Read the information below about an African country's foreign-exchange market. Egypt imports wheat, medicines and fuel that are priced in US dollars. In one...
Question 1 Report
Read the information below about an African country's foreign-exchange market. Egypt imports wheat, medicines and fuel that are priced in US dollars. In one month, demand for dollars rose sharply as importers placed new orders. The central bank sold part of its dollar reserves and received Egyptian pounds in exchange. Fig. 3 shows the intended short-run effect in the market for US dollars. The supply curve shifts from S1 to S2 and the market exchange rate moves from E1 to E2. The rate is measured in Egyptian pounds per dollar. The government argues that intervention can prevent a rapid increase in import prices, while firms are concerned about the long-run availability of reserves.
(a) Identify the action taken by the central bank in Fig. 3. [2]
(b) Calculate the percentage fall in the exchange rate from E£50 to E£44 per US dollar. Give your answer to one decimal place. [3]
(c) Explain how this intervention could affect the price of imported wheat and the costs of Egyptian firms. [10]
(d) Examine whether the Egyptian government should continue using foreign-exchange reserves to influence the exchange rate. [15]
Answer Details
(a) The central bank sold US dollars from its foreign-exchange reserves. [2] This increased the supply of dollars in the market, shifting supply from S1 to S2.
(b) [3]
\[\frac{E£50-E£44}{E£50}\times100=\frac{E£6}{E£50}\times100=12.0\%\]
The exchange rate fell by 12.0%.
(c) After intervention, fewer Egyptian pounds are required to buy each US dollar. [10] Wheat priced in dollars therefore costs less in Egyptian pounds than it would without the intervention. Food importers face lower purchase costs, which may limit the rise in retail wheat prices and reduce cost-of-living inflation.
Firms importing dollar-priced fuel, medicines, machinery or components also pay fewer Egyptian pounds. Their production costs may fall, or rise less quickly. Firms may pass these lower costs on in lower prices, or retain higher profits and invest. The effect may be limited if overseas suppliers increase their dollar prices or domestic distribution costs rise.
(d) Continued intervention can reduce sudden depreciation. [15] This limits rises in the domestic price of essential imports, reduces inflation and protects real incomes, especially for low-income households. Firms using imported inputs gain more predictable costs, which can encourage investment and production. A stable exchange rate can also reassure overseas suppliers and lenders.
Against this, reserves are finite. Repeated dollar sales reduce the ability to meet future external payments and may merely delay adjustment if demand for dollars remains high. Keeping the Egyptian pound artificially strong can make exports less competitive, reducing export revenue and future dollar inflows. Falling reserves may weaken confidence and encourage speculation, and borrowing to replenish reserves raises debt and interest payments. Intervention does not solve low export production or dependence on imports. A justified policy is temporary intervention while measures improve productivity and exports or reduce import dependence.
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