Foreign exchange rates — practice question

In June 2016, Nigeria moved to a floating exchange rate after the country’s central bank had spent months trying to preserve its fixed exchange rate. It had been using foreign currency reserves to support its currency, imposing tariffs and limiting how much foreign currency Nigerians could buy. Most economists expected the Nigerian currency to fall in value. A lower value of the Nigerian naira could help raise output and reduce the deficit on the current account of the country’s balance of payments. In 2015, Nigeria recorded a current account deficit for the first time in 20 years. Countries with a current account deficit often have a higher inflation rate and a lower economic growth rate than countries with a current account surplus. Fig. 1 shows the inflation rate, economic growth rate and the current account balance of selected countries in 2015. Fig. 1: The inflation rate, economic growth rate and current account balance of selected countries in 2015. The countries shown are China, Colombia, Germany, Nigeria and Turkey. The key indicates: Inflation rate; Economic growth rate; Current account balance (% of GDP). The horizontal scale runs from -8 to 10. When there is a current account deficit, the exchange rate can fall, which may push up import prices. A higher cost of imports, including imported food, can speed up inflation. In 2015, in addition to having a current account deficit, tax revenue fell in Nigeria and was below government expenditure. Some economists predicted that the government would cut spending on education and healthcare in 2016 to reduce the difference between tax revenue and government spending. The Nigerian government has been trying to reduce poverty in the country. In 2015, more than 60% of the population were living in poverty. One cause of the high level of absolute poverty was an unemployment rate of 9.5%. One policy measure suggested to reduce poverty in Nigeria is for the government to increase the wages of low-paid workers. The government also wants to diversify the economy because the oil industry provides almost 90% of the country’s export earnings. The oil industry pays high wages to some of its workers and relatively high interest rate payments to local banks. It also creates water pollution and air pollution.