There are two key tools of the fiscal policy:

Taxation: funds in the form of direct and indirect taxes, capital gains from investment,
etc, help the government function. Taxes affect the consumer’s income and changes in
consumption lead to changes in real gross domestic product (GDP).
Government spending: it includes welfare programmes, government salaries, subsidies,
infrastructure, etc. Government spending has the power to raise or lower real GDP,
hence
it is included as a fiscal policy tool.
In the standard textbook classification, government spending/expenditure has four
major
components, namely, government spending, transfer payments, grants in aid, and net
interest payments.
(a) Government spending (G)
Government spending is the sum of government expenditures on final goods and
services.
It includes salaries of public servants, purchase of weapons for the military, and any
investment expenditure by a government
(b) Transfer payments
Transfer payments are direct payments to individuals- such as unemployment
insurance
benefits, social security benefits, Medicare, or welfare payments - where goods or
services
are not provided in return. They are commonly referred to as entitlements because
they are
not made on a discretionary basis, but are locked in by earlier legislation. 4.2 Fiscal
Policy
75
UNIT 4: MACROECONOMIC POLICY INSTRUMENTS
(c) Grants in aid
This reflects federal assistance to state and local governments.
(d) Net interest payments
Net interest payments are interest payments that are made to holders of government
debt,
less interest which is paid to the government for debts like student loans.
From the revenue side, the four major components of tax revenue (taxes) are the
following:
 Personal taxes are composed of income taxes and property taxes, and are major
sources of total government revenue.
 Contributions for social insurance are primarily social security taxes, which are
assessed as a fixed percentage of a worker’s wages, up to a fixed ceiling (or cap).
 Taxes on production and imports are primarily sales taxes, but they also include
taxes on imported goods, known as “tariffs”.
 Corporate taxes are primary taxes on the profits of businesses.
 Grants in aid are the federal assistance to state and local governments and are
revenue for them (while they are spending for the federal government).
4.2.2 Types of Fiscal Policy
A fiscal policy can be of two types – expansionary or contractionary depending upon
prevailing economic conditions.
I. Expansionary Fiscal Policy
In a situation in which an economy is facing the problem of deficient demand, i.e.,
aggregate demand falling short of output at full employment, there is a depression
marked
by overproduction, a rise in unemployment, and a fall in prices and incomes. To
increase
the aggregate demand and thereby total output and employment levels, expansionary
fiscal
policies are adopted by governments. The major instruments of expansionary fiscal
policy
are:
 Expenditure policy (increase expenditure): the objective of an expenditure
policy
should be to pump more money into the system in order to boost demand. During
a period of deficiency in demand, the government should make large investments
in public works like the construction of roads, bridges, buildings, railway lines,
canals, etc. In such periods, the government should also provide free education
and medical facilities, even though these activities might enlarge budget deficits. 4.2
Fiscal Policy
76
Grade 12 Economics Student Textbook
The aim is to put more money in the hands of people so that they would also spend
more.
 Revenue policy (reduce tax rate): Taxes on personal incomes and taxes on
expenditures on buildings etc. should be reduced. If possible, taxes on lower
income groups should be abolished in order to increase their disposable income
for spending. In addition, subsidies, old age pensions, unemployment allowances,
grants, interest-free loans, expand so as to increase aggregate demand in the
economy.
The aggregate demand/aggregate supply model is useful in judging whether
expansionary
or contractionary fiscal policy is appropriate. For instance, as we can see in Figure 4.1,
the intersection of aggregate demand (AD0 ) and aggregate supply (SRAS0 ) are
occurring
below the level of potential GDP as the LRAS curve indicates. At the equilibrium
(E0 ), a
recession occurs and unemployment rises. In this case, expansionary fiscal policy
using
tax cuts or increases in government spending can shift aggregate demand to AD1,
closer to
the full-employment level of output. In addition, the price level will rise back to the
level
P1 that is associated with potential GDP.
II. Contractionary Fiscal Policy
When an economy’s aggregate demand is for a level of output that is more than the
full
employment, the demand is said to be an excess demand. In other words, excess
demand
refers to the excess of aggregate demand over the available output at full employment.
This gap results in an inflationary situation as it causes inflation (a continuous rise in
prices) in the economy. To control the situation of excess demand and thereby reduce
the 4.2 Fiscal Policy
77
UNIT 4: MACROECONOMIC POLICY INSTRUMENTS
pressure of high inflation, contractionary fiscal policies are adopted by governments.
Major instruments of contractionary fiscal policy are:
 Expenditure policy (reduce expenditure): In a situation of excess demand, the
government should curtail its expenditures on public works such as roads, buildings,
rural electrification, irrigation work, etc., thereby reducing the money income of the
people and thus, their demand for goods and services. In this way, the government
will
reduce the budget deficit, which shows excess expenditure over revenue.
 Revenue policy (increase taxes): during inflation, the government should raise
rates
of all taxes, especially taxes on rich people, because taxation withdraws purchasing
power from the taxpayers and, to that extent, reduces effective demand. Care should
be
taken that measures adopted to raise revenue are disinflationary and at the same time
have no harmful effects on production and savings.
Fiscal policy can also contribute to pushing aggregate demand beyond potential GDP
in a way that leads to inflation. As Figure 4.2 shows, a very large budget deficit pushes
up aggregate demand, so that the intersection of aggregate demand (AD0 ) and
aggregate
supply (SRAS0 ) occurs at equilibrium E0 , which is an output level above potential
GDP.
Economists sometimes call this an “overheating economy” where demand is so high
that there is upward pressure on wages and prices, causing inflation. In this situation,
contractionary fiscal policy involving federal spending cuts or tax increases can help
to
reduce the upward pressure on the price level by shifting aggregate demand to the left,
to
AD0 , and causing the new equilibrium E1 to be at potential GDP, where aggregate
demand
intersects the LRAS curve
.4.3 Monetary Policy
78
Grade 12 Economics Student Textbook
Activity 4.2
1. What is an expansionary fiscal policy? How does it operate in the economy?
2. What is the effect of a contractionary fiscal policy on economy?
3. Who manipulates fiscal policy tools and why?
4. Is there a fiscal policy in all kinds of economies? Why? /Why not?
5. Elaborate the policy implications of fiscal policy and examine the effectiveness
of the fiscal policy in an economy.
6. In groups of four, discuss the roles and objectives of fiscal policy in
underdeveloped or developing economy like Ethiopia. Prepare a report on the
outcome of your group discussion. Everyone in the group should be ready to
report as individual swill be chosen randomly.
4.3 Monetary Policy
At the end of this section, you will be able to:
 contrast expansionary monetary policy and contractionary monetary policy.
 explain how monetary policy impacts interest rates and aggregate demand.
 analyse why monetary policy is important.
Start-up Activity
1. What is monetary policy?
2. Who is responsible for implementing monetary policy in Ethiopia?
3. Why is monetary policy important in an economy?
Monetary policy is the process of drafting, announcing, and implementing the plan of
actions taken by the National Bank, or other monetary authority of a country that
controls
the quantity of money in an economy4.3 Monetary Policy
79
UNIT 4: MACROECONOMIC POLICY INSTRUMENTS
and the channels by which new money is supplied. The National Bank is a
government
agency that oversees the banking system and is responsible for the conduct of
monetary
policy. This bank takes different names in different countries: the Federal Reserve
System
in the United States and National Bank in Ethiopia, for instance.
Monetary policy consists of the management of money supply and interest rates,
aimed
at meeting macroeconomic objectives such as controlling inflation, consumption,
growth,
and liquidity. This is achieved by actions such as modifying the interest rate, buying
or
selling government bonds, regulating foreign exchange rates, and changing the
amount of
money which banks are required to maintain as reserves.
Monetary policy is formulated based on inputs which are gathered from a variety of
sources. For instance, the monetary authority may look at macroeconomic numbers
such
as gross domestic product (GDP) and inflation, industry/sector-specific growth rates
and associated figures, as well as geopolitical developments in international
markets—
including oil embargos or trade tariffs. These entities may also ponder concerns which
are
raised by groups representing industries and businesses, survey results from
organizations
of repute, and inputs from the government and other credible sources.
4.3.1 Tools of Monetary Policy
The National Bank influences the money supply indirectly by changing the monetary
base
or the reserve deposit ratio. To do this, it has three instruments/tools at its disposal:
Open
market operations (OMO): these are the purchases and sales of government bonds by
the National Bank. The Birr it pays when the National Bank purchases bonds
increases the
monetary base and the money supply. When the National Bank sells bonds to the
public,
the Birr it receives reduces the monetary base and then, decreases the money supply.
The conduct of OMO varies from country to country depending on the legal and
institutional
setting, the structure of financial system and the stages of development in the
securities
market of the country. NBE conducts its OMO actively through treasury bills market
to
influence the variables like liquidity level and net domestic assets of the banking
system
and money supply in the economy and monitor whether they conform with the
targeted
level. In light of this, the NBE uses open market operations as one of its monetary
policy
instruments. In the absence of its own securities, a certain amount of government
treasury
bills need to be allocated to NBE by the government for its monetary policy purpose
(NBE, 2009). 4.3 Monetary Policy
80
Grade 12 Economics Student Textbook
1. Discount rate (DR): the discount rate is the interest rate that the National Bank charges
banks to borrow funds from a National Bank. The discount rate is set by the National
Bank’s board of governors, and can be adjusted up or down as a tool of monetary
policy.
It is usually set below the short term inter-bank market rate. Accessing the discount
window allows institutions to vary credit conditions (i.e., the amount of money they
have to loan out), thereby affecting the money supply. Through the discount window,
the central bank can affect the economic environment, and thus unemployment and
economic growth. In Ethiopia the discount window facility for commercial banks
started in March 2001.
2. Required reserve ratio (RRR): this refers to the funds that banks must retain as a
proportion of the deposits made by their customers in order to ensure that they are
able
to meet their liabilities. Lowering this reserve requirement releases more capital for
the banks to offer loans or to buy other assets. Increasing the reserve requirement, on
the other hand, has a reverse effect, curtailing bank lending and slowing growth of the
money supply.
The NBE uses this instrument to control the liquidity of banks by varying the rate
according
with the targeted level. The higher reserve requirement contracts the liquidity as well
as
credit expansion power of commercial banks and the opposite will increase liquidity
and
credit expansion power of banks. The National Bank of Ethiopia cut the minimum
deposit
reserve from 15% to 10% in January 2012. It also cut the liquid assets to deposits
ratio by
the same margin to 20% from 25% previously. The move is aimed to encourage banks
to
lend money, particularly to the export sector.
4.3.2 Types of Monetary Policies
Generally speaking, monetary policies can be categorized as either: a monetary policy
that lowers interest rates and stimulates borrowing, i.e. an expansionary monetary
policy
or loose monetary policy, conversely or a monetary policy that raises interest rates
and
reduces borrowing in the economy, i.e. a contractionary monetary policy or tight
monetary
policy.
Expansionary Monetary Policy
If a country is facing a high unemployment rate during a slowdown or a recession, the
monetary authority can opt for an expansionary policy which aims at increasing
economic
growth and expanding economic activity. As a part of expansionary monetary policy,
the 4.3 Monetary Policy
81
UNIT 4: MACROECONOMIC POLICY INSTRUMENTS
monetary authority often lowers the interest rates through various measures, serving
to
promote spending and make money-saving relatively unfavourable.
Increased money supply in the market aims to boost investment and consumer
spending.
Lower interest rates mean that businesses and individuals can secure loans on
convenient
terms to expand productive activities and spend more on big-ticket consumer goods.
Major instruments of expansionary monetary policy are discussed below.
Reducing a discount rate: to increase money supply, the National Bank reduces the
discount rate and then, enables the commercial banks to take more loans from it and
in
turn to give more loans to producers (investors) at lower interest rates.
Buying securities through open market operations: this refers to the buying and selling of
government securities which influence money supply in the economy. For example,
during
a depression, the central bank buys government bonds and securities from commercial
banks, paying in cash to increase their cash stock and lending capacity.
Reducing required reserve ratio: every commercial bank is required to keep with the
central bank a particular percentage of its deposits or reserves in the form of cash.
This
percentage is called the “required reserve ratio (RRR)” or “cash reserve ratio (CRR)”.
During a depression, the central bank lowers the CRR, thereby increasing commercial
bank’s capacity to give credit.
If the economy is suffering a recession and high unemployment, with output below
potential GDP, expansionary monetary policy can help the economy return to
potential
GDP. Figure 4.3 below illustrates this situation. This example uses a short-run
upward
sloping Keynesian aggregate supply curve (SRAS). The original equilibrium during a
recession of E0 occurs at an output level of 600. An expansionary monetary policy will
reduce interest rates and stimulate investment and consumption spending, causing the
original aggregate demand curve (AD0 ) to shift right to AD1 , so that, the new
equilibrium
(E1 ) occurs at the potential GDP level of 700.4.3 Monetary Policy
82
Grade 12 Economics Student Textbook
Contractionary Monetary Policy
Increased money supply can lead to higher inflation, raising the cost of living and cost
of
doing business. Contractionary monetary policy, increasing interest rates, and by
slowing
the growth of the money supply, aims to bring inflation down. This can slow
economic
growth and increase unemployment but it is often necessary to cool down the
economy
and keep it in check.
Major instruments of contractionary monetary policy are discussed below.
Increasing the discount rate: in a situation of excess demand leading to inflation,
the central bank raises its rate. This raises the cost of borrowing, which discourages
commercial banks from borrowing from the central bank. An increase in the bank rate
forces the commercial banks to increase their lending rates of interest, which makes
credit
costlier. As a result, the demand for loans falls. On the other hand, the high rate of
interest
induces households to increase their savings by restricting expenditure on
consumption
and discourages investment. Thus, expenditure on investment and consumption is
reduced,
thereby reducing the aggregate demand.
Selling securities through open market operations: during inflation, the central bank
sells government securities to commercial banks, which lose an equivalent amount of
their
cash reserves, thereby reducing their capacity to offer loans. This absorbs liquidity
from 4.3 Monetary Policy
83
UNIT 4: MACROECONOMIC POLICY INSTRUMENTS
the system. Consequently, there is a fall in investment and in aggregate demand.
Increasing the RRR: during inflation, the central bank increases the RRR, thereby
curtailing the lending capacity of commercial banks.
For example, if an economy is producing at a quantity of output above its potential
GDP,
a contractionary monetary policy can reduce the inflationary pressures for a rising
price
level. In Figure 4.4 below, the original equilibrium (E0 ) occurs at an output of 750,
which
is above potential GDP. A contractionary monetary policy will raise the interest rate,
which
discourages borrowing for investment and consumption spending, and causes the
original
demand curve (AD0 ) to shift left to AD1 , so that, the new equilibrium (E1 ) occurs at
the
potential GDP level of 700.
The two examples above suggest that monetary policy should be countercyclical; that
is, it
should act to counterbalance the business cycles of economic downturns and
upswings. The
National Bank should loosen monetary policy when a recession has caused
unemployment
to increase and tighten it when inflation threatens. Of course, countercyclical policy
does
pose a danger of overreaction. If loose monetary policy that seeks to end a recession
goes
too far, it may push aggregate demand so far to the right that it triggers inflation. If
tight
monetary policy that seeks to reduce inflation goes too far, it may push aggregate
demand
so far to the left that a recession begins. Figure 4.5 (a) and (b) summarizes that the
chain
of effects that connect loose and tight monetary policy to changes in output and the
price
level.4.4 Income Policy and Wage
84
Grade 12 Economics Student Textbook
In the expansionary monetary policy (a) pathway. the central bank causes the supply
of money and loanable funds to increase, which lowers the interest rate, stimulating
additional borrowing for investment and consumption, and shifting aggregate demand
right. The result is a higher price level and, at least in the short run, higher real GDP.
(b)
In contractionary monetary policy pathway (b), the central bank causes the supply of
money and credit in the economy to decrease, which raises the interest rate,
discouraging
borrowing for investment and consumption, and shifting aggregate demand left. The
result
is a lower price level and, at least in the short run, lower real GDP.
Activity 4.3
1. What are the tool s of monetary policy?
2. Explain briefly any two measures of monetary policy, which can be used for
controlling excess demand.
4.4 Income Policy and Wage
At the end of this section, you will be able to:
 state income policy.
 explain how income policy impacts aggregate supply and aggregate demand.
 explain minimum wages and the effect of ‘pricing policy
 summarize the purposes of income policy.4.4 Income Policy and Wage
85
UNIT 4: MACROECONOMIC POLICY INSTRUMENTS
Start-up Activity
What do you understand about minimum wages, price ceiling and price
floor?
Income policies in economics are economy-wide wages and price controls, most
commonly instituted as a response to inflation, and usually seeking to establish wages
and
prices below free market level. Income policies vary from “voluntary” wage and price
guidelines to mandatory controls such as price/wage freezes.
Income policy is the suitable complement for expansionary monetary and fiscal
policies,
in particular under conditions that reduce the space for further macroeconomic
expansion..
In some developing countries, wage expansion has provd to be a more reliable source
of
demand expansion. A policy that maintains real wages expanding in line with
productivity
would provide a sustainable source of domestic demand expansion.
In an inflationary environment, it is possible to stabilize the price level through the
instruments of the income policy. Governments can take this step if restrictive fiscal
and
monetary policies fail to reduce the increasing price level. We can use these tools of
the
income policy to preserve price stability:
Determination of wage rates in a free market
Just as in any market, the price of labour, the wage rate, is determined by the
intersection
of supply and demand. When the supply of labour increases, the equilibrium price
falls,
and when the demand for labour increases, the equilibrium price rises.
A perfectly competitive labour market has the following characteristics:
 A large number of firms competing with each other to hire a specific type of
labour
to fill identical jobs.
 Numerous qualified people who have identical skills and independently supply
their labour services.
 “Wage taking” behaviour, that is, neither workers nor firms exert control over the
market wage,
 Perfect, costless information and labour mobility. 4.4 Income Policy and Wage
86
Grade 12 Economics Student Textbook
Market labour demand is a “price adjusted” downward- sloping curve, whereas, the
market
labour supply however, generally slopes upward to the right, indicating that
collectively
workers will offer more labour hours at higher relative wage rates. Higher relative
wages
attract workers away from either household production, leisure, or other labour
markets
and towards the labour market in which the wage is increased. This means that even
though
there are some workers who reduce hours of work as wage rate increase, there are still
new
workers who enter into the labour market looking at the higher wage rate. The vertical
height of the market labour supply curve, measures the opportunity cost of employing
the last labour hour. In other words, in perfectly competitive product and labour
markets,
labour supply curves measure marginal opportunity costs. Furthermore, in order to
attract
more hours to the labour market, the opportunity costs must be compensated via a
higher
wage rate.
Minimum Wages
A minimum wage is the lowest wage per hour that a worker may be paid as mandated
by
federal law. In simple words, it is a legally mandated price floor on hourly wages,
below
which workers may not be offered or accept a job.
Minimum wages have been defined as the minimum amount of remuneration that an
employer is required to pay to wage earners for the work that is performed during a
given
period, which cannot be reduced by collective agreement or an individual contract.
The purpose of minimum wages is to protect workers from unduly low pay. They help
ensure a just and equitable share of the fruits of progress to all, and a minimum living
wage to all who are employed and in need of such protection. Minimum wages can
also
be one element of a policy to overcome poverty and reduce inequality, including
between
men and women, by promoting the right to equal remuneration for work of equal
value.4.4 Income Policy and Wage
87
UNIT 4: MACROECONOMIC POLICY INSTRUMENTS
Pricing Policy
One of the income policies in economics is price controls; most commonly instituted
as a response to inflation, and usually seeking to establish prices which are below free
market level. Price ceilings and price floors are the two types of price controls. They
do
the opposite thing, as their names suggest. A price ceiling puts a limit on the cost that
one
has to pay or that one can charge for something; it sets a maximum cost, keeping
prices
from rising above a certain level. A price floor establishes a minimum cost for
something,
a bottom-line benchmark. It keeps a price from falling below a particular level.
Price Ceiling
A price ceiling is the mandated maximum amount that a seller is allowed to charge for
a
product or service. Usually set by law, price ceilings are typically applied to staples
such
as food and energy products when such goods become unaffordable to regular
consumers.
A price ceiling is a maximum legal price below the equilibrium price. It provides
perverse
incentives (unintended consequence), causing a shortage (see Figure 4.7).
Price Floor
A price floor is a government- or group-imposed price control or limit on how low a
price
can be charged for a product, good, commodity, or service. A price floor must be
higher
than the equilibrium price in order to be effective. An example of a price floor is
minimum
wage laws, where the government sets out the minimum hourly rate that can be paid
for
labour.4.4 Income Policy and Wage
88
Grade 12 Economics Student Textbook
Price floors are often imposed by governments; however, there are also price floors
which
are implemented by non-governmental organizations such as companies, and the
practice
of resale price maintenance. With resale price maintenance, a manufacturer and its
distributors agree that the distributors will sell the manufacturer’s product at certain
prices
(resale price maintenance), at or above a price floor (minimum resale price
maintenance).
A price floor which is set above the market equilibrium price has several side-effects.
Consumers find that they must now pay a higher price for the same product. As a
result,
they reduce their purchases, switch to substitutes (e.g., from butter to margarine) or
drop
out of the market entirely. Meanwhile, suppliers find that they are guaranteed a new,
higher
price than they were charging before, but with fewer willing buyers.
Taken together, these effects mean that there is now an excess supply (known as a
“surplus”) of the product in the market to maintain the price floor over the long term.
The equilibrium price is determined when the quantity demanded is equal to the
quantity
supplied. Furthermore, the effect of mandating a higher price transfers some of the
consumer surplus to producer surplus, while creating a deadweight loss as the price
moves
upward from the equilibrium price. A price floor may lead to market failure if the
market
is not able to allocate scarce resources in an efficient manner (see Figure 4.8).4.5 Foreign
Exchange Policies
89
UNIT 4: MACROECONOMIC POLICY INSTRUMENTS
Activity 4.4
1. Explain the difference between price ceilings and price floors.
2. What is the effect of a price ceiling on the quantity demanded of a product?
3. Does a price ceiling change the equilibrium price?
4. What would be the impact of imposing a price floor below the equilibrium
price?
4.5 Foreign Exchange Policies
At the end of this section, you will be able to:
 explain how appreciating or depreciating currency affects exchange rates.
 analyse how the foreign exchange market works.
 identify exchange rate policies.
Start-up Activity
What do you think about the economic importance of government’s
foreign exchange rate policies?
The policy of the exchange rate affects aggregate demand through its effect on export
and import prices of tradable goods and services; in turn, influencing other prices in
the
economy depending on the foreign exchange regime in place. The policymakers may
exploit this connection, in order to influence the macroeconomic trends through the
so
called foreign exchange policy, which is defined as the foreign exchange regime
including
floating, fixed, managed, etc. and regulates foreign exchange transactions in the
financial
system.
Most countries have different currencies, although that is not true in all cases.
Sometimes
small economies use an economically larger neighbour’s currency. For example,
Ecuador,
El Salvador, and Panama have decided to dollarize; that is, to use the US dollar as
their 4.5 Foreign Exchange Policies
90
Grade 12 Economics Student Textbook
currency. Sometimes nations share a common currency. A large-scale example of a
common
currency is the decision by 17 European Nations—including some very large
economies
such as France, Germany, and Italy to replace their former currencies with the Euro.
With
these exceptions, most of the international economy takes place in a situation of
multiple
national currencies in which both people and firms need to convert from one currency
to
another when selling, buying, hiring, borrowing, travelling, or investing across
national
borders. We call the market in which people or firms use one currency to purchase
another
currency, the foreign exchange market. Exchange rate policy is concerned with how
the
value of the domestic currency, relative to other currencies, is determined.
An exchange rate is nothing more than a price, that is the price of one currency in
terms
of another currency and so we can analyse it with the tools of supply and demand.
The
formula for calculating exchange rates is: Starting amount (original currency) /
Ending
amount (new currency) = Exchange rate. For example, if you exchange 1 U.S. Dollars
for
30 Birrs, the exchange rate would be 0.033, but if you exchange 30 Birr for 1 U.S.
dollars,
the exchange rate would be 30.
In foreign exchange markets, demand and supply are closely interrelated. This is
because a
person or firm who demands one currency must at the same time supply another
currency
and vice versa. To get a sense of this, it is useful to consider four groups of people or
firms who participate in the market: (1) firms that are involved in international trade
of
goods and services; (2) tourists visiting other countries; (3) international investors
buying
ownership (or part ownership) of a foreign firm; (4) international investors making
financial investments that do not involve ownership.
Firms that buy and sell in international markets find that their costs for workers,
suppliers,
and investors are measured in the currency of the nation in which their production
occurs,
but their revenues from sales are measured in the currency of the different nations in
which
their sales took place. Thus, an Ethiopians firm exporting abroad will earn some other
currency, say US dollars, but will need Ethiopian Birr to pay the workers, suppliers,
and
investors who are based in Ethiopia. In the foreign exchange markets, this firm will be
a
supplier of US. dollars and a demander of Ethiopia Birr.
International tourists will supply their home currency to receive the currency of the
country that they are visiting. For example, an American tourist who is visiting
Ethiopia
will supply US dollars into the foreign exchange market and demand Ethiopian
Birr.4.5 Foreign Exchange Policies
91
UNIT 4: MACROECONOMIC POLICY INSTRUMENTS
Types of Exchange Rate Policies
There are two types of exchange rate policy. Namely: fixed and flexible exchange rate
policies. Each of them is discussed below.
a) Fixed Exchange Rate Policy
Exchange rate is determined by the government’s political and economic decisions.
There
are some problems which are associated with this policy. An example is the creation
of
a parallel market (also known as aa “black market”). Governments use fixed exchange
rate systems to accomplish various goals. For example, an undervalued exchange rate
acts as an import tax and an export subsidy. Fixing the exchange rate at an artificially
low
level promotes domestic industries by encouraging exports and discouraging imports.
It
can also hurt other industries by increasing the price of imported inputs. An
overvalued
exchange rate has the opposite effect, acting as an import subsidy and an export tax.
Fixing
the exchange rate at an artificially high level, benefits domestic consumers by
encouraging
imports and discouraging exports, through decreasing the price of imported inputs.
Fluctuation in exchange rate under fixed exchange rate policy:
 Devaluation: an increase in the exchange rates due to political and economic
decisions of the government.
 Revaluation: a decrease in exchange rate due to political and economic
decisions of the government.
b) Flexible/Floating Exchange Rate Policy
Exchange rate determination is left for market forces. A flexible/floating exchange
rate is
a regime where the currency price of a nation is set by the foreign exchange market
based
on supply and demand relative to other currencies.
Fluctuation in the exchange rate under flexible exchange rate policy:
 Depreciation: an increase in exchange rate due to market forces.
 Appreciation: a decrease in exchange rate due to market forces.
The exchange rate under a floating exchange rate policy is determined by the supply
and
demand for foreign currencies (see Figure 4.9 below).4.5 Foreign Exchange Policies
92
Grade 12 Economics Student Textbook
Impact of Exchange Rate Fluctuation
a) Impact of devaluation and depreciation: improves the current account balance and/or
overall balance of payment by making exports cheaper and imports more expensive.
Given a depreciation of a currency, foreigners find exports cheaper while residents
find
imports more expensive.
b) Impact of revaluation and appreciation: worsens the external balance by making
exports more expensive and import cheaper than before. Given an appreciation of a
currency, foreigners find exports more expensive while residents find imports cheaper.
All else being equal, an appreciation raises the relative price of the country’s exports
and decreases the relative price of its imports. Depreciation has the opposite effect.
Key Factors that Affect Foreign Exchange Rates
The foreign exchange rate is one of the most important means through which a
country’s
relative level of economic health is determined. A country’s foreign exchange rate
also
provides a window to its economic stability, which is why it is constantly watched
and
analysed. If you are thinking of sending or receiving money from overseas, you need
to
keep a keen eye on the currency exchange rates.
The exchange rate is defined as “the rate at which one country’s currency may be
converted
into another”. It may fluctuate daily with the changing market forces of supply and
demand
of currencies from one country to another. For these reasons, when sending or
receiving
money internationally, it is also important to understand what determines exchange
rates.
Inflation rates: changes in market inflation cause changes in currency exchange rates.
A 4.5 Foreign Exchange Policies
93
UNIT 4: MACROECONOMIC POLICY INSTRUMENTS
country with a lower inflation rate than another will see an appreciation in the value
of its
currency. The prices of goods and services increase at a slower rate where the
inflation
is low. A country with a consistently lower inflation rate exhibits a rising currency
value
while a country with higher inflation typically sees depreciation in its currency and is
usually accompanied by higher interest rates.
Interest rates: changes in the interest rate affect currency value and dollar exchange rate.
Foreign exchange rates, interest rates, and inflation are all correlated. Increases in
interest
rates cause a country‘s currency to appreciate because higher interest rates provide
higher
rates to lenders, thereby attracting more foreign capital, which causes a rise in
exchange
rates.
Balance of payments: a country’s current account reflects the balance of trade and earnings
on foreign investment. It consists of the total number of transactions including its
exports,
imports, debt, etc. A deficit in the current account due to spending more of its
currency on
importing products than its earning through sale of exports causes depreciation.
Government debt: this is public debt or national debt that is owned by the central
government. A country with government debt is less likely to acquire foreign capital,
leading to inflation. Foreign investors will sell their bonds in the open market if the
market
predicts government debt within a certain country. As a result, a decrease in the value
of
its exchange rate will follow.
Terms of trade: related to current accounts and balance of payments, the terms of trade is
the ratio of export prices to import prices. A country’s terms of trade improves if its
export’
prices rise at a greater rate than its imports prices. This results in higher revenue,
which
causes a higher demand for the country’s currency and an increase in its currency’s
value.
This in its turn results in an appreciation of the exchange rate.
Political stability and performance: a country’s political state and economic performance
can affect its currency strength. For example, a country with less of political turmoil is
more attractive to foreign investors, so, drawing investment away from other
countries
with more political and economic stability. An increase in foreign capital, in its turn
leads
to an appreciation in the value of its domestic currency. A country with sound
financial and
trade policy does not give any room for uncertainty in the value of its currency.
However,
a country prone to political unrest may see depreciation in exchange rates.
Recession: when a country experiences a recession, its interest rates are likely to fall, 4.5
Foreign Exchange Policies
94
Grade 12 Economics Student Textbook
decreasing its chances to acquire foreign capital. For this reason, its currency weakens
in
comparison to that of other countries, therefore lowering the exchange rate.
Speculation: if a country’s currency value is expected to rise, investors will demand more
of that currency in order to make a profit in the near future. Thus, the value of the
currency
will rise due to the increase in demand. With this increase in currency value comes a
rise
in the exchange rate as well.
Advantages and Disadvantages of Fixed Exchange Rate Systems
Advantages of fixed exchange rates
 Certainty - with a fixed exchange rate, firms will always know the exchange rate
which makes trade and investment less risky.
 Absence of speculation - with a fixed exchange rate, there will be no speculation
if people believe that the rate will stay fixed with no revaluation or devaluation.
 Constraint on government policy - if the exchange rate is fixed, then the
government may be unable to pursue extreme or irresponsible macro-economic
policies as these would cause a run on the foreign exchange reserves and this
would be unsustainable in the medium-term.
Disadvantages of fixed exchange rates
 The economy may be unable to respond to shocks - a fixed exchange rate means
that there may be no mechanism for the government to respond rapidly to balance
of payments crises.
 Problems with reserves - fixed exchange rate systems require large foreign
exchange reserves and there can be international liquidity problems as a result.
 Speculation - if foreign exchange markets believe that there may be a revaluation
or devaluation, then there may be a run of speculation. Fighting this may cost the
government significantly in terms of its foreign exchange reserves.
 Deflation - if countries with balance of payments deficits deflate their economies
to
try to correct the deficits, this will reduce the surpluses of other countries as well as
deflating their own economies to restore their surpluses. This may give the system
a deflationary bias.
 Policy conflicts - the fixed exchange rate may not be compatible with other
economic
targets for growth, inflation and unemployment and this may cause conflicts of 4.5
Foreign Exchange Policies
95
UNIT 4: MACROECONOMIC POLICY INSTRUMENTS
policies. This is especially true if the exchange rate is fixed at a level that is either
too high or too low.
Advantages and Disadvantages of Floating Exchange Rates
Advantages of floating exchange rates
 Protection from external shocks - if the exchange rate is free to float, then it can
change in response to external shocks like oil price rises. This should reduce the
negative impact of any external shocks.
 Lack of policy constraints - the governments are free with a floating exchange rate
system to pursue the policies they feel are appropriate for the domestic economy
without worrying about them conflicting with their external policy.
 Correction of balance of payments deficits - a floating exchange rate can
depreciate to compensate for a balance of payments deficit. This will help restore
the competitiveness of exports.
Disadvantages of floating exchange rates
 Instability - floating exchange rates can be prone to large fluctuations in value
and this can cause uncertainty for firms. Investment and trade may be adversely
affected.
 No constraints on domestic policy - governments may be free to pursue
inappropriate domestic policies (e.g. excessively expansionary policies) as the
exchange rate will not act as a constraint.
 Speculation - the existence of speculation can lead to exchange rate changes that
are unrelated to the underlying pattern of trade. This will also cause instability and
uncertainty for firms and consumers.
Exchange Rate Structure in Ethiopia
The legal currency of Ethiopia (Birr) was first introduced in 1945 with an official
exchange
rate of Birr 2.48 per US dollar with a value of 0.36 grams of fine gold. The linkage
with
fine gold was in accordance with the monetary system established by the Bretton
Woods
Agreement of 1944 which established the exchange rate between the national
currency and
other currencies with the same arrangement. This fixed exchange rate was under
operation
for almost two decades. On 1 January 1964 the Ethiopian Birr was slightly devalued
to
2.50 birr per US dollar. Following the collapse of the Bretton Woods System in 1971,
the Ethiopian dollar was revalued to 2.30 birr per US dollar on 21 December 1971.
The 4.5 Foreign Exchange Policies
96
Grade 12 Economics Student Textbook
subsequent 10% devaluation of the US dollar temporarily brought about
undervaluation
of the Birr. It was again revalued to 2.07 Ethiopian Birr per US dollar in February
1973.
From then on, the Ethiopian currency was pegged to the US dollar at the rate of 2.07
Birr
per dollar until massive devaluation in October 1992.
Following the overthrown of the Derg Regime, EPRDF introduced the auction-based
exchange rate determination scheme and the interbank money market. Additionally,
the
principle of gradualism in liberalization of exchange rate market is at the heart of this
policy development. The exchange rate reform was started by devaluing the currency,
which had been fixed for about two decades to 2.07 Birr per US dollar, by 140% to 5
birr
per US dollar in October 1992. In 1993 the NBE introduced the auction-based
exchange
rate system. It was conducted on a fortnightly basis and took the form of
discriminatory
price which clears the market for the coming two weeks. The supply of funds for this
market was obtained from export earnings, loans and grants. The auction-based
exchange
rate system was initially worked side by side with the official exchange rate. Before
the
unification of official exchange rate and auction-based exchange rate systems in
August
1995, the official exchange rate was used for imports of fertilizer, petroleum,
pharmaceutical
products, Ethiopia’s contribution to international organizations and external debt
service
payments. In July 1996 the NBE introduced a weekly auction replacing the previous
auction system. The NBE also replaced the retail auction system by a wholesale
auction
system where banks are considered as wholesale bidders.
In 1998, the NBE issued directives aimed at establishing interbank foreign exchange
and
money markets. The interbank foreign exchange market is a wholesale market, where
the
amount traded is large and the spread between buying and selling rates is narrower
than the
normal situation for commercial transactions. It is an exclusive market for banks to
trade
foreign exchange with each other. The establishment of this market is primarily
motivated
by the recognition that the foreign exchange supply by NBE through the auction
system
is not sufficient to satisfy the demand of banks. Currently, the exchange rate is
determined
through an interbank foreign exchange market on a daily basis, a clear indication of
the
government’s policy of gradualism toward liberalizing the exchange rate market.4.5
Foreign Exchange Policies
97
UNIT 4: MACROECONOMIC POLICY INSTRUMENTS
Furthermore, NBE continued to devalue the Birr in August 2010 by 20% from 13.63
to
16.35 per US dollar as a mechanism to boost foreign exchange earnings. The
devaluation
of the Birr in 2010 was followed by the rise in inflation of about 33% in 2011 (after
one
year of currency devaluation). This type of relationship between exchange rate change
and
change in inflation tells us that inflation in Ethiopia responds positively to devaluation.
The Birr continued to depreciate but at a very slow rate and it reached
18.19/US$ October
2012/13. This gradual depreciation is in line with the goal to enhance the
competitiveness
of Ethiopian exports and attract foreign direct investment. The average exchange rate
of Birr against US dollar in the official market showed an annual depreciation of 5.4%
since 2011/12. In January 2014, the exchange rate reached 19.107 Birr/US$, a 4.85%
depreciation since January 2013.
The fluctuation in commodity prices in international markets and the strength of US
dollar relative to other currencies, led to the decline of Ethiopia’s export commodities,
especially coffee, oilseed, gold, and leather. The World Bank suggested that the
Ethiopian
government should devalue its currency by at least 10%, pointing out that in real
terms
it may lead to a 5% increase in export earnings and 2% increase in growth. As a result,
on October 10, 2017, the NBE devalued the Birr by 15% against international
currencies
(National Bank of Ethiopia, 2017). According to the government, the devaluation was Unit
Summary
98
Grade 12 Economics Student Textbook
undertaken to encourage exports and overcome the foreign exchange shortage as well
as to suppress the black market. Since 10 October 2017, inflation seems to have
picked
up. Annual inflation as measured by the CPI growth rate increased from 2.8% in 2010
to
20.2% 2020. In general, at every time of devaluation, the rise in inflation is inevitable.
(National Bank of Ethiopia, 2020/21).
.