Foreign exchange rates — practice question

In June 2016, Nigeria moved to a floating exchange rate after its central bank had spent several months trying to hold on to a fixed exchange rate. To support its currency, it had been using foreign currency reserves to buy it, imposing tariffs and restricting how much foreign currency Nigerians could purchase. Most economists believed that the Nigerian currency would depreciate. A lower value of the Nigerian naira could help to raise output and cut the deficit on the country’s current account of the 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 presents the inflation rate, economic growth rate and current account balance of selected countries in 2015. When there is a current account deficit, the exchange rate can fall and this may push up import prices. A higher price of imports, including imported food, can speed up inflation. In 2015, Nigeria not only had a current account deficit, but tax revenue also declined and was below government expenditure. Some economists forecast that the government would reduce spending on education and healthcare in 2016 in order to narrow the gap between tax revenue and government spending. The Nigerian government has been working to reduce poverty in the country. In 2015, over 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 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 workers and relatively high interest rate payments to local banks. It also causes water pollution and air pollution.