Practice Exam Questions
Impact of a Currency Appreciation (Revision Essay Plan)
Last updated 7 Jan 2022
Here is a walk through of a 25-mark essay question (EdExcel) on the impact of a currency appreciation on the Zambian economy.
Between mid-2017 and mid-2021 the Zambian currency depreciated by over 150% against the US dollar, contributing to consumer price inflation peaking at 25% in July 2021. But more recently, the Zambian kwacha appreciated 27% against the US dollar during 2021. The Zambian government is trying to tackle $17 billion in external debt and is in talks with creditors ranging from holders of $3 billion in Eurobonds to $5.8 billion owed to China. The currency of Africa’s second-biggest copper producer has been buoyed by near-record global prices for the metal, which makes up more than 70% of their export earnings and which has helped boost Zambia’s trade surplus.
Evaluate the possible impact on the Zambian economy of an appreciation in the value of their currency. (25 marks)
KAA Point 1
If Zambia’s currency rises in value, one possible impact is a fall in their very high inflation rate which reached 25% in 2021. This is because a stronger currency makes imports cheaper, so for example, imports of medicines, foodstuffs and components for manufacturing will become cheaper. This leads to an outward shift of short run aggregate supply (SRAS) which, ceteris paribus, will lead to a fall in cost-push inflationary pressures and improved real incomes. A fall in inflation might then encourage the Zambian central bank to lower their main monetary policy interest rates which can help to support Zambian economic growth.
Evaluation Point 1
The extent to which a strong currency will help bring down inflation in Zambia depends on the share of imports in their total GDP. Zambia is a low-middle income country and must import fuel and food which is often priced in US dollars. So, these costs should fall assuming overseas suppliers keep their prices constant. However, as the world economy recovers from the pandemic, global prices for food and energy are surging which might increase imported inflation for the Zambian economy. And rising export revenues from copper output might cause some demand-pull inflation especially if there is a positive output gap.
KAA Point 2
A second impact of an appreciation of Zambia’s currency is that their trade and current account surplus might improve in the short term. This is partly because the main reason for the appreciation is an increase in the world price of a major export copper. This has significantly improved Zambia’s terms of trade and increased their export earnings because copper has a low coefficient of price elasticity of demand. One of the immediate effects of a rising currency can be an inverted J-curve because imports are cheaper and export earnings remain high. This is shown in my analysis diagram. An improved trade surplus will then generate the extra US dollars needed to service Zambia’s $15bn of external debts and reduce the risk of default.
Evaluation Point 2
A counter argument is that an appreciating currency might worsen Zambia’s current account of the Balance of Payments in the medium term. One reason is that many Zambian copper mines are part-owned by TNCs and the higher profits they make from rising global prices may leave the economy causing a net outflow of property income. And whilst copper exports might be rising, other Zambian export sectors such as trucks, fertilizers and tourism might be hit by a strong currency with profits and planned investment falling due to a loss of price and cost competitiveness in overseas markets.
Final Reasoned Comment
The impact of an appreciating currency on the Zambian economy depends on why the exchange rate is increasing in value. It seems that theircurrency is highly correlated with the world price of their main export (copper accounts of 70% of exports). So, it is crucial that the Zambian government makes effective use of the increased US $ earnings, for example using taxation of higher profits from copper mining to invest in health and education to raise human development outcomes, improve overall competitiveness and reduce their primary product dependency.