Annex 2B


and demand of foreign exchange, and hence a current account deficit: the world market
prices of importables and exportables. Many developing countries have suffered a
worsening of their terms of trade, i.e. a deterioration of their export prices in relation to the
prices of imports. From formula 3a) it can be easily deduced that current account deficits are
an inevitable consequence of such a situation. Collective adjustment, i.e. efforts of various
countries to promote exports of the same commodities, are likely to reinforce this trend.

4. Effects of a Fixed Overvalued Exchange Rate

Contrary to the ideal of a free market economy (see Annex 2A), the governments of many
countries have decided not to allow a free floating of the exchange rate according to the
market forces of supply and demand, but to keep the exchange rate fixed, usually at a rate
below the real exchange rate which means an effective over-valuation of the domestic
c._Srrency. A principal reason for this policy is to fight inflation which would be accelerated by
rising prices of imports resulting from a devaluation. Other reasons may be the interest of
influential groups in getting access to cheap imports or to foreign exchange at favourable
rates.

An overvalued exchange rate has a number of crucial consequences on the macro-meso
economic level of the economy:
* It leads to a perpetuation of a trade and balance of payment deficit (see Salter-Swan-
 model in Annex 2A).
 It implies a divergence between the nominal and the equilibrium exchange rate, as
 well a between the nominal and the real exchange rate. The equilibrium rate and real
 exchange rate are closely related but differently defined: the first is the level of the
 exchange rate which brings about a trade balance (see above), while the latter is a
 measure of a country's exchange rate against the currencies of other countries over time,
 adjusted for the difference in the rates of inflation between the countries. If the rate of
 inflation in other countries is lower than in the country concerned, the equilibrium rate as
 well as the real exchange rate will tend to rise above the initial fixed nominal rate (which
 means an effective overvaluation of the local currency).
 It has depressing effects on the domestic prices of tradables (importables as well as
 exportables), leading to distortion in price structures and inappropriate price signals to
 producers as well as consumers. The price effect of an overvalued currency is often
 referred to as a negative indirect rate of protection (see Annex 2D).
 As the nominal exchange rate does not lead to a balance of supply and demand of foreign
 exchange, it requires official regulation and restrictions of the foreign exchange
 market and gives rise to the emergence of parallel markets, with additional
 administrative costs and associated risks of corruption and market distortion (see below).

 Figure B2-1 depicts the typical shape of supply (S) and demand (D) functions for foreign
 exchange ($), with the exchange rate (price of $) as the independent and the quantities of
 foreign exchange demanded and supplied as the dependent variable. Point E indicates the
 equilibrium situation with the equilibrium exchange rate Pe. Here, demand and supply of
 foreign exchange are equal. If the nominal exchange rate (Pn) is fixed below Pe (which means


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