The value of a currency is not just the exchange rate
The Sunday Nation
Nairobi,
05 February 2012
Josphat Mulama is wondering about the value of money. He writes “Apart from the exchange rate, does our shilling change value? I ask because I have always wondered about the value of the US dollar. We value our shilling against the dollar, but what do the Americans use as a ‘yard-stick’? When the exchange rate moves from Sh85 to Sh100 per dollar, is it the shilling that has weakened or the dollar that has strengthened?”
This is a misleading question because it is based on a faulty assumption. It is not entirely true that “we value our shilling against the US dollar”. If you look at the foreign exchange page of the daily newspapers, you will see that many other currencies are listed and their shilling values also given.
However, since most of our imports are paid for in US dollars, this is the currency that gets prominence in press reports. Indeed, it is not uncommon to find the shilling weakening against one currency, say, the US dollar while strengthening against another, say, the euro.
In addition, we import more commodities than we export, therefore, more often than not, we are buying foreign currency and not selling. This is the reason why many people (Josphat included) think that we use the foreign currencies as a yard-stick to value our shilling.
The value of a currency is not simply the exchange rate. It is a combination of many factors including its purchasing power in the home country. I discussed that matter at length in a past article (April 2007).
Still, even in its home country, the value of a currency does change with time. This is due to inflation, that is, the continuous rise in the prices of commodities. Some economists contend that inflation is necessary for economic growth…but that’s story for another day.
Suppose that today you can buy 100 pieces of a certain product for Sh10. If the inflation rate is 10 per cent, then the same 100 pieces will cost you Sh11 in one year’s time.
Now if you only have Sh10 next year, how many pieces will you be able to buy? Well, Sh11 buys 100 pieces, therefore, one shilling will get you 9.1 (100 divided by 11 = 9.09). So if you have Sh10, you will get only 91 pieces instead of the 100 that you would have bought a year earlier.
Clearly the value of the shilling has gone down – it now buys fewer items. But by what percentage: 10? The value of Sh10 in this example has dropped from 100 pieces to 91. Therefore, the change is 9 pieces and this is equivalent to 9 per cent of the original value.
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