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Explain what is meant by a semi-fixed exchange rate? With reference to the BBC news story in the link below, explain why the Nigerian central bank increased interest rates and devalued their currency (the naira)?

http://www.bbc.co.uk/news/business-30196496

 

An exchange rate is the price of one currency in terms of another. When this rate is semi-fixed the exchange rate is allowed to fluctuate between a specified range before an institution, usually a central bank, will intervene.

Should the exchange rate deviate from this institution has two main mechanisms at their disposable: Interest rates and foreign currency reserves.

The Nigerian central bank operates the naira on a semi-fixed exchange rate system with the target band of the naira being 160-176 NGN to the dollar.

Falling oil prices are likely to apply downward pressure on the naira as this currency is used to pay for the oil Nigeria exports. As such, when the price of oil goes down less naira is required to purchase the oil which means that the demand for the currency will fall in the short term. The extent to which the demand falls depends on how large a proportion of total export value oil is. The larger it is the greater this fall in demand will be. Falling currency demand, just like for other markets, leads to a fall in the price/value of the Naira.

From the news story we read that this led to the central bank increasing interest rates and intervening in the forex markets with reserves. It increased interest rates as this could offset the depreciation occurring due to the falling oil prices. Higher interest rates increase hot money flows (the flow of money into a county due to the better return on savings or investments) which drive up demand for the currency. The extent to which this appreciates the currency depends on the size of the increase in interest rates and the magnitude of interest rates relative to other nations. This was used in addition to the foreign currency that is held by the central bank. Foreign currency can be used to purchase Naira therefore boosting demand, just like higher interest rates.

Secondly, we can determine that both higher interest rates and the use of foreign currency reserves was not offsetting the fall in value the Naira was experiencing. The central bank reduced the semi-fixed range to 150-160. This range is likely closer to the market equilibrium as there is less downside pressure on the currency. Less pressure means that the higher interest rates in tandem with some intervention in the forex market will now be able to restore stability to the Nigerian Naira.

 

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