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Functional Finance for Fixed Exchange Rate Economies


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Roundtable on Post Keynesian Approaches to MENA Economics session at 12th International Conference

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Functional Finance for Fixed Exchange Rate Economies

  1. 1. FUNCTIONAL FINANCE FOR FIXED EXCHANGE RATE ECONOMIES SHAMA AZAD University of Missouri-Kansas City Binzagr Institute for Sustainable Prosperity
  2. 2. FIXED EXCHANGE RATE REGIMES  Countries on a fixed exchange rate must ensure that they have sufficient reserves in order to deficit spend.  The outstanding units of currency must be backed by foreign exchange reserves.  Interest rates in such countries cannot be set independently.  Factors that determine the rate at which governments borrow money include the market’s assessment of the country’s creditworthiness and the country’s requirements to maintain its peg.
  3. 3. TWO OPTIONS FOR GOVERNMENT SPENDING  SPENDING BY ISSUING CURRENCY The risk here is that the outstanding units of currency must be converted on demand to the reserve currency unit.  SPENDING BY BORROWING The bank reserves are preserved and the government is less likely to default on its conversion requirements, but the interest rate for borrowing is set by the market. Market forces determine the ‘indifference’ levels in choosing between the two financing options. This is different from flexible exchange rate economies where the interest rate is set by the Central Bank.
  4. 4. PURSUING POLICIES IN COUNTRIES WITH FIXED EXCHANGE RATES  Countries on pegged exchange rates have relatively limited policy space.  These countries are only able to issue currency in accordance with the amounts of foreign exchange reserves they hold and their legal conversion requirements.  They do not have a ‘free hand’ in undertaking government spending to meet policy goals such as full employment, price stability and other economic welfare goals.
  5. 5. COUNTRIES THAT HOLD SUFFICIENT RESERVES What if a nation on a fixed exchange rate system has ample reserves?  Such countries are more likely to be able to maintain their exchange rate peg.  They also run a lower risk of defaulting on their legally binding conversion requirements.  If their reserve levels are greater than those required for maintaining their peg, they have a greater ability to spend through issuing currency.
  6. 6. IMPLICATIONS FOR MEETING POLICY GOALS  Countries with more than sufficient currency reserves have more fiscal policy space.  They have a greater degree of freedom to undertake government spending by running deficits.  They have more independence in pursuing goals such as full employment and economic welfare programs, such as JG schemes, investment in infrastructure, education programs, etc.
  7. 7. IMPLICATIONS FOR INTEREST RATES  Markets will also view countries that have greater than required foreign exchange reserves differently.  Interest rates are likely to be lower for such countries as their risk of default is perceived to be lower.  This could also mean that they are in a better position to undertake government spending through borrowing.
  8. 8. EXAMPLE: Saudi Arabia  The country’s currency has been pegged to the US dollar at a rate of 3.7500 since 1986.  Major exporter of oil in the world market.  Oil revenues are the greatest source of foreign exchange reserves, making up 87% of total revenues between 2003 to 2011.  Oil revenues have seen a general upward trend since 2003.  Levels of foreign exchange reserves have also been on a steady incline since 2003.
  9. 9. RISING FOREIGN EXCHANGE RESERVES IN SAUDI ARABIA 1,400,000 1,200,000 1,000,000 800,000 600,000 400,000 200,000 0 Oil Revenues (Million Riyals) Oil Revenues (Million Riyals) Saudi Arabian Foreign Exchange 800,000,000,000 700,000,000,000 600,000,000,000 500,000,000,000 400,000,000,000 300,000,000,000 200,000,000,000 100,000,000,000 0 Reserves (Current US$) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Saudi Arabian Foreign Exchange Reserves (Current US$) Source (TOP): SAMA 44th, 45th & 49th Annual Reports. 2008, 2009, 2013. Source (LEFT): World Bank Data on Total Reserves in Saudi Arabia (including gold, current US$). RES.TOTL.CD
  10. 10. MEETING POLICY GOALS With rising foreign exchange reserves, the country has a greater ability to increase their level of deficit spending.  Large foreign exchange reserves provide the country with more independence and greater fiscal policy space.  Can address multiple economic and social issues with a greater ability to deficit spend.
  11. 11. APPLICATION OF FUNCTIONAL FINANCE  Can we apply the laws of functional finance to a country such as Saudi Arabia?  If private spending is insufficient, public spending can fill the gaps.  With more flexibility in the country’s ability to run deficits, the government in to ensure price stability.
  12. 12. DAILY AVERAGE OIL PRODUCTION (MIILLION BARREL) 10 9.5 9 8.5 8 7.5 7 2004 2005 2006 2007 2008 2009 2010 2011 2012 Daily Avg Oil Production (Million Barrel) Source (TOP): SAMA 44th, 45th & 49th Annual Reports. 2008, 2009, 2013.
  13. 13. PREPARING FOR THE FUTURE  Daily average oil production per barrel has not fallen below 8 million in the last decade.  Proven reserves of crude oil stand at 265.9 billion barrels.  Proven reserves of natural gas are 290.8 trillion standard cubic feet. With these levels, the country is expected to be a major exporter of oil and gas for several decades to come.