Annex 2B Annex 2B: The Exchange Rate-Price-Market Mechanism 1. Introduction The exchange rate represents the major link between the national economy and the outside world, and exchange rate policies play a prominent role in most adjustment programmes. By influencing the domestic prices of tradables, the exchange rate affects, directly or indirectly, the supply and demand of almost all goods and services produced in a national economy, and has, furthermore, significant effects on the overall current account and balance of payments situation. 2. Exchange Rate and Prices of Tradables The exchange rate determines the price which exporters get in local currency for the goods (and services) being exported, and the price which importers have to pay, again in local currency, for the goods (and services) being imported. This can be expressed by the following simple formula: 1) Px/m,1c = ER Px/m,fc Pxim,lc stands for the price of exported and imported goods, expressed in local currency, ER for the exchange rate, and Px/m,fc for the price of an exported and imported good in foreign currency. The latter expression refers to the border price of imported/exported goods, i.e. the world market price, increased by the international handling and transport costs up to the border in the case of imports (commonly referred to as cif. price), or decreased by the international handling and transport costs in the case of exports (commonly referred to fob. price). If the border price of an imported/exported product were 100 $-US and the exchange rate 50 (50 local currency units exchange for 1 $-US), the price in domestic currency (also called import/export parity price) would amount to 5000 local currency units. The domestic market of tradables, importables as well as exportables is linked through the exchange rate-price mechanism with the world market. Under liberal trade conditions (see section on trade policy reform), goods are likely to be imported, if the import parity price is below domestic prices, and good are likely to be exported, if their export parity price is above domestic price levels. The condition determining whether a good is an exportable, an importable, or a non-tradable is given by: 2) Px:5 (Pw q) ER