1.3 More about Exchange Rates
In Bangladesh announcements of the official exchange rate (of the Taka against all other currencies) are made by Bangladesh Bank on a daily basis. Besides this official exchange rate, there is another exchange rate determined in the Black Market for foreign exchange where transactions take place in a fashion such that the market resembles a formal Secondary Market. Most transactions take place in this so-called “legalized” illegal market for foreign exchange.
Exchange rates can be classified into:
- Nominal Exchange Rate (unadjusted for Inflation)
- Real Exchange Rate
- Nominal Effective Exchange Rate
- Real Effective Exchange Rate
In this paper, we will deal only with Real Exchange Rates (RER); that is, we will adjust the data for exchange rates (the nominal exchange rate) for rises in the price level.
Further clarification is required regarding exchange rate appreciation and depreciation. An appreciation of the domestic Taka refers to the fact that less of Taka needs to be exchanged for a Dollar, and likewise, a depreciation may be understood by the fact that more of Taka has to be traded for one Dollar.
With such preliminary understanding on exchange rates and a brief history on the exchange rate system in Bangladesh, progress into more detailed analysis of the effects of Exchange rates on Money Supply, Trade, and Foreign Exchange Reserves is plausible.
PART- TWO
2.1 Real Exchange Rate (RER) and Money Supply
Theory suggests that changes in exchange rates (and hence real exchange rates) have an effect on the money supply of an economy. Depreciation of a currency will require a sale (in order to reduce its value) of domestic currency in the foreign exchange market (and a purchase of foreign assets in return), leading to an increase in money supply. Following the same formula, an appreciation of the domestic currency will require a purchase of domestic currency in exchange of foreign currency, which is sold in the foreign exchange market. This purchase of domestic currency reduces the currency in circulation, affecting the high- powered money, and hence increases money supply.
Money supply here will be defined by M2, the Broad Money definition. A plot of the tabulated values below is shown in Fig-1. Table-1 provides the values of the Real Exchange Rate (RER) and Broad Money, M2 (in croreTaka) respectively over the period 1988-1998. After 1998, the values for the RER were not available, and hence the relationship between the respective variables are plotted only till 1997 in Fig-1.
Table - 1: Real Exchange Rate & Money Supply
Source : * Rahman, Atiqur. A.K.M. Exchange Rate Policy and Real Exchange Rate Behavior in Bangladesh, June 2000, North South University, Dhaka.
** Bangladesh Bank. Economic Trends, April 2001, Dhaka.
The graph above clearly depicts a positive relationship between exchange rates and money supply (M2). An increase in exchange rates can be explained in the context of the Taka and US$, where an increase implies more Taka being needed to be paid in exchange of one US$ hence pointing towards currency depreciation. In other words, as theory suggests, devaluation of a currency or depreciation of the domestic currency (and hence an increase in exchange rates) leads to an increase in money supply. Bangladesh had persistently devalued its currency over the years tabulated above, and this had been followed by an increase in Broad Money. A clear illustration of theoretical knowledge is etched by the response of money supply to the behavior of the exchange rate in Bangladesh.
2.2 Effect of Real Exchange Rates on Trade
An essential ingredient for international trade to take place is the domestic and foreign currency. Exporters in Bangladesh receive Taka in return for their exports. In order to purchase these exports from Bangladesh, foreign buyers require Taka in return for their currency, and the Taka they obtain from the foreign exchange market is later paid to the exporters. Similarly, Bangladeshi importers require foreign currency when purchasing import items from abroad, and thus sell domestic currency for foreign currency at the foreign exchange market. This process of buying and selling foreign goods and services can therefore affect the exchange rates of the countries concerned.
The reverse causality is also visible. When foreign exchange appreciates or depreciates, the Trade Balance is also likely to be affected. Theoretically, for a trade deficit running country such as Bangladesh that is unable to affect the world terms of trade, a devaluation leads to local consumers viewing the prices of imported goods to be higher in terms of the local currency. Local consumers reduce their consumption of imports depending on the extent of the elasticity of demand for imports. Exporters also view the prices of exports to be higher in local currency and tend to export more at the going world price depending on the elasticity of demand for imports. Hence, with no changes in the world price of the foreign currency, devaluation can actually improve the trade balance for a country such as Bangladesh. An appreciation of the domestic currency can, on the other hand, cause the trade balance to tilt further towards a deficit.
Fig-2 illustrates a plot between Real Exchange Rates (RER) and trade deficits (Exports less Imports) in crore Taka.
Table - 2: Nominal & Real Exchange Rate, Export Receipts & Import Payments and Trade Balance
** Figures in crore Taka
Source : ^ Rahman, Atiqur. A.K.M. Exchange Rate Policy and Real Exchange Rate Behavior in Bangladesh, June 2000, North South University, Dhaka.
# Bangladesh Bank. Economic Trends, April 2001, Dhaka.
A close look at Table 2 and Fig-2 will reveal the close to what theory suggests in terms of the effect of exchange rates on the Balance of Trade. Initially, between1988-89 and 1989-90, when the real exchange rates were 86.4 and 90.1 respectively, a rise in RER (in other words, a devaluation) led to a mild increase in trade deficits from 4000-6000. This is somewhat against theoretical understanding. This may have been due to other specific reasons such as the easing of trade barriers. From 1990 onwards, it is clearly evident that as the RER jumped significantly (to 97.6), the devaluation led to a persistent fall in trade deficits. Again, in 1994-95, when the RER fell from 103 to 100, trade deficits rose to 7421 crore Taka. This implies that a fall in RER (and hence a currency appreciation) leads to worsening of the Balance of Payments problem. Following this, from 1995 onward, a rise in RER (and hence a depreciation) led to a fall in trade deficits. Thus, theoretical insight is illustrated in almost all instances by the Bangladesh economy in the context of the relationship between RER and the trade situation.
2.3 Effect of Real Exchange Rates (RER) on Foreign Exchange Reserve
A rise in RER, analogous to currency depreciation, means that more domestic currency is sold in the foreign exchange market (same reasoning as for 2.1 and 2.2) along with more purchase of foreign currency. The foreign currency, here US$, travels straight to the Foreign Exchange Reserve section of Bangladesh Bank. This is what theories suggest- currency devaluation leads to a rise in foreign exchange reserves, and vice versa.
Table 3 and Fig-3 help to reveal a scenario similar to theoretical perception. From a close look at Table 3 it is revealed that the amount of devaluation over the period 1988-97 was around 2.71% on an average. During the same period on an average foreign exchange reserve, however, was Taka 7183.81 crore. Within the period only in 1994-95 an appreciation of 2.71% is observed when foreign exchange reserve grew by rather a sluggish manner pointing to the validity of theoretical understanding. The effect of this appreciation, however, became apparent in the period next when foreign exchange reserve fell drastically from Taka 12784.88 crore to Taka 8787.08 crore giving 31.27% decline in the foreign exchange holding of the country (graphical representation is given in Fig- 3). In an attempt to overcome this dire wane in the reserve, government took a devaluationary measure by devaluating Taka by 3.97% in 1995-96. Such measure indeed responded in a positive manner as depletion in the foreign exchange reserve came to a lethargic pace from 31.27% to 11.06% and stood at Taka 7815.50 crore at the end of 1996-97. This also complements the academic perception concerning the matter.
Table – 3: Real Exchange Rate, Percentage of Devaluation, Foreign Exchange Reserve and Percentage Change in the Foreign Exchange Reserve
Fig- 4 reflects the reserve holding compared to the exchange rate of Taka against US$. From this figure it revealed that a sharp fall in the reserve has always been counter attacked by a sharp depreciation of Taka. This continual devaluation can also be attributed to some other factors like- export promotion strategy of the government, attempt to improve the deficit condition in BOP and an effort to minimize the gap of exchange rate between official and black market. All in all, the trend in the exchange rate and the foreign exchange reserve picture what is indicated in theory.
Conclusion
As specified earlier the purpose of this paper was to reveal how far practical happenings match with the theoretical suggestions. Towards that end, based upon above discussion, it can be stated that the impact of exchange rate on three of the factors- Money Supply, Trade, and Foreign Exchange Reserves, shows the trend that is indicated by the theoretical understanding. Over the years concerned authority in Bangladesh handled the problems of either regarding Money Supply or Foreign Exchange Reserve or Trade Deficit through by taking appropriate measures in the exchange rate.
REFERENCES
Bangladesh Bank. Economic Trends. April 2001, Bangladesh Bank Press, Dhaka.
Bangladesh Bank. Economic Trends. January 2001, Bangladesh Bank Press, Dhaka.
Bangladesh Bank. Economic Trends. August 2000, Bangladesh Bank Press, Dhaka.
Bangladesh Institute of Development Studies. The Bangladesh Development Studies. Vol. XXIII, Sep-Dec 1995, BIDS Press, Dhaka.
Rahman, Atiqur. A. K. M. “Exchange Rate Policy and Real Exchange Rate Behavior in Bangladesh”, June 2000, North South University, Dhaka.
