With the new flexible exchange rate policy released today June 15, 2016, many are at a loss as to what the policy change really means or how it would affect the economy.
It will be recalled that the CBN Monetary Policy Committee on May 24 rose from its bi-monthly meeting and announced plans to adopt greater flexibility in the management of foreign exchange.
Addressing journalists at the end of the MPC meeting in Abuja, Governor of the Central Bank of Nigeria (CBN), Mr. Godwin Emefiele said, “The MPC voted unanimously to adopt greater flexibility in exchange rate policy to restore the automatic adjustment properties of the exchange rate. Consequently, all nine members voted to hold and introduce greater flexibility in managing the foreign exchange rate.”
Encomium.ng’s Daniel Fayemi examines the Flexible Exchange Rate as well as its pros and cons.
What does it mean?
Flexible exchange rates are determined by global supply and demand of currency. In other words, they are prices of foreign exchange determined by the market. These prices can rapidly change due to supply and demand, and are not pegged nor controlled by central banks. The opposite scenario, where central banks intervene in the market with purchases and sales of foreign and domestic currency in order to keep the exchange rate within limits, is called fixed exchange rate.
There are two types of flexible exchange rates: Pure floating regimes and Managed floating regimes. Pure floating regimes exist when, in a flexible exchange rate regime, there are absolutely no official purchases or sales of currency. Managed floating regimes on the other hand, are those flexible exchange rate regimes where at least some official intervention happens.
Automatic stabilizers: In a fixed exchange rate regime. If the relative price of currencies is fixed and a country’s output, employment, and current account performance and other relevant economic variables change, the exchange rate cannot change. This causes friction in the entire economic system. However, if exchange rates are allowed to change, they change in the appropriate direction, given the nature of changes in the variables affecting the exchange rates. The monetary policy and growth performance of a country affect exchange rates.
For example, when there is a reduction in foreigners’ demand for Nigeria’s exports, output also decline and the Naira depreciates. This situation helps improve the country’s export performance because depreciation makes the country’s goods cheaper to foreigners. If the same initial shock happened under the fixed exchange rate regime (decline in the demand for the country’s exports), then because the exchange rate can’t change, the country must reduce the money supply, which further decreases the output.
Monetary policy autonomy: Under the flexible exchange rate regime, countries can implement autonomous monetary policies to address problems with inflation and output. Because monetary policies affect inflation rates, countries can decide on their long-run inflation rate and don’t have to import their trade partners’ inflation rate, as is the case under a fixed exchange rate.
Exchange rate risk: The main disadvantage of flexible exchange rates is their volatility. The changes in exchange rates are more frequent and larger than the underlying fundamentals imply.
Questionable stabilizing effects: Previously, automatic stabilizing was mentioned as an advantage of the flexible exchange rate system. Exchange rates change in the appropriate direction when the country’s inflation rate, output, and current account balance change. Especially in terms of current account imbalances, exchange rates determined in the foreign exchange markets are supposed to change to prevent the occurrence of persistent and large current account deficits and surpluses.
However, some countries have deficits (such as the U.S., Spain, Portugal, and Greece), and some countries have a surplus (such as Germany and China). Moreover, the data indicate long swings in major exchange rates, which are called misalignments.
Therefore, it seems that flexible exchange rates do not change frequently enough to eliminate current account imbalances. An adverse effect of these misalignments is that they give deficit countries the motivation to impose trade restrictions.