Saudi Electronic University Currency Pegging Discussion Paper

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While Saudi Arabia seeks to diversify its economy, the Saudi economy is dominated by the petroleum sector. In addition, the Saudi Arabian Riyal (SAR) is pegged to the U.S. Dollar. For this week’s discussion, please answer the following questions:

What are the advantages and disadvantages of the pegged exchange rate? Highlighted your answer in yellow .

Analyze the effect on the economy of Saudi Arabia (GDP, interest rates, inflation, and trade balance) given two scenarios when there is a dramatically declining world oil price or a dramatically increasing world oil price. Highlight your answer in red, and separated the required two scenarios in blue. Using tables in the  analyze is appreciated. 

Directions:

  • Your essay is required to be 6 to 7 pages in length, which does not include the title page and reference pages, which are never a part of the content minimum requirements.
  • Support your submission with course material concepts, principles, and theories from the textbook and at least three scholarly, peer-reviewed journal articles. VERY IMPORTANT; highlight your support by underlines. https://www.sciencedirect.com/science/article/pii/...   Attached another materials ( Which is the most important ).


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INTERNATIONAL ECONOMICS SEVENTEENTH EDITION ROBERT J. CARBAUGH © 2019 Cengage. All rights reserved. 1 Chapter 12 Exchange Rate Determination © 2019 Cengage. All rights reserved. 2 Chapter Outline What Determines Exchange Rates? Determining Long-Run Exchange Rates Inflation Rates, Purchasing Power Parity, and Long-Run Exchange Rates Determining Short-Run Exchange Rates: The Asset-Market Approach Exchange-Rate Overshooting Forecasting Foreign-Exchange Rates © 2019 Cengage. All rights reserved. 3 What Determines Exchange Rates? (1 of 3) Factors that cause the supply-and-demand schedules of currencies to change • Market fundamentals (economic variables) • Productivity, inflation rates, real-interest rates, consumer preferences, and government trade policy • Market expectations • News about future market fundamentals • Traders’ opinions about future exchange rates © 2019 Cengage. All rights reserved. 4 What Determines Exchange Rates? (2 of 3) • Factors affecting exchange rates • Short run: transfers of assets • Differences in real-interest rates and shifting expectations of future exchange rates • Medium run: cyclical factors • Fluctuations in economic activity • Long run: flows of goods, services, and investment capital • Inflation rates, investment profitability, consumer tastes, productivity, and government trade policy © 2019 Cengage. All rights reserved. 5 What Determines Exchange Rates? (3 of 3) © 2019 Cengage. All rights reserved. 6 Determining Long-Run Exchange Rates (1 of 5) Exchange rate changes • Reactions of traders in foreign-exchange market to changes in four key factors: • Relative price levels • Relative productivity levels • Preferences for domestic or foreign goods • Trade barriers © 2019 Cengage. All rights reserved. 7 Determining Long-Run Exchange Rates (2 of 5) TABLE 12.1 Determinants of the Dollar’s Exchange Rate in the Long Run Factor* Change Effect on the Dollar’s Exchange Rate U.S. price level Increase Decrease Depreciation Appreciation U.S. productivity Increase Decrease Appreciation Depreciation U.S. preferences Increase Decrease Depreciation Appreciation U.S. trade barriers Increase Decrease Appreciation Depreciation *Relative to other countries. The analysis for a change in one determinant assumes that the other determinants are unchanged. © 2019 Cengage. All rights reserved. 8 Determining Long-Run Exchange Rates (3 of 5) • Relative Productivity Levels • Increase in U.S. price level leads to increase in demand for foreign currency, decrease in supply of foreign currency, and depreciation of dollar • Decrease in U.S. price level leads to decrease in demand for foreign currency, increase in supply of foreign currency, and appreciation of dollar © 2019 Cengage. All rights reserved. 9 Determining Long-Run Exchange Rates (4 of 5) • Preferences for Domestic or Foreign Goods • Increased demand for U.S. exports and appreciation of dollar • Increased demand for U.S. imports and depreciation of dollar • U.S. imposes trade barriers • Appreciation of dollar © 2019 Cengage. All rights reserved. 10 Determining Long-Run Exchange Rates (5 of 5) © 2019 Cengage. All rights reserved. 11 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (1 of 13) Law of One Price • Identical goods should be sold everywhere at same price when converted to common currency, assuming it is costless to ship goods between nations, there are no barriers to trade, and markets are competitive • Prevailing market-exchange rate is the true equilibrium rate © 2019 Cengage. All rights reserved. 12 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (2 of 13) • Burgeromics: The Big Mac Index and the Law of One Price • Attempt to measure the true equilibrium value of a currency based on one product, the Big Mac • Can be used to determine extent to which market-exchange rate differs from true equilibrium-exchange rate • Big Mac prices show law of one price does not hold across countries © 2019 Cengage. All rights reserved. 13 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (3 of 13) TABLE 12.2 Big Mac Index, 2017 Country/Currency Price of Big Mac in Local Currency Price of Big Mac in U.S. Dollars* Local Currency Overvaluation (+) Undervaluation (−) (percent) United States (dollar) $5.06 $5.06 — Switzerland (franc) 6.50 6.35 25.5 Norway (krone) 49.0 5.67 12.1 Sweden (krona) 48.0 5.26 4.0 Canada (dollar) 5.98 4.51 −10.9 Euro Area (euro) 3.88 4.06 −19.7 China (yuan) 19.6 2.83 −44.1 Mexico (peso) 49.0 2.23 −55.9 *At market exchange rate, January 12, 2017. The price in each country is based on the average of four cities. Source: From “Big Mac Currencies,” The Economist, available at http://www.economist.com. © 2019 Cengage. All rights reserved. 14 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (4 of 13) • Purchasing Power Parity • Theory that exchange rates adjust to make goods and services cost same everywhere • Application of law of one price © 2019 Cengage. All rights reserved. 15 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (5 of 13) • Purchasing Power Parity • If the rate of inflation is much higher in one country • Its money has lost purchasing power over domestic goods • Currency should depreciate to restore parity with prices of goods abroad © 2019 Cengage. All rights reserved. 16 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (6 of 13) TABLE 12.3 The Law of One Price Applied to a Single Product—Steel According to the law of one price, if the yen price of steel increases by 10 percent and the dollar price of steel remains constant, the yen will depreciate by 10 percent against the dollar to ensure that price is the same in both countries. Dollar Price of a Ton of Steel Exchange Rate: Yen per Dollar 50,000 yen 500 100 55,000 500 110 Yen Price of a Ton of Steel © 2019 Cengage. All rights reserved. 17 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (7 of 13) • Purchasing Power Parity(cont’d) • Trade flows are mechanism that makes a currency depreciate or appreciate • Changes in relative national price levels determine changes in exchange rates over long term © 2019 Cengage. All rights reserved. 18 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (8 of 13) • Purchasing Power Parity (cont’d) • Foreign-exchange value of currency tends to appreciate or depreciate at rate equal to difference between foreign and domestic inflation • Changes in relative national price levels • Determine changes in exchange rates, long term © 2019 Cengage. All rights reserved. 19 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (9 of 13) • Purchasing Power Parity (cont’d) • A currency is expected to depreciate by amount equal to the excess of domestic inflation over foreign inflation • A currency is expected to appreciate by amount equal to excess of foreign inflation over domestic inflation © 2019 Cengage. All rights reserved. 20 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (10 of 13) • Purchasing Power Parity (cont’d.) • Used to predict long-term exchange rates • P - price indexes of U.S. and Switzerland • 0 - base period • 1 - period 1 • S0 - equilibrium exchange rate in base period • S1 - estimated target at which actual rate should be in the future S1 = S0 PUS1 PUS0 PS1 PS0 © 2019 Cengage. All rights reserved. 21 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (11 of 13) • Purchasing Power Parity (cont’d.) • Exchange-rate movements may be influenced by investment flows • Problems • Choosing appropriate price index to be used in price calculations • Determining equilibrium period to use as base © 2019 Cengage. All rights reserved. 22 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (12 of 13) • Purchasing Power Parity (cont’d.) • Government policy may interfere with operation of theory • Forecasting exchange rates appropriate in long run; poor forecasters in short run © 2019 Cengage. All rights reserved. 23 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (13 of 13) © 2019 Cengage. All rights reserved. 24 Determining Short-Run Exchange Rates: The Asset-Market Approach (1 of 9) Foreign-exchange market activity • Dominated by investors in assets • Treasury securities, corporate bonds, bank accounts, stocks, and real property Asset-market approach • Investors decide between domestic and foreign investments based on • Relative levels of interest rates • Expected changes in exchange rate itself over term of investment © 2019 Cengage. All rights reserved. 25 Determining Short-Run Exchange Rates: The Asset-Market Approach (2 of 9) TABLE 12.4 Determinants of the Dollar’s Exchange Rate against the Pound in the Short Run Change in Determinant* Repositioning of International Financial Investment Effect on Dollar’s Exchange Rate Increase Toward dollar-denominated assets Appreciates Decrease Toward pound-denominated assets Depreciates Increase Toward pound-denominated assets Depreciates Decrease Toward dollar-denominated assets Appreciates Appreciate Toward dollar-denominated assets Appreciates Depreciate Toward pound-denominated assets Depreciates U.S. Interest Rate British Interest Rate Expected Future Change in the Dollar’s Exchange Rate *The analysis for a change in one determinant assumes that the other determinants are unchanged. © 2019 Cengage. All rights reserved. 26 Determining Short-Run Exchange Rates: The Asset-Market Approach (3 of 9) • Relative Levels of Interest Rates • Level of nominal interest rate is first approximation of rate of return on assets that can be earned in a particular country • Differences in level of nominal interest rates between economies • Likely to affect international investment flows as investors seek highest rate of return © 2019 Cengage. All rights reserved. 27 Determining Short-Run Exchange Rates: The Asset-Market Approach (4 of 9) • Relative Levels of Interest Rates (cont’d) • If interest rates in U.S. > rates abroad • Increase in demand for dollars • Dollar appreciation • If interest rates in U.S. < rates abroad • Decrease in demand for dollars • Dollar depreciation • Real-interest rate • Nominal-interest rate minus inflation rate © 2019 Cengage. All rights reserved. 28 Determining Short-Run Exchange Rates: The Asset-Market Approach (5 of 9) © 2019 Cengage. All rights reserved. 29 Determining Short-Run Exchange Rates: The Asset-Market Approach (6 of 9) TABLE 12.5 Nominal and Real Interest Rates, April 2017 Country Nominal Interest Rate* (percent) Inflation Rate** (percent) Real Interest Rate (percent) Greece 6.7 0.8 5.9 Russia 8.1 4.5 3.6 South Africa 8.8 5.7 3.1 Indonesia 7.0 4.3 2.7 United States 2.2 2.4 −0.2 Canada 1.5 1.9 −0.4 Euro Area 0.2 1.6 −1.4 Venezuela 10.4 56.2 −45.8 *Rates are for 10-year government bonds. **Measured by the Consumer Price Index for the latest three months. Source: From The Economist, “Economic and Financial Indicators,” April 22, 2017. See also International Monetary Fund, International Financial Statistics, and World Bank, Data and Statistics, available at www.data.worldbank.org. © 2019 Cengage. All rights reserved. 30 Determining Short-Run Exchange Rates: The Asset-Market Approach (7 of 9) • Expected Change in the Exchange Rate • Future expectations of appreciation of dollar can be self-fulfilling for today’s value of the dollar © 2019 Cengage. All rights reserved. 31 Determining Short-Run Exchange Rates: The Asset-Market Approach (8 of 9) © 2019 Cengage. All rights reserved. 32 Determining Short-Run Exchange Rates: The Asset-Market Approach (9 of 9) • Diversification, Safe Havens, & Investment Flows • Relative levels of interest rates strongly impact investment flows • Other factors affecting investment flows among economies • Size of stock of assets denominated in a particular currency in investor portfolios may induce change in investor preferences for diversification purposes • Safe-haven effect: investors may be willing to sacrifice return for safe repository for their funds © 2019 Cengage. All rights reserved. 33 Exchange-Rate Overshooting (1 of 4) Exchange-Rate Overshooting • Short-run response (depreciation or appreciation) to change in market fundamentals is greater than its long-run response • Changes in market fundamentals exert a disproportionately large short-run impact on exchange rates © 2019 Cengage. All rights reserved. 34 Exchange-Rate Overshooting (2 of 4) • Exchange-Rate Overshooting (cont’d) • Helps explain why exchange rates depreciate or appreciate so sharply from day to day • Volatility of exchange rates intensified by overshooting © 2019 Cengage. All rights reserved. 35 Exchange-Rate Overshooting (3 of 4) • Exchange-Rate Overshooting (cont’d) • Overshooting explained by: • Tendency of elasticities to be smaller in short run than in long run • Ex. (Figure 12.6): Increased demand for pounds leads to initial pound appreciation (dollar depreciation); with U.S. prices lower, quantity of pounds supplied increases over time, dampening the initial pound appreciation • Exchange rates tend to be more flexible than many other prices, which are often written into long-term contracts © 2019 Cengage. All rights reserved. 36 Exchange-Rate Overshooting (4 of 4) © 2019 Cengage. All rights reserved. 37 Forecasting ForeignExchange Rates (1 of 9) Forecasting exchange rates • Very tricky, especially in short run • Necessary for exporters, importers, investors, bankers, and foreign-exchange dealers • Choosing currency in which to make deposits requires idea of what currency’s value will be • Decisions about foreign investment necessitate awareness of where exchange rates will move over time • Need for exchange rate forecasting resulted in emergence of consulting firms © 2019 Cengage. All rights reserved. 38 Forecasting ForeignExchange Rates (2 of 9) • Judgmental forecasts • Subjective or common sense models require • Wide array of political and economic data • Interpretation of these data in terms of timing, direction, and magnitude of exchange-rate changes • Projections based on thorough examination of individual nations • Based on economic indicators, political factors, technical factors, psychological factors © 2019 Cengage. All rights reserved. 39 Forecasting ForeignExchange Rates (3 of 9) • Technical forecasts • Involve use of historical exchange-rate data to estimate future values • Ignore economic and political determinants of exchange-rate movements • Founded on idea that “history repeats itself” • Used to analyze short-run movements of exchange rates © 2019 Cengage. All rights reserved. 40 Forecasting ForeignExchange Rates (4 of 9) TABLE 12.7 Exchange Rate Forecasters Forecasting Organization Methodology Horizon Global Insights Econometric 24 months JPMorgan Chase Judgmental Under 12 months Econometric Over 12 months Econometric Over 12 months Technical Under 12 months Technical Under 12 months Econometric Over 12 months Judgmental 8 months Econometric 12 months Bank of America Goldman Sachs UBS Global Asset Management Source: Data collected by author. © 2019 Cengage. All rights reserved. 41 Forecasting ForeignExchange Rates (5 of 9) © 2019 Cengage. All rights reserved. 42 Forecasting ForeignExchange Rates (6 of 9) • Fundamental Analysis • Opposite of technical analysis • Considers economic variables likely to affect supply and demand of a currency • Uses statistical estimations of economic theories • Attempts to incorporate fundamental variables that underlie exchange-rate movements • Interest rates, balance of trade, productivity, inflation rates © 2019 Cengage. All rights reserved. 43 Forecasting ForeignExchange Rates (7 of 9) • Limitations of econometric models used to forecast exchange rates • Rely on predictions of key economic variables for which reliable information may be hard to obtain • Some factors affecting exchange rates cannot easily be quantified • Precise timing of factor’s effect on currency’s exchange rate may be unclear • Currency traders generally prefer technical to fundamental analysis; most forecasters use combination of fundamental, technical, judgmental analysis © 2019 Cengage. All rights reserved. 44 Forecasting ForeignExchange Rates (8 of 9) • Econometric models best suited for forecasting long-run trends in the movement of an exchange rate • Models do not generally provide foreign currency traders precise price information regarding when to purchase or sell a particular currency • Currency traders generally prefer technical to fundamental analysis; most forecasters use combination of fundamental, technical, judgmental analysis © 2019 Cengage. All rights reserved. 45 Forecasting ForeignExchange Rates (9 of 9) • Exchange-Rate Misalignment • Deviation of exchange rate from fundamental value • Has implications for country’s trade position and job creation • Undervalued currency gives country trade advantage at expense of trading partners • Undervaluation widely considered unfair; however, there’s no sure way to estimate correct value of currency and thus determine extent of undervaluation © 2019 Cengage. All rights reserved. 46
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1

Currency Pegging.

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2

Advantages and disadvantages of the pegged exchange rate.
Currency pegging is the fixing or indexing of the exchange rates of one currency against
another currency which is a macroeconomic activity that objects to abridging international
trade and lessening the rates of inflation of the pegged currency. The central bank of Saudi
Arabia pegged the Saudi Riyal currency against the U.S. dollar. In order to maintain and sustain
the pegging of a local currency, the central bank has to trade its local currency with the pegged
currency and maintain a large reserve of the pegged currency to enable it to control the supply
of its currency (Althibani et al., 2020). The Central Bank of Saudi Arabia (SAMA) has set the
rate of the riyal to the dollar at 3.75 for more than 20 years. This action was taken to stabilize
the riyal's external and internal values. SAMA decided on the dollar due to its widespread use
in international oil transactions.
The value of all circulating printed riyals must be covered by adequate "foreign
exchange convertible to gold," which is mostly short-term U.S. dollar measures. The riyal's
pegging to the U.S. dollar has become successful in "helping the economic expansion."
Althibani (2020) argued that the nation's inflation has been kept under control. The pegged
riyal is under pressure due to changes in the price of oil on the global market. For instance, the
price of oil decreased globally in 1993. The issue of budget deficits was also a concern. This
led to predictions that the value of the riyal would decrease. Similar events occurred in 1998
and 1999 as a result of a drop in oil prices and the economic crisis in Turkey (Arbaa & Varon,
2019).
Recently, SAMA reaffirmed its dedication to its strategic decision to peg the Saudi riyal
to the U.S. dollar. It said the currency pegging has helped Saudi Arabia's whole economy to
expand for over three decades. The pegging has also proved that maintaining the official
currency exchange rates of 3.75 riyals to the U.S. dollar served as a pillar of economic and

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monetary stability (Belanes et al., 2022). Additionally, it noted that the Saudi Arabia’s foreign
currency exchange reserves were still adequate to meet all financial demands, cover imports
for fourty-three months, and also account for 88 percent of comprehensive money. The
Kingdom has aided the nation in achieving sustainable economic growth, managing inflation,
and maintaining financial and monetary stability by implementing a standing polic...


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