Getting the prices right

Explain and critically appraise the policy approach summarized as “getting the prices right” as a means of improving the economic position of an open African economy such as that of Tanzania. Macroeconomics is the management of a country’s economy. It is the management of a country’s economic relationship with other countries through trade, investment and foreign exchanges. If the country is poor it is then more important for that countries government to manage the international relationships efficiently. With the role of the state being central, the developmental state has many challenges.

In the 1980’s and 1990’s African economies became deindustrilaized. Before this the states pursued their own policies for economics, employment and welfare, when global trade agreements and financial flows allowed. To see If a policy such as “getting the prices right” improves the position of an open African economy we look at Tanzania. Tanzania is one of the low income countries in the world. The economy is heavily dependent on agriculture. Industry is mainly limited to processing agricultural products and light consumer goods.

In the early 1980’s aid donors did not like the policies of the government. Less aid meant that the investment and savings rates went down also. The government tried to borrow money at this time of crisis but his just made the situation worse. In 1981 the World Bank produced a report called the Berg Report. This report strongly supported the view tat the economic crisis of the 1970’s was due to state intervention. It said that because of mistakes in economic policy decisions that African economies had a poor export performance.

Two Key price ratios that were affected were: The prices for agricultural goods compared to prices for industrial goods, and the price in local currency of the foreign exchange needed to buy imports on the foreign market… The Berg report recommended that these prices be determined by the market, and so this policy approach was called “getting the prices right”. The Berg report also said that African countries should try to create incentives for the market to increase exports, and use their advantage of agriculture and mining.

The macroeconomic policies were then being governed by the IMF and the World Bank. The foreign exchange market is a good example of supply and demand. Looking at US Dollars. The demand for US dollars in the exchange market comes from different types of agents. The demand for dollars comes from importers of US Goods, Investors selling their own currency and buying US Securities (other financial assets) and US exporters of American goods in other countries who have been paid in their own currency and want to convert to dollars.

If the currency of a country depreciates, U. S. goods become more expensive and that country’s imports of U. S. goods are reduced; since imports of U. S. goods have to be paid in U. S. Dollars, a depreciation of the country’s currency reduces the demand for Dollars as the reduced imports by that country of American goods leads to a reduced demand for Dollars. On the other side of the exchange rate markets there are agents who are selling (supplying) U. S. Dollars. These agents are: exporters of goods to the U. S. who have been paid in U. S.

Dollars and need to convert them to their own currency, U. S. importers of Tanzanian goods who need Tanzanian Shillings if they need to pay in Tanzanian Shillings for their imports; and investors who are buying Tanzanian Shillings in order to buy Tanzanian securities (bonds, stock and any other asset).

As the exchange rate of Tanzania (Tanzanian Shillings per Dollar) depreciates the supply of U. S. dollars is increased. In fact, if the Tanzanian Shilling depreciates, Tanzanian goods become cheaper in international markets and Tanzanian exports to the U.S. goods are increased;

Since Tanzanian exporters are paid in U. S. Dollars, a depreciation of the Tanzanian Shillings increases the supply of Dollars as the greater exports of Tanzanian goods lead to larger Dollar receipts that need to be converted into Tanzanian Shillings. When a country has a system of “flexible exchange rates”, it will allow the demand and supply of foreign currency in the exchange rate market to determine the equilibrium value of the exchange rate.

So the exchange rate is market determined and its value changes at every moment in time depending on the demand and supply of currency in the market. Some other countries do not allow the market to determine the value of their currency. Instead they “peg” the value of the foreign exchange rate to a set rate, a certain amount of Pesos per Dollar. In this case, we say that a country has a system of “fixed exchange rates”.

In order to maintain a fixed exchange rate, a country cannot just announce a fixed parity: it must also obligate itself and its central bank to defend that rate by its own willingness to buy (sell) foreign reserves whenever the market demand for foreign currency is greater (smaller) than the supply of foreign currency. In order to prevent a depreciation of the domestic currency, the central bank of the country has to provide to the market an amount of foreign exchange reserves equal to the difference between the market demand and the market supply of the foreign currency.

In other terms, the central bank has to sell foreign exchange reserves that it was holding among its assets in order to prevent the currency depreciation. Therefore, a country can defend a fixed exchange rate that differs from the equilibrium exchange rate (that would hold under flexible rates) only as long as it has a sufficient amount of foreign exchange reserves to satisfy the market excess demand for the foreign currency.

If the country runs out of foreign exchange reserves, the fixed exchange rate becomes unsustainable and the central bank will be forced to give up the defence of the currency: the exchange rate will depreciate to its flexible rate value. If the supply of a good increases, and nothing else changes, the price of that good will decrease. If the supply of a country’s currency increases, we should see that it takes more of that currency to purchase a different currency than it did before.

Suppose there was a big jump in the supply of the Tanzanian Shilling. We would expect to see the Tanzanian Shilling become less valuable relative to other currencies. So the Tanzanian-to-U. S. Exchange rate should decrease. Each Tanzanian Shilling would give us less American dollars than it did before. Similarly, the U. S. -to-Tanzanian exchange rate would increase so each U. S. dollar would give us more Tanzanian Shillings than it did before, as a Tanzanian Shilling is less valuable than it used to be.