Harambee University

Faculty of Business and Economics

Master of Business Administration (MBA)

Group Assignment for the Course Managerial Economics

Name ID

1.
2.
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Instructor

January 2022

Adama, Ethiopia

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Introduction

Fiscal and monitory policies are the prominent economic policy instruments that governments
use to monitor and adjust their economy. Though these policies mainly affect apparently
different markets, it is practically proved that using both policies together help a lot in
determining the level of output and interest rate. The methods used in monetary policy include
the rate at which we exchange domestic and foreign currencies. The exchange rate policy that a
country is following has a significant role on the country’s trade balance, net international capital
flow and other macro-economic developments (Elias, 2011).

In the modern world- where international trade plays a crucial role for development- countries
more often depreciate or devalue their currency to be more competitive and obtain the advantage
of bilateral and multilateral trade with their partners. Therefore; it is important to look through
the exchange rate movement which is one of the instruments applied to observe countries
competitiveness in world market. At the same time it is essential to maintain domestic inflation
rate that may perhaps come along with the exchange rate movements. Trade boosts growth by
increasing market opportunities, allowing specialization according to comparative advantage and
facilitating access to latest technologies. Although the debate as to the direction of causation
between exports and growth is contested, there is a consensus that exports are critical for growth,
particularly for developing countries. However, the impact of exports on growth is not only
influenced by the volume exported but also more importantly by its composition (Elbadawi,
2014).

First, devaluation makes the country's exports relatively less expensive for foreigners. Second,
the devaluation makes foreign products relatively more expensive for domestic consumers, thus
discouraging imports. This may help to increase the country's exports and decrease imports, and
may therefore help to reduce the current account deficit.

1. To Boost Exports

On a world market, goods from one country must compete with those from all other countries.
Car makers in America must compete with car makers in Europe and Japan. If the value of the
euro decreases against the dollar, the price of the cars sold by European manufacturers in

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America, in dollars, will be effectively less expensive than they were before. On the other hand,
a more valuable currency make exports relatively more expensive for purchase in foreign
markets.

In other words, exporters become more competitive in a global market. Exports are encouraged
while imports are discouraged. There should be some caution, however, for two reasons. First,
as the demand for a country's exported goods increases worldwide, the price will begin to rise,
normalizing the initial effect of the devaluation. The second is that as other countries see this
effect at work, they will be incentivized to devalue their own currencies in kind in a so-called
"race to the bottom." This can lead to tit for tat currency wars and lead to unchecked inflation.

2. To Shrink Trade Deficits

Exports will increase and imports will decrease due to exports becoming cheaper and imports
more expensive. This favors an improved balance of payments as exports increase and imports
decrease, shrinking trade deficits. Persistent deficits are not uncommon today, with the United
States and many other nations running persistent imbalances year after year. Economic theory,
however, states that ongoing deficits are unsustainable in the long run and can lead to dangerous
levels of debt which can cripple an economy. Devaluing the home currency can help correct
balance of payments and reduce these deficits.

There is a potential downside to this rationale, however. Devaluation also increases the debt
burden of foreign-denominated loans when priced in the home currency. This is a big problem
for a developing country like India or Argentina which hold lots of dollar- and euro-
denominated debt. These foreign debts become more difficult to service, reducing confidence
among the people in their domestic currency.

 Reduce Sovereign Debt Burdens

A government may be incentivized to encourage a weak currency policy if it has a lot of

government-issued sovereign debt to service on a regular basis. If debt payments are fixed, a
weaker currency makes these payments effectively less expensive over time.

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EXPORTS

The short-run effect of devaluation on exports is particularly large if there is unutilized capacity
in that sector. Also, the easier it is to shift resources into the export sector, the greater would be
the initial effects of devaluation. However, to sustain the export expansion, the relative price of
exports has to be maintained at a higher level than before the devaluation, so that resources and
products continue to move into the export sector. The domestic rate of inflation, particularly the
domestic price of home goods, has to be restrained.

The supply response of exports to the change in their domestic price resulting from a devaluation
is significantly different from the price stimulus of normal fluctuations in external prices. Under
normal conditions, external prices may fluctuate every year, so that an expected increase in
export prices may be substantially discounted by producers in view of the possible fall in prices
in the near future. Devaluation, however, gives certainty to the direction of change, and this
change is usually significant. This implies that an increase in the domestic price of exports as the
result of devaluation can be expected to have a greater effect on production than the same price
increase under normal price fluctuations. In other words, the absolute and relative domestic price
of exports, relevant for supply response, is an “expected” price which takes into account the
possibility of fluctuations, and devaluation is likely to affect this expected price. If, in addition,
government takes supporting measures for export expansion, these reinforce the favorable
expectations and producers are even more convinced that expansion of output will be profitable.

The measurement of the effects of devaluation on exports can in theory be approached by

estimating the price elasticity of the supply curve. However, the common method of estimating
the supply elasticity of exports by using data of the predevaluation period may not be accurate
for the reasons mentioned above. Scarcity of appropriate data makes the task additionally
difficult. For these reasons, three types of analyses have been combined in this paper to measure
the effect of devaluation on exports.

Import demand analysis

To take into account the effect of world demand on export receipts of the devaluing country, the
import demand functions were estimated for 14 industrial countries on the basis of ten yearly
observations before devaluation. For each industrial trading partner, the gain in export earnings

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after devaluation was measured as the difference between actual export earnings for the three-
year period after the devaluation and the estimated value of exports based on these import
equations. This approach recognized the possible effects of changes in the level of economic
activity of the importing countries on the exports of the devaluing country.

Because no appropriate import price index was available for the industrial countries, an
assumption was made that the ratio of prices of their imported goods to the gross national
product (GNP) deflator remains constant. When this assumption does not hold, the import
demand analysis will not give the expected results. In such cases, two types of market share
analyses were used.

IMPORTS

Imports of the devaluing country are affected by devaluation in several ways. Higher domestic
prices of imports affect demand adversely and encourage substitution of domestic for imported
goods, both in production and consumption. On the other hand, the higher income from the
expansion of export and import substituting industries stimulates the growth of imports. A third
aspect closely related to the second (and often important for developing countries) is the increase
in imports of capital goods. An upsurge in investment activity because of higher profitability in
external sectors after devaluation would lead to an upsurge in imports of capital goods. While the
price effect tends to reduce imports, the other two effects tend to increase them; the net effect
depends on their relative magnitudes. However, in most of the developing countries the price
elasticity of the demand for imports may be small, and import substitution may be limited in the
short run; therefore, devaluation may lead to an increase in imports rather than to a decrease. The
behavior of imports after the devaluation also depends on the monetary-fiscal and wage policies
in that period.

Another relevant factor is that a significant portion of imports may be subject to restrictions. The
changes in prices and incomes may not have the expected effects upon imports, if devaluation is
accompanied by an exchange and trade reform involving relaxation of existing restrictions. For
all these reasons no attempt was made to estimate the pre devaluation import function and to
measure the effect of devaluation on imports. Instead, a comparison is made of the average
growth rates of imports before and after devaluation. The trend of imports over the ten-year

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period before devaluation is estimated, and the movement in imports after devaluation is
analyzed, by studying deviations from this trend. Also, imports might have started to increase at
a lower rate than the ten-year annual average rate a few years before devaluation due to declining
or slowly growing foreign exchange receipts from exports and restrictive measures to reduce
balance of payments deficits. Therefore, the three-year average growth rates of imports in the
pre-devaluation period are also compared with the pre devaluation ten-year average and the
three-year average of the post devaluation period.

Advantages and disadvantages of devaluation

Devaluation is the decision to reduce the value of a currency in a fixed exchange rate. A
devaluation means that the value of the currency falls. Domestic residents will find imports and
foreign travel more expensive. However domestic exports will benefit from their exports
becoming cheaper.

Advantages of devaluation

1. Exports become cheaper and more competitive to foreign buyers. Therefore, this provides
a boost for domestic demand and could lead to job creation in the export sector.
2. A higher level of exports should lead to an improvement in the current account
deficit. This is important if the country has a large current account deficit due to a lack of
competitiveness.
3. Higher exports and aggregate demand (AD) can lead to higher rates of economic growth.

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 4. Devaluation is a less damaging way to restore competitiveness than ‘internal
devaluation‘. Internal devaluation relies on deflationary policies to reduce prices by
reducing aggregate demand. Devaluation can restore competitiveness without reducing
aggregate demand.
5. With a decision to devalue the currency, the Central Bank can cut interest rates as it no
longer needs to ‘prop up’ the currency with high interest rates.
Disadvantages of devaluation

1. Inflation. Devaluation is likely to cause inflation because:

 Imports will be more expensive (any imported good or raw material will increase in
price)
 Aggregate Demand (AD) increases – causing demand-pull inflation.
 Firms/exporters have less incentive to cut costs because they can rely on the devaluation
to improve competitiveness. The concern is in the long-term devaluation may lead to
lower productivity because of the decline in incentives.
2. Reduces the purchasing power of citizens abroad. e.g. it is more expensive to go on holiday
abroad.

3. Reduced real wages. In a period of low wage growth, a devaluation which causes rising import
prices will make many consumers feel worse off. This was an issue in the UK during the period
2007-2018.

4. A large and rapid devaluation may scare off international investors. It makes investors less
willing to hold government debt because the devaluation is effectively reducing the real value of
their holdings. In some cases, rapid devaluation can trigger capital flight.
5. If consumers have debts, e.g. mortgages in foreign currency – after a devaluation, they will see
a sharp rise in the cost of their debt repayments. This occurred in Hungary when many had taken
out a mortgage in foreign currency and after the devaluation it became very expensive to pay off
Euro denominated mortgages.

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 Evaluation of impact of devaluation
 It depends on the state of the business cycle – In a recession a devaluation can help boost
growth without causing inflation. In a boom, a devaluation is more likely to cause
inflation.
 The elasticity of demand. A devaluation may take a while to improve current account
because demand is inelastic in the short term. However, if demand is price elastic, then it
will cause a relatively bigger increase in demand for exports. (See: J-Curve effect)
 If the country has lost competitiveness in a fixed exchange rate, a devaluation could be
beneficial in solving that decline in competitiveness.
 Exports and imports increasingly invoiced in dominant currencies such as Euro and
Dollar. This means that a fall in the value of Sterling has less impact on UK
competitiveness because UK exports may be involved in Euros anyway. See paper on
“Dominant Currency Paradigm” August 7, 2017 (Casas, Gopinath)
 Type of economy. A developing economy which relies on import of raw materials may
experience serious costs from a devaluation which makes basic goods and food more
expensive.
3. With limited export promotion power, the devaluation policy measure is mainly related to
exchange rate stability due to imbalance between supply and demand of hard currencies. As repeatedly
explained by the government officials of Ethiopia, there is severe shortage of hard currencies in
Ethiopia caused by limited hard currency earning power of Ethiopia’s exports whereas imports have
grown folds more than exports. Ethiopia gets dollar from exports and needs dollar for the imports. The
gap between the dollar earning and dollar spending capacity leads to part of the current account deficit
called trade deficit (export values less than import values). The gap has been expanding every year-
even more so in recent years. If you buy something (imports) you have to pay for it via exports,
foreign aid in hard currency, remittances, etc. The growing gap between exports and imports is not
sustainable. It’s important to note that foreign exchange rate crisis is one of the major sources of
economic crises that ravaged the economies of a number of countries including Ethiopia. Therefore,
the devaluation of Birr, which has been urged by the World Bank for years, is the policy measure
undertaken by the regime to relieve a crippling dollar shortage and meager foreign exchange reserve of
Ethiopia. Although the shortage of hard currency is a common phenomenon of poor countries like
Ethiopia with limited exports, the widening gap between Ethiopia’s earning and spending in hard

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currency is evidently not sustainable. It can kill economic growth. At worst, it can lead to economic
crisis due to currency (exchange rate) crisis since there is vivid evidence of liquidity gap in hard
currency in Ethiopia owing to its weak foreign exchange earning capacity. The developing countries
economy like Ethiopia were open to different economic problems like increase in current account
deficit, continues decline of foreign exchange reserve and high inflation rate at home.