conservation of the environment.


Economic growth on the other hand, is a narrower concept than economic development. It is defined as the increase in the value of goods and services produced by every sector of the economy. It is usually expressed in terms of the gross domestic product or GDP of the country
Economic growth is the expansion of a country’s productive capacity. This leads to a rise in total national output. Growth can occur in two different ways; the increased use of land, labour, capital and entrepreneurial resources by using better technology or management techniques and increased productivity of existing resource use through rising labour and capital productivity. While theoretically having an increasing national output means greater material welfare and a rise in living standards, it does not equate to having higher levels of well being for individuals in that nation. Economic growth can, in fact, have negative impacts on a nation including environmental degradation and the loss of traditional cultural values. It also may mean there is greater inequality between different classes in society, that is, the gap between the rich and the poor may grow. It is for these reasons that economic development measurements are also used.
Economic development basically implies that individuals of that nation will be better off and takes into account changes in economic and social structures that will reduce or eliminate poverty. Economic development can be measured in a number of different ways including the Human Development Index, a Gender Empowerment Measure, a Human Poverty Index and a Human Freedom Index. All of these measures were developed by the United Nations Development Program. The World Bank also has its own indicator called the World Bank Development Indicator. Economic Development takes into account the depletion of natural resources which might lead to pollution, congestion & disease. Development is concerned with sustainability which means meeting the needs of the present without compromising future needs.
Economic growth as a measure fails to account for other important social and economic factors such as the size of the black market, domestic work which is not given a financial value, the level of damage to the environment and inequalities in income distribution. Various indicators have been developed to compensate for the limitations of economic growth measurements. Rather than just measuring the economic living standards in a country, development indicators measure the welfare of individuals in that country. The main development indicator used is the Human Development Index (HDI). It was devised by the United Nations Development Program (UNDP) to measure the economic achievements of a nation in combining economic growth as well as social welfare. The HDI takes into account three major factors:
• Life expectancy at birth: High levels of longevity are critical for a country’s economic and social well being.
• Levels of educational attainment: The HDI measures adult literacy and the ratio of people in primary, secondary and tertiary education.
• Gross Domestic Product per capita: seen as being a measurement of the ability of people to access goods and services.

The HDI is essentially a score between 0 and 1. A score of 0 would mean no human development has taken place and a score of 1 is the maximum amount of human development. In 2000, the Human Development Report places Canada as the top ranked nation with a HDI of 0.935. Australia was ranked fourth, with a HDI of 0.929 behind Norway and the United States. The lowest ranked nation was Sierra Leone with a HDI of 0.252. When comparing the HDI of certain countries, the GNP per capita should also be considered. A nation with a much higher-ranking HDI than GNP per capita has had a relatively high level of economic development given their level of economic growth. Examples of this are Tajikistan (+43) and Cuba (+40). In contrast, some nations may have a higher GNP per capita ranking than their HDI ranking. This indicates that there is a very high level of inequality, that is high income levels are only enjoyed by a small proportion of the population. A country with this problem is South Africa with a GNP per capita ranking 54 places higher than their HDI ranking.
The UNDP has also developed a number of other indicators. It has developed a specific Gender Development Index which compares the HDI between male and female populations, a Gender Empowerment Measure, which shows gender inequality in economic and political opportunities and a Human Poverty Index (HPI) which measures similar outcomes to the HDI, but examines the extent of disadvantage faced by people who are being deprived of human development. The HPI is adjusted for developing and developed countries.
In 1991, the UNDP developed a one off indicator called the Human Freedom Index (HFI). This included such things as the right to travel in ones own country, the right to teach ideas and receive information, the right to have an ethnic language, the freedom from forced or child labour, the freedom from compulsory work permits, the freedom from censorship, the freedom for political, legal, social and economic equality for women, social and economic equality for ethnic minorities and the existence of independent trade unions. The UNDP discontinued this measurement as it was based on subjective facts and would not be a consistent measurement from year to year.
The World Bank Developed its own indicator called the World Bank Development Indicator (WBDI). This was made to supplement the Human Development Index. The WBDI mainly measures the quality of life, the success of measures to alleviate poverty, the current account balance, malnutrition, traffic congestion, tax rates, life expectancy, population size, educational standards such as literacy and infant mortality.
Another smaller economic development indicator is one developed by economists, James Tobin and William Nordhaus called the Measurement of Economic Welfare. This index takes into account real GNP per capita plus the value of a family’s work. It also takes into account the balance of hours spent in leisure and work, pollution levels and the rate of environmental damage.

What is the relationship between economic level and forex rate
The exchange rate, a price of one currency against others, is one of the major economic parameters and policy tools.
Exchange rates play a vital role in a country's level of trade, which is critical to almost every free market economy. For this reason, exchange rates are among the most watched, analysed and governmentally manipulated economic measures, as part of the monetary policy measures.

A movement in the exchange rate of a currency (such as the Tanzania) vis-a-vis other currencies will mean different things to different players in the money markets. Some will be winners while others will be losers.
In general, however, a fall in the exchange rate means that the price of imports will rise while exporters can choose either to lower prices for their buyers or leave them the same and increase their profit margins. As a result, domestic producers should become more internationally competitive. In essence, import volumes should fall whilst export volumes should rise. Output at home should rise, leading to higher economic growth and a fall in unemployment. There should be an improvement in the current account of the balance of payments too as the gap between export values and import values improves. This however is ideal for the country with necessary resources to produce such as technology, capital, labour and other resources. Tanzania cannot do away with increase in prices of imports as a result of fall in exchange rates of Tshs as it happened in last few months where prices of oil were sky- rocketing and Tanzania was compelled to import oil.
Decrease in exchange rates of Tshs (decrease in value of our currency) may have the following impact: One, it may feed through to a rise in inflation in the economy. This is because businessmen will be forced to increase prices of imported consumable goods for them to earn a profit. Likewise, prices for locally produced goods made from imported raw materials will be sold at high prices so as to absorb production costs and make some margins. For instance, being a net importer of oil products, the country is likely to see a direct impact on the cost of local manufactured goods based on the effect of the oil component in the total production cost (including transportation cost). This, of course, will add to the inflationary pressure.
Two, foreign currency denominated financial obligations will also cost more in shilling terms. Both private and public foreign currency debt obligations will require more shillings per unit than before. This is also likely to add to the production costs of those concerned, who may pass on all or part of that additional interest cost to the final consumers. Further, given that the government revenues has also been severely disrupted by the crisis, it may force the government to borrow more from the local financial markets, with the resulting effect of higher interest rates.

In conclusion, there is a relationship between the exchange rates and the rate of economic growth of a particular country. But it does not necessarily imply that the low value of a certain country’s currency means that country has low level of economic growth.

By Samson Katemi,
Association of Community Banks
Dar es Salaam

DEO KIMOLO "a life economist" said...

THERE ARE TWO QUESTIONS:
1. ARE FOREIGN EXCHANGE TRUE INDICATORS OF ECONOMIC STANDARDS?

THE ANSWER IS YES but NOT SUFFICIENT

in normal circumstance we expect the country with strong currency(in terms of forex rate) to have high standard of living. BUT MIND U FOREX RATE IS A NECESSARY BUT NOT SUFFICIENT CONTRIBUTING FACTOR TOWARDS HIGH STANDARD OF LIVING

2.COMPARISON BETWEEN FOREX AND ECONOMIC LEVEL OF COUNTRY A AND B

THE ANSWER IS NO

economic level is by far determined by many things apart from foreign exchange so, there is no guarantee for country A which is economically advanced to have strong currency(in TERMS OF FOREX RATE) than country B.

MgonjwaUkimwi said...

Exchange rates are not direct indicators of levels of economic growth as measured by gross domestic product GDP. They are only indicators of economic activities in a particular time.

The concept is simple: GDP is a function of consumption (c), government expenditure (G), investment (I),and different between import(Imp) and export (Exp)so; GDP =(C+G+I+(Exp-Imp)

Sasa exchange rate affects the last part of the equation above (exp-imp). Sasa kama sh ya Tz ikipanda thamani manake exports za Tz zinapendwa, na kinyume chake ikiteremka thamani. So what exchange rate tells us is the DIRECTION of economic dynamics, NOT LEVEL of growth.

Most important, athari ya kupanda au kushuka kwa thamani ya ela hakuna jibu mbadala, na wachumi wamekuwa wakibishana hadi kunakucha.

Wakati wachumi wote wanakubaliana kwamba exchange rate inaashiria mwenendo wa shughuli za kiuchumi; hadi sasa hawajuwi na wanaendelea kubishana kwenye swali lifuatalo: ili uchumi ukuwe ela ya inchi inatakiwa ipande au ishuke?

IMF wanasema ela ya nchi inatakiwa iwe na thamani pungufu ili kuchochea mapato ya exports; wanaobisha wanasema njia hii ya kuchochea export inaumiza kwa maana kwamba inasabisha mfumuko wa bei unaosababishwa na upungufu wa import purchasing power na vile wanadai kwamba mara nyingi investment inafuata ela yenye thamani. Wabishaji wanahitimisha kwa kusema kwamba devaluation ambayo inasisitizwa na IMF ni contractionary.

Hitimisho: exchange rate sio kiashirio cha kiwango cha uchumi au maendeleo, bali ni kiashirio cha mwenendo wa shuguli za uchumi katika wakati husika. Je ela ya nchi ipande au ishuke ili economic dynamics zilete maendeleo ya kiuchumi? Hapa bado wachumi wa mchepuo wa International trade and economic development hawana jibu wanalokubaliana.

David Villa said...

Thanks guys.I have been taking my time to go thru all the comments above.I am not an economist but I can see what exchange rate is all about.I can now answer the question as to why 1Ethiopian Birr=11.17JPY!!.I did some findings on why Japan currency looks weak to a dollar.Japan is the 2nd country around the world in economic power after USA and 3rd purchasing power after USA and China.Most exports from Japan are Cars,motorcycles,electrical devices,computers etc which earns the country plent revenue.Unfortunately,Japan is facing one big problem;resources of raw materials are very limited and the mining industry rather very small(I am a geologist,I am sure with this one).So,it needs a lot of foreign currency to imports raw materials like Iron Ore,Copper Ore,Precious metals,Oil etc for its manufacturing industry.Ethiopia,being poor,no much on imports and exports,and therefore,her currency may look stronger than a Yen(Ideally).Enonimists correct me if I am wrong.

Anonymous said...

The value of a given currency is detrmined by a multitude of factors all governed by the monetary policies and economic conditions of the said nation. The effects of inflation, GDP, trade deficits/surpluses, liquidity, interest rates will all determine in one way or another the value of the local currency. For example in a high inflation economy such as currently being witnessed in Zimbabwe, a monetary policy approach aimed at tightening the money supply may be to stop printing money, sell more treasury bills/notes with the intent of increasing the demamd for liquidity and rasing purchasing power for the currency. Monetary and Fiscal policy can also be driven to purposely suppress the value of a given currency to aid in establishing a trade surplus as seen in China with the Yuang and in Japan with the Yen. Because of their monetary policy approach i.e increasing the money supply and relatively lowered interest rates, these countries have continued to enjoy a trade surplus with the rest of the world. Japan is the second largest economy in the world and China is on pace to become one of the richest countries on earth with a GDP growth of approx 8% annualy. Both these countries have local currencies that trade lower than both the Euro and the Dollar. So , to put it simply, the value of a foreign currecny is not an an indicator of economic strength but an indicator of monetary policy. The monetary policy is determined by current economic conditions and future economic objectives. What our readers need to understand is that as Economists, Although there are many, one of the main drivers of ecomic growth/strength is GDP.

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