Important Reasons for Changes in the Exchange Rate
1) A Rise in the Domestic Price of Exports
2) A Rise in the Price of Imports from the U.S.
3) Changes in the overall price levels
The Rand and the U.S. Dollar in 2001
1) Inflation
This essay seeks to highlight the causes of exchange rate variances between the South African Rand and the United States Dollar. The exchange rate is defined by Lipsey, Courant and Ragan as the price that one has to pay in his local currency in order to purchase one unit of another currency. They point out an instance in August 1998 when the price of one Japanese yen was 0.7 U.S. cents or 0.007 U.S. dollars. This means that the exchange rate between the yen and the U.S. dollar was 0.007. Why are there variances in the exchange rate? Lipsey, et al summarise this in once sentence – changes in the demand and supply in the foreign exchange market will cause the exchange rate to vary.
Using Lipsey’s ideas, putting it in the South African context, basically if there is an increase in the demand for foreign exchange or if there is a decrease in the supply of foreign exchange then there will be a rise in the exchange rate. According to Lipsey, et al this will mean that the rand will lose its value against the U.S. Dollar. Conversely if there is a decrease in the foreign exchange demand and in an increase of its supply, then the rand will gain value and the exchange rate will drop. Lipsey, et al use examples with the United States and Japan. Since such examples are relevant to South Africa, they have also been used below to explain the determination of the exchange rate between South Africa and the U.S.
If, for example, the price in rands of a South African product rises, what will happen to the supply of foreign exchange (or the demand for South African rands)? If the demand for the product is elastic (i.e. if the demand for the product is strongly affected by the price), perhaps because other countries on the world market supply the product, then the total amount spent on the South African product will decrease (Lipsey, et al: 816). This will mean that less foreign exchange will be supplied to purchase the product. Thus the South African rand will lose its value. If price has not effect on the demand (this will occur when South Africa is the only country in the world which supplies that product), then more money will be spent on the product and the rand will appreciate in value.
Lipsey, et al considers a situation where the price of American-produced vehicles rises drastically. In this situation South African consumers’ demand strongly depends on the prices of the foreign vehicles because they can easily switch to South African made substitutes. As a result, they will spend fewer U.S. dollars on American vehicles than they did before and consequently they will require much less American dollars. Again by the economic laws of supply and demand the South African rand will gain in value. If the demand for the American cars did not depend on their price then the total amount spent on the cars would increase and hence the demand for U.S. dollars would also increase and subsequently the value of the rand would decrease.
Lipsey, et al highlights another situation where instead of a change in the price of a particular product, there is a change in the prices of all products due to general inflation. Separate case are then highlighted (Lipsey, et al: 817), each corresponding to a different pattern of South African inflation relative to foreign inflation.
A) Equal Inflation in Both Countries
If inflation is 5 percent in both South Africa and the United States, the prices of both local and American goods will both rise by 5 percent (Lipsey, et al). At the existing exchange rate, the price in rands of American good and the price in U.S. dollars of South African goods will each also increase by the same percentage. Thus the relative prices of imports and locally produced goods will remain unchanged in both the United States and South Africa. Because there is no reason for the demand for imports from either country to change, the exchange rate will also remain unchanged.
B) Inflation in Only One Country
Lipsey, et al indicates that if there is inflation in South Africa while there is no inflation in the U.S. then the rand price of South African goods will increase and will thus become more expensive for American consumers. This will obviously cause the number of South African exports to lower and thus the amount of foreign currency supplied by the American importers will decrease. In this situation the price of American goods will remain unchanged and therefore they will appear more attractive than the locally manufactured goods. This means that more American goods will be acquired. The demand for the U.S. dollars to buy these goods will increase. These changes in supply and demand will cause the rand to lose its value.
C) Inflation at Unequal Rates
Lipsey, et al makes the logical assumption that if price levels change in both South Africa and the United States then it is only the relative size of the changes in the two countries, which will determine the attractiveness of local and foreign products. If South Africa’s prices rise relative to the United States’ then the rand will depreciate and vice-versa.
Lipsey, et al has determined that capital flows can have a strong influence on exchange rates. A situation is considered where there is an increased desire by South Africans to acquire American assets. The demand for foreign exchange will increase and therefore the rand will depreciate. This statement holds true for any type of capital movements, however the reasons for the capital movements are different and thus they will therefore be discussed separately below:
A) Short-Term Capital Movements
Lipsey, et al has realised that one of the main reasons why there are short-term capital flows is because of changes in interest rates. Just like domestic traders, international traders hold transactions balances. Instead of the balances lying idle, they are often loaned out on a short-term basis. Obviously the balance holders will be more likely to lend out their money in situations where the interest rate is high. Thus if a South Africa’s short-term interest rate increases then there is like to be a large inflow of short-term capital into the country. This will appreciate the rand. Conversely if the short-term interest rate decreases then they will be a lower inflow of short-term capital and hence a depreciation of the rand.
Lipsey also indicates that another incentive for short-term capital movements is speculation about a country’s exchange rate in the future. If the United States predicts that the rand is going to gain value in the near future then they will rush to buy assets that pay off in rands. If the opposite is the case then the U.S. will be reluctant to buy assets.
B) Long-Term Capital Movements
Lipsey, et al indicates that long-term movement of capital is greatly impacted by the long-term expectations about another country’s profit opportunities and the value of its currency in the long term. For instance an American business is more likely to invest in a South African factory if it is believed that the rand profits will be able to buy more U.S. dollars in the future than profits from an American factory. This would be true in an instance where the South African factory is more profitable than the American one while the exchange rate remains unchanged. Another valid situation is one where the profits from both South African and American factories are the same but the rand is expected to gain significant value over the dollar.
Lipsey, et al defines structural change as an all-purpose term for a change in cost structures, the creation of new products, changes of preferences between products or any other situation, which will result in a change in the pattern of comparative advantage. An example is provided where local firms are reluctant to advance their technology and this results in the country’s products not improving as fast as its counterparts. Consumers will naturally switch to foreign products since they will be more advanced than the local ones. The demand for foreign currency will increase and this will cause a depreciation of the rand.
According to a 5 FM news report (17/8/2000) 1 U.S. dollar can purchase 6.92 rands. I believe that come 1 January 2001, the rand will lose value further and 1 dollar will buy between 7.5 and 8.5 rands. Some of the factors mentioned earlier on in the essay will play a major part in the devaluation of the rand. All the ideas expressed below are from Lipsey, et al. Listed below are the relevant factors:
Inflation in the United States is much lower than that in South Africa. This means that South Africa’s prices will rise relative the American prices. This will mean that the South African products will be less attractive to American consumers and therefore the demand for rands will decrease thereby decreasing the value of the rand.
South Africa is known to have a shocking crime rate especially in Johannesburg. There is no indication of this crime rate dropping within the next few months. This means that American firms are not likely to buy assets in the country. They will feel that such assets would be in danger of being robbed and so their profits would be greatly depleted. They would rather remain in the United States where things are much safer.
Americans are notorious for being naïve, especially when it comes to matters concerning Africa. There is a tendency for them to think that whatever happens in one part of Africa, happens in all parts. They will probably assume that the current farm invasions are also happening (or could happen) in South Africa and so they will therefore be unwilling to invest here. This unwillingness to invest will mean a reduced demand for South African rands and hence a devaluation of the rand.
A severe shortage of foreign currency in Zimbabwe has also meant that South Africa has had to reduce its trade with it. Because Zimbabwe can no longer pay South Africa in foreign currency (e.g. the situation where Zimbabwe owes Eskom millions of rands). This means that the demand for South African rands will continue to decrease over the next 2 years or so and therefore the rand will lose value.
It can be seen that the exchange rate for any country has many factors, which contribute to its appreciation or depreciation (i.e. the value or strength of its currency). It all boils down to the fact that a currency’s strength depends on its demand and supply. Therefore because the demand of the rand from Americans is going to decrease, the value of the rand is going to drop at the beginning of next year.
Lipsey R G, Courant P N and Ragan C T S (1999). Economics, Twelfth Edition, United States: Addison-Wesley Publishing Company Inc.
5 FM News Report, (2000, 17 August). [Radio programme]. Johannesburg: 5 FM.