The adjustment process in the United States

The adjustment process in the United States

Attached two chapters of the course which are 7 & 8 if its possible to use most of the sources from books, dissertations or academic journals … I have put 40 sources if the writer could put them all that’s good if he can’t meet the number at least 35 sources as per the instructions the writer should do the following:

1- Introduction:

A theoretical background about the case !

Chapter 07 gives you theoretical discussion that you should summarize in the beginning of your work, i.e., the theoretical background means the theory on which the case can be applied.

2- Facts of the case study :

Discuss the facts of the case

?3- Implement the case facts and theory to one of GCC markets:

There is no trade deficit in GCC countries in order to apply the US case on. So, either you look for any country in MENA region to apply the U.S. case on or you just go deep in the U.S. case itself.

4- Conclusion:

This part will be a summary about the case and the theory

5- Recommendation:?
opinions and recommendations on the case

the case and the chapters will be uploaded shortly


Inestic price of for- I more attractive. While this is an accurate description of the general pattern,

3119)’ 18.51 trade bar- . depreciations often have delayed effects. In the United States, for example, there

33fP31131V€- ” is a median average lag of about nine and a half months between a change in the

fiscal Or monetary ‘- exchange rate and an impact on U.S. exports. The median average lag for import

In most Cases» they responses is slightly less, but still more than seven months. Consequently, it is a

ise without Overall mistake to think that exchange rate changes will affect trade flows overnight.

‘CSUC expenditures In addition to the lag effects, the first impact of a depreciation on the current

lmducers For thi5 account may be a further deterioration rather than an improvement. This deteri-

l by 1‘€f?ll1CtioHS in oration is known as the J-curve, and is shown in Figure 11.6.

After a depreciation, there is usually a short period of no noticeable impact
nflat1onary,expen~ on the flow of goods and services. When imports and exports begin to respond,
r5°eS3101131’Y- This ” the immediate change is an increase in the value of imports, pushing the current
E loW3Yd doH1€StiC account balance deeper into deficit. The size of the deterioration and the length
my With thfi 531116 – _ of time before there is an actual improvement varies from country to country. In
L new to use both ‘ 3; the United States, a depreciation results in an improvement in the trade balance
enditure shifts are only after a year or more. The reasons are straightforward. A depreciation
7 Essential ‘3omPo- makes foreign goods immediately more expensive, but it takes time for house-
zcount deficit. holds and businesses to find substitutes. In the short-rnn they lack information,

1 and it takes time to find new suppliers in the domestic economy, to check the
quality of their products, and to negotiate contracts. Meanwhile, until the alter-
trade deficit that . ‘ native suppliers are found, foreign goods continue to be “used even though they
33 that a depreCi_ _ cost more.
stitutes relatively

From the third quarter of 1980 to mid-1987, the U.S. trade deficit widened from
0.48 percent of GDP to over 3.5 percent of GDP. In 1985, the Plaza Accord
among the G5 (France, Germany, Japan, the United Sta_tes, and the United
=i,=..;-;fi,’-‘i Kingdom) created a cooperative effort to bring down the value of the dollar. The
dollar began to fall in early 1985 with the introduction of a new team of officials
at the Treasury Department; from January 1985 to January 1987, it fell from an
E :2″-.__ index of 152.83 to 101.13, ornearly 34 percent.
7 While the dollar was falling, the trade deficit continued to widen. This was unset-
Z” tling to a number of politicians, economists, and others, who had predicted a signifi-
T cant decline in the U. S. trade deficit as a result of the depreciation. Some journalists
and politicians began to argue that the trade deficit would never respond to a
lC’=’E’§.I change in the value of the dollar, that foreign trade barriers would make it impossi-
U ble for the United States to substantially expand exports, and that our own open
I ;_;’ market would ensure a growing volume of imports regardless of the dollar’s value.
ier. With time, ._f.3′;‘3. Nevertheless, after a little more than two years, the trade balance began



Chapter 07: National Income Accounting and the Balance of Payments (BOPs)
Consider an open economy with an income identity like the one we have discussed in macroeconomics: Y = C + I + G + EX – IM


The Current account and Foreign Indebtedness:-

The difference between exports (EX) of goods and services and imports (IM) of goods and services is known as Current Account Balance (CA). When a country’s imports exceed its exports, we say that the country has a current account deficit. A country has a current account surplus when its exports exceed its imports.

CA = EX – IM If: EX < IM ? CA Surplus If: EX < IM ? CA Deficit Since, EX – IM = CA

Y = C + I + G + CA
Expenditure by domestic individuals and institutions. Net Expenditure by foreign individuals and institutions

It follows that: Y – (C + I + G) = EX – IM = CA Y is the production and, (C + I + G) is domestic expenditure. So, if production > domestic expenditure ? EX > IM
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CA > 0.



? Trade Balance > 0. ? Trade Surplus. Such a country with trade surplus and, therefore, will tend to lend the surplus to foreigners. But, If production < Domestic expenditure ? EX < IM and CA < 0. ? Trade Balance < 0. In this case the economy is experiencing trade deficit and, therefore, it will tend to international Borrowing.

International lending and borrowing were identified with intertemporal trade in a previous chapter. A country with current account deficit is importing present consumption and exporting future consumption. A country with current account surplus is exporting present consumptions and importing future consumption.

When a country’s exports are less than its imports, it earns less income from exports than it spends on imports. So, net foreign wealth will decrease.

Saving and the current account:
National Saving is the portion of output, Y, which is not devoted to household consumption, C, or government purchases, G. In a closed economy, national saving always equals investment. Since in this closed economy: Y=C+I+G ? I=Y–C–G and in this economy: I=S ? I=Y–C–G While in a closed economy saving and investment must always be equal, in an open economy they can differ. Remembering that national saving, S , equals (Y – C – G) and that CA = EX – IM, we can rewrite the national income identity as:
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S = I + CA This equation highlights an important difference between open and closed economies: an open economy can save either by building up its capital stock OR by acquiring foreign wealth but a closed economy can save only by building up its capital stock. In an open economy, it is possible simultaneously to raise investment and foreign borrowing without changing saving. For example, if country A decides to build a new project, it can import the materials it needs from country B and borrow B’s funds to pay for them. This transaction raises A’s domestic investment because the imported materials contribute to expanding A’s capital stock. The transaction also raises A’s current account deficit by an amount equal to the increase in investment. A’s saving does not have change, even though investment rises, remember: S = I + CA. I ? : CA ? The result is another example of intertemporal trade, in which “A” imports present consumption (when it borrows from B) and exports future consumption (when it pays off the loan).

Private and Government Saving:
Unlike Private saving decisions, government saving’s decisions are often made with an eye toward their effect on output and employment.

Private saving is defined as the part of disposable income that is saved rather than consumed. Disposable income is national income, Y, less the net taxes collected from household and firms by the government, T. Private saving, denoted SP, can therefore be expressed as: Sp = Y – T – C The government’s income is its net tax revenue, T, while its consumption is government purchases, G. If we let Sg stands for government saving, then: Sg = T – G Thus: S = S p + Sg S=Y–C-G ,

Since :
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S = Y – C – G = ( Y – T –C) + (T – G) = SP + Sg S = Sp + Sg = I + CA, SP = I + CA – Sg = I + CA – (T – G) = I + CA + (G – T) OR: CA = SP – I – (G – T)


This equation relates private saving to domestic investment, the current account surplus, and government saving. This equation states that: a country’s private saving can take three forms: (i) investment in domestic capital (I), (ii) purchases of wealth from foreigners (CA), and (iii) purchases of the domestic government’s newly issued debt (G – T).


The Balance of Payments Accounts

Balance of payments is a detailed record of the composition of the current account balance and of the many transactions that finance it. It represents the net transactions with the external world. Any transactions resulting in a payment to foreigners is entered in the BOPs accounts as a debit and is given a negative (-) sign. Any transaction resulting in a receipt from foreigners is entered as a credit and is given a (+) sign. There are three Types of International Transactions recorded in the Balance of Payments:

1. Current Account: The Current Account measures all current, nonfinancial transactions between a country and the external world. The Current Account items are: (i) merchandise trade. That is, the value of goods and services exported less the value of goods and services imported; (ii) net investment income from abroad. That is, investment income from abroad less investment income outflow to foreigners; and (iii) current transfer. That is, net flow of foreign aid and of other current transfers. When Saudi customer imports Lebanese apple, for example, the transaction enters the Saudi BOPs accounts as a debit and as a credit in Lebanese BOPs on current account. 2. Financial Account: Transactions that involve the purchase or sale of financial assets are recorded in the BOPs under financial account. An asset is any one of the forms in which wealth can be held, such as money, stocks, factories, or government debt. When a Saudi company buys a Turkish factory, the transaction enters the Saudi BOPs as a debit in the financial account. This transaction seems like an import of assets (purchase of asset) and therefore enters the
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financial account with a negative sign. But if a Saudi company sells shares to Turkish company, the transaction enters the Saudi BOPs as a credit in the financial account.

3. Capital Account: Transactions of special activities or flows of special categories of assets (capital) which are typically resulting from non-market, non-produced, or intangible assets like debt forgiveness, copyrights and trade markets all are recorded in BOPs under capital accounts. All accounts of the BOPs are recorded on the base of the rule of double –entry bookkeeping: “every international transaction automatically enters the balance of payments twice, once as a credit and once as a debit”.

Example of Paired Transactions: 1. A Saudi citizen buys a typewriter from the Italian company Olivetti and pays for his purchase with a US $ 1000 check , which is deposited in Olivetti’s account in HSBC in Saudi Arabia this transaction will enter the Saudi BOPs by using double –entry principle as follows: Typewriter purchase (current account, good import) Sale of bank deposit by HSBC (Financial account , asset export) Credit +$1000 Debit – $1000

2. A US citizen travels in France and pays $200 for fine dinner in a French restaurant by his visa credit card. This transaction is recorded in US BOPs as follows: Meal purchase (current account, service import) Sale of claim on first card (financial account, US asset export) Credit +$200 debit – $200

The buyer’s signature on the visa slip entitled the restaurant to receive $200 from first card, the company that issued your visa card.

3. Suppose that the Saudi citizen Abo Ali buys a newly issued share of stock in the UK oil giant British Petroleum (BP). Abo Ali places his order with his stockbroker paying $ 95 with a check drawn on his stockbroker money market account .BP, in turn, deposits the $ 95 Abo Ali has paid in its own Saudi bank account at Al Belad Bank. Abo Ali’s acquisition of the stock creates a $ 95 debit in the Saudi financial account (he has purchased an asset from a
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foreign resident , BP), while BP’s $ 95 deposit in its bank account at Al Belad Bank is the offsetting financial account credit (BP has expanded its Saudi asset holdings). The Mirrorimage effects on the Saudi BOPs therefore both appear in the financial account:

Credit Abo Ali’s purchase of a share of BP, (Financial account, asset import) BP’s deposit of Abo Ali’s payment + $ 95 at Albelad Bank (Financial account, asset export)

Debit – $ 95

4. Imagine that the Japanese government forgives $ 5 million in debt owed to Japan by the government of Pakistan. In this case Japan makes a $ 5 million capital transfer to Pakistan, which appears as a -$ 5 million entry in Japan’s capital account. The associated credit is in the financial account of Japanese BOPs, in the form of a $ 5 million reduction in Japanese assets held abroad (a net asset “export”, and therefore a positive balance of payments entry):

Credit Japan’s debt forgiveness (capital account, Japanese transfer Payments) Reduction in Japanese claims on Pakistan (Financial account, Japanese asset export)

Debit – $ 5 million

+ $ 5 million

The Fundamental Balance of Payments Identity:
Because any international transaction automatically gives rise to two offsetting entries in the BOPs, the current account balance, the financial account balance, and the capital account balance automatically add up to zero: Current account + financial account + capital account = 0.

A Study of Saudi Arabian Balance of Payments in 2009: 1. Current Account:
Saudi ‘net exports’ of goods and services is measured by the current account balance. Saudi EXs and IMs in the BOPs are divided into three categories:

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(1) Trade Balance: (a) Merchandise trade: EXs and IMs of goods, including oil. (b) Services: Transportation, travel (tourism), insurance services, etc. (2) Income: Income is made up mostly of international interest and dividend payments (portfolio investments), direct investment (profits of domestically owned firms operating abroad), etc. (3) Current Transfers. Trade balance: As seen in the BOPs 2009’s appendix, Saudi EXs were $ 192.2 billion compared with $ 313.4 billion in 2008, a decline of 38.7% in 2009. Why? It was all about oil prices. Oil price fell from $ 95.2 /Barres in 2008 to $ 61.4 /Barred in 2009, a fall of 55%. Although IMs decreased from $ 100.6 billion in 2008 to $ 86.4 billion in 2009, goods EXs dropped from $ 212.01 billion in 2008 to $ 105.2 billion in 2009, because of the dramatic fall in oil exports. So, did the policymakers have had a contingency plan to offset the decline in oil prices? Did this fall in crude oil exports was faced by oil manufacturing products (SABIC petrochemicals)? Net investment income from abroad: The effect of economic and financial crisis that hit the US economy seems to have a negative effect on the Saudi net transactions, where the direct investment income inflow fell from $ 3.1 billion in 2008 to $ 2.3 billion in 2009. Current Transfer: (a) Government Current Transfers: The Third category of current account in KSA is current transfers. One of this is usually in form of unilateral transfers. In 2009, the Saudi balance of unilateral transfers (General government transfers) were Debit $ 1.92 billion, i.e., -$ 1.92 billion. This government transfer is generally defined as international gifts, that is, payments that do not correspond to the purchase of any good, service, or asset.

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(b) Remittances. Another very affecting form of current transfers is workers’ remittances. The workers’ remittances inflow is almost zero, whereas the workers’ remittances outflow is $ 25.2 billion in 2009, constituting huge outflow payments. The Saudi Current account surplus would have been doubled (or more) had the workers’ remittances outflow been zero in 2009.

2. and .3 Capital Account and Financial Account:
In the Saudi BOPs, capital account and financial account are combined together. Just as the current account is the difference between sales of goods and services to foreigners and purchases of goods and services from them, the financial account measures the difference between sales of assets to foreigners and purchases of assets located aboard. These assets are such as money (lending and borrowing), stocks (purchasing and selling of shares), factories (foreign direct investments), or government debt. Borrowings, for example, enter the financial account with a positive sign because the loan itself is a payment to the country that borrows money. Lending, on the other hand, is an outflow of money payments to a foreign country and, therefore, enters the financial account with a negative sign.

Capital and Financial Accounts in KSA includes: Net FDI (Inflow – Outflow), net portfolio investment (Inflow – Outflow) or (Assets – Liabilities), other investments (Assets – Liabilities), and reserve assets (which includes monetary gold, SDRs, reserve position in the fund, currency and deposit, and securities). These reserves are kept with SAMA as a cushion against national economic misfortunate. These foreign reserves, after deducting the outflow reserve assets, are $ 32.6 bn. in 2009.

4. Errors and Omissions:
Errors and omissions items in the BOPs are also called “The statistical Discrepancy”. Errors and Omissions items in KSA was $ 36.3 billion in 2009, which is relatively very huge reflecting less accuracy in BOPs calculations. BOPs identity in KSA as of 2009, then is:

$ 22.765 billion + $ 13.572 billion + Errors & Omissions = 0

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But: Current Account + capital of Financial Account = + $ 36.337 Therefore, Errors and Omissions = – $ 36.337.

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e balance. -_ respond to the fall in the dollar. Figure 11.7 shows the change in the value of the


Chapter 08: Exchange Rates and Exchange Rate Systems
1. INTRODUCTION One of macroeconomic key objectives is “Economics and Price Stability”. The term “Price” means all prices, such as the price of final product, price of factors of production, price of raw materials, price of shares in capital markets, and price of national currency. The term “Exchange Rate” refers to the price of national currency in terms of foreign currency (or currencies). 2.

Exchange Rate can be defined as the price of one currency in terms of another. For example, you need 3.75 Saudi Riyals to buy one unit of the US currency, the dollar, so the Riyal’s exchange rate against the UD dollar is 0.267 dollars per Riyal, or the dollar’s exchange rate against Saudi Riyal is 3.75 Saudi Riyals per dollar. The following Table shows the exchange of selected foreign currencies in terms of Saudi Riyal:
(Saudi Riyals) End of Period 2005 2006 2007 2008 2009 2010 2011 U.S. Dollar 3.7500 3.7500 3.7500 3.7500 3.7500 3.7500 3.7500 4.4239 4.9388 5.5095 5.2189 5.4022 4.9800 4.8521 EURO* Sterling Japanese Swiss Chinese Australian Indian Korean Brazilian Pound 6.4571 7.3612 7.4993 5.4668 6.0731 5.7881 5.7979 Yen 0.0318 0.0315 0.0329 0.0411 0.0409 0.0460 0.0483 Franc 2.8532 3.0730 3.3218 3.5254 3.6390 3.9911 3.9856 Yuan 0.4579 0.4804 0.5133 0.5500 0.5491 0.5666 0.5958 Dollar 2.7514 2.9674 3.2753 2.5980 3.3634 3.8138 3.8085 Rupees Won Real 1.6143 1.7466 2.0968 1.5834 2.1318 2.2600 2.0132

0.0832 0.0037 0.0850 0.0039 0.0952 0.0040 0.0772 0.0030 0.0806 0.0033 0.0837 0.0033 0.7073 0.0032

Source: Reuters. Important Note: You can see from the table in 2011, for example, that one Chinese Yuan is more valuable than Japanese Yen. It is a common mistake to interpret this to mean that the Yen is weaker than Yuan. Currencies are scales like kilometers and miles. It does not matter how many kilometers equal miles. So, we cannot take these scales to describe a currency weak or strong. The strength and weakness of currencies is measured by the tendency of their values against other currencies over time, and this is called as appreciation or depreciation of currency. Therefore: Appreciation of national currency is a rise in the value of that national currency against a foreign currency. For example, from the above Table, in 2010 the SR was appreciated against EURO, if compared with 2009. In other words, the EURO was depreciated
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against SR. That is, less units of national currency for one unit of foreign currency. In this case, we can conclude that the SR was strong against EURO in 2010. Depreciation of the national currency, on the other hand, means a fall in the value of national currency against foreign currency. For example, from the above Table, in 2009 the SR was depreciated against EURO, when compared with that in 2008, i.e., more Saudi Riyals (SR) for 1 EURO. In this case, it is clear that the SR was weak against EURO in 2008. The implication of appreciated national currency, considering Saudi Riyal, is that this appreciation in Saudi Riyal, ceteris paribus, makes Saudi products more expensive for foreigners (in foreign markets). In the same way the depreciation of Saudi Riyal, ceteris paribus, makes the Saudi products cheaper for foreigners (in foreign markets). For example, if a Saudi petrochemical product price (PX) is unchanged in 2009 and 2010 and equals SR 1000 in EU market, the EURO price of this product in 2010 (the year of Riyal’s appreciation) is equal to: PX in Saudi Riyal / the exchange rate of EURO against Saudi Riyal in 2010 = 1000/4.98 = € 200.8 But, in 2009 this product cost in terms of EURO was: PX in Saudi Riyal / the exchange rate of EURO against Saudi Riyal in 2009 = 1000/5.40 = € 185.2 Thus, it is very obvious that when the SR was appreciated (in 2010), the Saudi product (petrochemicals in our example) became more expensive for the Europeans. The following Table outlines the main factors (determinants) causing an appreciation or depreciation in different time horizons: Time Horizon R Falls: An Appreciation R Rises: A Depreciation in Domestic Currency in Domestic Currency Long-run: Purchasing Power Parity Medium-run: The Business Cycle Short-run 1: Interest Parity Short-run 2: Speculation Home products are cheaper Home products are more than foreign products expensive than foreign products Domestic economy grows Domestic economy grows more slowly than foreign faster than foreign economies economy Home interest rate rises, or Home interest rate falls, or foreign interest rate falls foreign interest rate rises Expectations of a future Expectations of a future appreciation depreciation



There various types of exchange rate regimes. Countries around the globe have to pick up the exchange rate regime (for their currencies) that best suits their economic and social
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conditions. Extremely, there are two types of exchange rate systems, namely Fixed Exchange Rate and Floating Exchange Rate. In between these two types, there are different innovations of exchange rate systems such as Crawling Pegs or Target Rate Zones. Fixed Exchange Rate Regime: is set and maintained by a country’s monetary authority or central bank (Saudi Arabian Monetary Agency in KSA). Under fixed exchange rate system, the value of a nation’s currency is defined in terms of s fixed amount of a commodity (e.g., gold) or in terms of a fixed amount of another currency (e.g., the U.S. dollar). Till the beginning of the 1970s, fixed exchange rates were the norm, and the amount of gold was the base to fixed exchange rate (Bretton Woods Exchange Rate System: 1947-1971). The Bretton Woods Exchange Rate System was based on gold standard governed by three rules: Rule I: Countries must fix the value of their currency unit (dollar, dinar, riyal, and so on) in terms of gold. U.S. dollar was fixed at $35 per ounce and the British. Pound was set at £12.5 per ounce. It follows that £1 = $2.8. As far as Saudi Arabian Economy is concerned, The Saudi Riyal was set at SR4.5 per U.S. dollar during 1950-1970. Rule II: Countries must maintain the supply of domestic money fixed in some constant proportion to their supply of gold. Rule III: Countries must stand ready to provide gold in exchange for their domestic currency. The collapse of Britton Woods System in early 1970s led to a new mechanism for fixed exchange rate which is called Pegged Exchange Rates. Pegged Exchange Rate Systems operate similarly to a gold standard except that instead of gold, another currency is used to anchor the value of home currency. Many countries nowadays adopt Pegged exchange rate such as Saudi Arabia, where the Saudi Riyal is pegged to U.S. dollar at SR3.75 per U.S. dollar. The problem with pegged-to-one currency exchange rate system is that the domestic currency will follow the appreciation and depreciation movements of its peg. For example, suppose that Saudi Arabia has huge exports to Japan and the Saudi Riyal as of now is pegged to U.S. dollar. If the dollar appreciates against the yen, then so does the riyal against yen, at the same rate. As a result the Saudi export competitiveness in Japanese market will deteriorate. Having said that, Japanese imports became cheaper for Saudis. To avoid the problem associated with pegged-to-one-currency exchange rate system, another type of fixed exchange rate regimes can be used, which is called Exchange Rate Pegged to A Basket of Foreign Currencies in which the domestic currency’s exchange rate is set based on a basket of foreign currencies, such as the Kuwaiti Dinar nowadays is pegged to a basket of foreign currencies. This will reduce the risk associated with depreciation or appreciation of the currency’s peg. The selection of foreign currencies to peg the home currency to them depends on the main trade partners with home country.
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The Exchange rate pegged to a basket of foreign currencies is constructed based on the Real Exchange Rate (Rr). Real Exchange Rate (Rn) can be defined as: The market exchange rate (or nominal exchange rate) adjusted for the price differences between countries in order to measure the purchasing power of domestic currency. Rr can be computed using the following equation: Rr = Rn (Pf / Ph) Where: Rr stands for real exchange rate of domestic currency, Rn is the nominal exchange rate: number of units of domestic currency per one unit of foreign currency, and Pf and Ph are the price level (price index such as CPI) in foreign country and home country, respectively. Note: if we reverse the nominal exchange rate by considering Rn is the number of units of foreign currency per one unit of domestic currency, in this case the equation will be revised as follows: Rr = Rn (Ph / Pf). Example: Suppose that the Saudi Riyal’s exchange rate is SR3.75 per 1 U.S. dollar and the price levels indicated by consumer price indexes (CPI) are 120 and 140 in KSA and U.S.A., respectively, then the real exchange rate of riyal will be computed as follows: Rr = 3.75(140/120) = 4.38. This result tells that the real exchange rate is greater than the nominal exchange rate, that is, the purchasing power of riyal is much less in U.S. than in Saudi Arabia. Now, if CPI is the same in the two countries, let it be 100, it follows that: Rr = 3.75(100/100) = SR3.75 per dollar. In this case, the nominal exchange rate is equal to real exchange rate, which is called Purchasing Power Parity (PPP). That is, the riyal buys the same quantity of a product in U.S. as in K.S.A. But, in order to maintain a certain degree of purchasing power parity, the real exchange rate must be managed. For example, if inflation rate increased in Saudi Arabia (higher CPI over time in Saudi Arabia), this will lead to a real appreciation of riyal. That is, Saudi producers are less competitive and U.S. producers are more so (in Saudi Arabia). Therefore, there must be a solution for such a problem of real appreciation of domestic currency. This solution can be made through the adoption of a Crawling Peg.

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Crawling Peg is fixed (pegged) exchange rate that is periodically adjusted for price differences. If correctly handled, the real exchange rate remains constant and the impact of inflation differences never be reflected on competitiveness. For example, if CPI in home increases, the monetary authority should increase the nominal exchange rate (number of units of domestic currency per a unit of foreign currency), and vice-versa.

Floating Exchange Rates Regime: is the completely flexible exchange rate system that is determined by the market forces of supply of and demand for currency. The following Table compares the advantages and disadvantages of fixed exchange rate and floating exchange rate:



The foreign exchange market is defined as the market in which exchange rate is determined based on the interaction between sellers and buyers of currencies (households, firms, and financial institutions to make international payments). THE ACTORS: There are four main participants (actors) in foreign currency market:
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1. Retail customers (importing and exporting companies and individuals), 2. Commercial banks, 3. Foreign exchange brokers, and 4. Central banks. The most important actors in foreign exchange markets are commercial banks. Retail customers include firms and individuals that would like to hold foreign exchange for the motive of transactions (selling and buying products) and speculation (profit from expected future currency movements). The central banks engage in foreign currency trade (through open market operations) in order to solve certain macroeconomic problems such inflation curb, national currency depreciation/appreciation. EXCHANGE RATE RISK AND RISK AVERSION : Firms and individuals indulged in international businesses are subject to exchange rate risks due to the fluctuation in in the value of currencies over time. Therefore, the real value of future payments will be different from that when the business contract was signed. For example, if the Almarai Company in Saudi Arabia singed a contract with Anna Creek Station (ACS) in Australia to buy 5000 cows that must be delivered to Almarai in July, 2014 but the contract was signed in January, 2014 at a total amount of SR 25 million. In this case, the exchange rate risk shifts from Almarai to ACG. For Almarai, there is no risk since the riyals nominal value is known but ACG has to face the expected risk because ACG does not know how much the 25 million Saudi riyals will be equal to in terms of Australian dollar in July 2014. But if the contract was specified in Australian dollar, then the exchange rate risk shifts to Almarai. Solution for exchange rate risk is found in the mechanism of what is called forward exchange rate and the forward market. The forward exchange rate is the price of a currency agreed upon in present but will be delivered in the future (at today’s agreed upon exchange rate). But if the contract, delivery, and payments are executed in the same date, the exchange rate is called spot exchange rate. It is like spot price. The forward market is the market in which the buying and selling of currencies for future delivery takes place. By contrast, the market for buying and selling in the present is called spot market. THE SUPPLY AND DEMAND FOR FOREIGN EXCHANGE : The price on a nation’s currency can be analyzed in the same way as the price of goods and services. The interaction between demand and supply for cars, for example, determines the price of cars in car market. Likewise, the currency’s price (exchange rate) can be determined based on the interaction between supply of and demand for that currency. This is called as market mechanism. First, we analyze supply of and demand for foreign exchange under floating exchange rate. Once we understand the money market
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mechanism under floating exchange rate, it will be easy to understand such an analysis under fixed exchange rate regimes. Supply and Demand with Floating Exchange Rates: The Saudi riyal is pegged to U.S. dollar; following fixed exchange rate regime. But for simplicity, let’s say hypothetical that the exchange rate of Saudi riyal in under floating exchange rate system. Who do demand foreign exchange? In cease of British pounds in Saudi Arabia, Saudis demand British pounds. Consider Figure 1, as bellow:

Figure 1: The Demand Curve for Foreign Exchange R = SR/£

Dp Quantity of £
Figure 1 shows the demand for British pound in Saudi Arabia (DP). The exchange rate (R) is presented, on the vertical axis of Figure 1, by the number of riyals per one pound. Quantity of pounds demanded in Saudi Arabia is measured on the horizontal axis of Figure 1. The curve DP is a downward-sloping curve, indicating that as the pound depreciates against riyal (downward movement along the vertical axis of Figure 1), the quantity demanded of pounds by Saudis increases (forward movement along the horizontal axes of Figure 1), and vice-versa. The quantity demanded of pounds increases in the Saudi market (as the pound depreciates against riyal) is because of the fact that when pound depreciates against riyal, British products become cheaper for Saudis inside Saudi Arabia and, hence, Saudis will tend to buy (import) more British products. To buy more British products, Saudis will demand more pounds to pay for the purchased British products. The second player in the foreign exchange market is supply of foreign currency. Who do supply foreign exchange? Simply, it is foreigners who supply foreign exchange. In case of supply of pounds, British supply pounds. Consider Figure 2, below. Figure 2 shows the supply of pounds in Saudi market (SP). In contrast to the demand curve for pounds in Saudi market, the supply curve of pounds in Saudi market is an upward-sloping curve, reflecting that as the Saudi riyal depreciates against British pound (upward movement along the vertical axis of Figure 2), the Saudi products become cheaper for British and they demand more of Saudi products, injecting more pounds (greater supply of pounds) in Saudi market (forward movement along the horizontal axis of Figure 2).
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Figure 2: The Supply Curve for Foreign Exchange R = SR/£


Quantity of £
Under floating exchange rate regime, the equilibrium exchange rate and the quantity of foreign exchange will be determined based on the interaction between demand for and supply of foreign exchange (British pound in our example) in the domestic market (Saudi market in our example). When demand for pound is equal to supply of pound in Saudi market, the equilibrium will take place in the foreign exchange market, that is: DP = SP In Figure 3, below, we combine demand for and supply of foreign exchange (pound) together in order to analyze the interaction between demand for and supply of foreign exchange (pound) and, hence the equilibrium exchange rate.

Figure 3: The Foreign Exchange Market R = SR/£ E



DP Quantity of £ Q1
Figure 3 shows that the demand for foreign exchange (DP) equals the supply of foreign exchange (SP) at point E (the point of intersection between DP and SP), where the demand for
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pounds equals supply of pounds. At the point of intersection, the market exchange rate is R1 and the demand for and supply of pounds is Q1. Determinants of Exchange Rate: Remember that we still analyze the foreign exchange rate under floating exchange rate with our hypothetical example that assumes the Saudi riyal is under floating exchange rate regime. Under floating exchange rate, exchange rate is determined by the following factors (determinants): 1. 2. 3. 4. Purchasing Power Parity (in the Long-run). Business Cycles (in the Medium-run). Interest Parity (in the Short-run). Speculation (in the Short-run).

An increase of Saudi demand for British pound means that the quantity demanded of pounds increases from Q1 to Q2 or an upward shift in DP from DP1 to DP2, as shown in Figure 4, below:

Figure 4: An Increase in Demand for British Pound in KSA R = SR/£ R2 R1 DP2 Quantity of £ Q1 Q2
E1 E2



The increase in the demand for pound in Saudi Arabia (a forward shift from DP1 to DP2) causes a rise in the exchange rate (from R1 to R2 in Figure 4), an appreciation in the pound and depreciation in riyal. By contrast, a decrease in the demand for pound would shift the demand curve left (a backward shift from DP2 to DP1) and lead to a fall in the exchange rate from R2 to R1 in Figure 4 (depreciation in pound and appreciation in riyal). On the supply side, an increase in the supply of pounds to Saudi market shifts the supply curve of pounds rightward from SP1 to SP2, as shown in Figure 5, below, Causing a fall in the exchange rate (i.e., depreciation in pound and appreciation in riyal). But if there is a decrease in supply of pounds in Saudi Arabia, the supply curve shifts backward from SP2 to SP1, indicating a rise in the exchange rate (i.e., appreciation in pound and depreciation in riyal), as shown in Figure 5.
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Figure 5: An Increase in the Supply of British Pound in KSA R = SR/£



R1 R2


DP Quantity of £ Q1 Q2

Since the effects of the determinants of demand for and supply of foreign exchange do not appear simultaneously and immediately, it would be useful to divide them into three time horizons; long run, medium run, and short run. The determinants of demand for and supply of foreign exchange are discussed as follows: 1. Exchange Rates in the Long Run: The Effect of Purchasing Power Parity In the long-run, the equilibrium exchange rate is determined by the Purchasing Power Parity (PPP) of money in both home and foreign country. Purchasing Power Parity states that the equilibrium exchange rate occurs when a given amount of money buys in foreign country the same quantity of goods and services that it buys at home country. By this criterion, the equilibrium exchange rate is the point where riyal buys pounds at a rate that keeps the purchasing power over goods and services constant. Example: If a basket of goods costs SR3000 in Saudi Arabia or £500 in Britain. This means that SR3000 is equal to £500 (or the goods price is 6 : 1) and, therefore, the equilibrium exchange rate is: SR6 per £1. This long-run equilibrium exchange rate is necessary to maintain the purchasing power parity between Saudi Arabia and Britain. If the exchange rate is above the equilibrium, then the pound is overvalued and the riyal is undervalued. An overvalued pound buys more in Saudi Arabia than in Britain since it would be possible to exchange £500 by more than SR3000 and, hence by a larger basket of goods in Saudi Arabia than can be bought in Britain. By contrast, if the exchange rate is below the equilibrium exchange rate (e.g., SR4 per £1), then the pound is undervalued and the riyal is overvalued. Overvalued or undervalued currency creates an opportunity for profit-making for merchants. To explain how profit-making opportunities can be created under overvalued/undervalued currency, let’s stay with the same example as above and assume that the riyal is overvalued (i.e., pound is undervalued) and instead of SR6 per £1, the exchange rate is SR5.25 per £1.
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Prices are assumed to be with the same relationship (i.e., 6:1). In this case, SR3000 buys more with the overvalued riyal because the SR3000 can now buy SR3000/5.25 = £571.43. Merchants can make more profit if they take this £571.43, buy British goods, ship and sell them in Saudi Arabia. Since the prices are 6:1, then merchants can earn SR3428.57 instead of SR3000. In the long-run, the demand for pound increases and, as shown in Figure 4, the exchange rate rises and this process continues until the overvaluation of riyal (undervaluation of pound) is totally eliminated, i.e., until the long-run equilibrium exchange rate is restored at SR6 per £1 and there are no more profit-making opportunities from shipping goods from Britain to Saudi Arabia. Critique of the Assumption of Price Equalization: The above effect of PPP in the long-run is based on an unrealistic assumption of price equalization or the constant relationships between prices. This is unrealistic and the constant relationship between prices does not hold because of the following factors: 1. Transportation costs are changing persistently and are affected by several determinants. 2. The existence of tariff and non-tariff barriers to trade. 3. The existence of non-tradable goods and services. In spite of these obstacles, the PPP plays a significant role in the determination of the exchange rate in the long-run because some of these obstacles can be eliminated from time to time and between different nations based on trade agreements. Also transportation costs can be adjusted in one way or another to avoid the effect of price differentials. 2. Exchange Rates in the Medium Run: The Effect of Economic Business Cycles Business cycle is the natural but irregular rhythms of economic expansion and recession that every country undergoes. As far as demand for and supply of foreign exchange is concerned, business cycles have more immediate effect than PPP and less immediate effect than interest parity and financial and capital flow. Every business cycle prevails for a certain period of time commonly more than one year but less than five or seven years. This time horizon of five to seven years is described as medium run. Therefore, the effect of business cycles on demand for and supply of foreign exchange appears in the medium run. During domestic economic expansion (say in Saudi Arabia, the home country), incomes and consumption levels increase and, therefore, imports and travelling abroad will accordingly increase. As a result, the demand for foreign exchange will increase, and the demand curve for foreign exchange (say British pound) by Saudis will shift forward (from DP1 to DP2) , showing an increase in the exchange rate from R1 to R2 , as shown in Figure 4, above. To sum up, holding the short-run forces constant, the effect of economic expansion in the mediumrun is a depreciating home currency. Symmetrically, slower domestic economic growth or recession implies that output and national income fall, consumption and expenditure will consequently fall, leading to a lower level of imports and may be lower level of travel abroad, decreasing the demand for foreign exchange (say demand for pound by Saudis) and the demand for foreign exchange (pound)
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will shift leftward, appreciating the home currency (riyal in our example). Thus, economic recession, ceteris paribus, lead to an appreciation of national currency. Global economic expansion (or expansion abroad) does not have a direct effect on the home country’s demand for foreign exchange, but it has a direct effect on the supply curve for foreign currency at home. Growth abroad will increase the foreign demand for home’s exports. When home country’s exports increase, the supply of foreign exchange in home country will for sure increase and the supply curve for foreign exchange shifts rightward, lowering the exchange rate (from R1 to R2 in Figure 5) , i.e., appreciating home country’s currency, as shown in Figure 5, above. Symmetrically, global economic recession and slower growth abroad (or recession abroad) does not have a direct effect on home country’s demand for foreign exchange but it does have a direct effect on supply of foreign exchange in home country. Global recession, or recession abroad, will lower the demand for home country’s export and the supply of foreign exchange will decrease in home country, the supply curve for foreign exchange shifts leftward, the exchange rate will increase, showing depreciation in home country’s currency. 3. Exchange Rates in the Short Run: The Effect of Interest Parity and Speculations The effects of financial flows are capable of creating slight day-to-day fluctuations in the value a currency. Two very important variables are responsible for a large share of short-run capital flows, namely interest rates and expectations about future exchange rates.

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