Exchange
rate is the price of the domestic currency in terms of another currency. The
worth of a nation currency depends on a number of factors including the state
of the economy, the competitiveness of her exports, the level of domestic production
and the quantum of her foreign reserves. In a free market economy the exchange
rate of a currency is determined by the interplay of supply and demand for that
currency, the major objectives of exchange rate in Nigeria are to preserve the
value of the domestic currency, maintain a favourable externally reserve position and ensure price
stability. However, the exchange rate policies applied in Nigeria
have
traversed into two main mechanisms the fixed and the flexible regimes. A fixed
exchange rate regime exists when the central bank issues an official price of
its currency in terms of a reserve currency. The rate fixed is known as the
currencies per value. Dwivedi (1980). In contrast, a flexible exchange rate
regime depicts a situation in which there is no restriction on the foreign
exchange transaction. Flexible exchange rates are permitted to fluctuate freely
on the market or to respond to daily changes in demand and supply.
However, the choice of exchange rate
regime is significantly influence by the degree of openness of an economy.
According to World Bank (1997) the more diversified an economy is the more
geographically concentrated the trade and the stronger the case for fixed
exchange rate regime. On the other hand, the more diversified an economy is the
greater the openness of the economy, the better for the country to adopt
flexible exchange rate adjustment regime. Such regime reflects economic
fundamentals and aims at achieving a stable exchange rate. Borrow et.
al.,(1995) argued that the degree of openness of an economy influences the
level and rate of economic growth. Thus, countries that are more open to
international trade will tend to grow more rapidly because they have developed
a greater ability to absorb technological advances and can take advantage of
large markets. To this extent, the exchange rate regime influences the volume
of international trade, which could bring about a positive effect on the growth
of the economy. What this literature suggests is that the type of exchange rate
regime which a country adopts influence her international trade. In the view of
frankel and Rose (2002) trade should be higher under fixed regimes since
exchange rate volatility and uncertainty will be lower, which will tend to
reduce the cost of trade and hence increase its volume.
To Corden (2002) every country has
wide array of exchange rate regimes to choose from depending on the desired
degree of flexibility of the exchange rate regime and the nature of shocks
faced by the economy. He said that the good of an exchange rate regime is
optimization of output stabilization. Where the shocks are predominantly
external such as terms of trade shocks, necessitating changes in relative
prices, then flexibility in the exchange rate is most desirable because it’s
the real exchange rate. However, where the shocks are mainly domestically
induced through growth in monetary aggregate a flexible exchange rate would not
be an ideal policy. Here, a proffered option would be a fixed exchange rate
regime as money supply becomes an endogenous variable under a fixed exchange
rate regime and triggers of an automatic adjustment mechanism that adjust to
the shocks in money demand with minimal impact on growth (Celasun: 2003).
Aizenman (1994) has argued that
exchange rate regime can influence economic growth through their effect on the
rate of physical capital accumulation. This position finds supports in Edwards
(1993) who argues that investment will tend to be higher under a fixed exchange
rate variability. An exchange rate regime as a result of reduction in policy
uncertainties, real interest rates and exchange rate regime could therefore
influence growth through its effect on the level of development and financial
market. According to an economic and financial review of the central bank of
Nigeria presented by the external sector division of its. Research department
in September 2003. Labour market efficiency ensures that the normal exchange
rate will adequately address the real shocks to the economy. Where real wages
are flexible and there is a low pass through of changes in the nominal exchange
rate to domestic price levels, movement in the nominal exchange rate will
translate into change rate. Where wages are rapid and there is high mobility of
labour between sector across regions. The costs associated with exchange rate
rigidity are quite high. Moreover, a well-diversified economy lowers the cost
of exchange rate rigidity as the associated costs are more diversely
distributed among the sectors of the economy and a shock to any one sector is
insignificant to the balance of overall output of the economy.
The United Nations economic
commission for Africa (UNECA) in its report little exchange rate management
policies in Africa: Recent experience and prospects, (2002), opined that among
the policy challenges facing many monetary authorities in African countries are
exchange rate managements. This report went further to reveal that many of
these countries have moved liberalized their exchange systems and a number have
adopted a “managed floating exchange rate regime” or an in dependently floating
exchange rate by African countries has not been without its challenges and
problems. Indeed, the need to change the institutional and regulatory framework
and to develop well functioning foreign exchange markets of the countries.
Furthermore, the need to understand
and appreciate the impact of exchange rate liberalization of external stability
of currencies, on inflation, supply response and external competitiveness are
also some of the challenges that African governments and policy matters have to
deal with.
Ojo (1990) is of the view that one
appropriate exchange rate will tend to maintain equilibrium in the inflow and
outflow of foreign exchange in the economy while an inappropriate exchange rate
policy, for instance under the over-valuation of the currency will tend to
create instability in the foreign exchange market and make foreign exchange
management more difficult. Obadan (1995) asserts that the desirability of
exchange rate stability is not doubt in view of the implication of instability
for micro and macroeconomic planning and projections and foreign investment
flows.
In terms of volatility of rates,
most countries have intervened in foreign exchange market in order to influence
their exchange rates. This is simply because volatility in market fundamentals
such as money supply income and interest affects exchange rate volatility
because the exchange rate is a function of these fundamental. Large changes in
money supply lead to change (wide swings) in the level of the exchange rate
volatility (Bonser, 1996:44). Regardless of the origin of volatility, it could
impede international investment flows by reducing investment in foreign
financial assets and disrupting the efficient allocation of resources by
creating disincentive for movement in investment capital. Therefore, countries
that intervene in the foreign exchange rate volatility through the reduction of
expected volatility of future market fundaments and policies, and reduction of the
likelihood of speculative exchange rate movement.
However Nnanna (2003) is of the view
that although the flexible exchange rates has a number of advantage including
output stabilization that should ordinarily endure it over the fixed exchange
rate regime, exchange rate pegs are rather common amongst small open economy
because of the pass through effects of exchange rates movement into domestic
prices, issues bordering on credibility, and the associated risks of unfledged
foreign currency liabilities given incessant exchange rate volatility. The
thinness of the foreign exchange markets in developing countries makes the
likelihood of excessive volatility eminent, while the shallowness of the
financial.
Obaseki (1998) explains that the
equilibrium exchange rate is the desired level of the rate that ensures the
simultaneous attainment of internal and external balance. Internal balance
reflects a low inflationary variability and competitiveness on account of
adequate accommodating capital flows to finance imbalances in the current
accounts. Thus, the achievement of a high and sustainable rate of domestic
economic growth in addition to price stability and external sector
competitiveness amount to the attainment of internal and external balance. The
exchange rate at which this is attained is the equilibrium exchange rate.