Monetary policy (Research Paper Sample)

Exchange Rate Regimes: Monetary Policy Author Date Table of Contents TOC \o "1-3" \h \z \u Exchange Rate Regimes: Monetary Policy PAGEREF _Toc145030056 \h 3The Monetary Policy in KSA PAGEREF _Toc145030057 \h 4The Monetary Policy in KSA (continued) PAGEREF _Toc145030058 \h 7Country Experiences with Transition to Flexible Exchange Rates PAGEREF _Toc145030059 \h 8Mexico PAGEREF _Toc145030060 \h 8Brazil PAGEREF _Toc145030061 \h 9Russia PAGEREF _Toc145030062 \h 10Egypt PAGEREF _Toc145030063 \h 11Sweden PAGEREF _Toc145030064 \h 11Lessons Learned from Exchange Rate Regime Transitions PAGEREF _Toc145030065 \h 12In the First 5 Years Post-Transition PAGEREF _Toc145030066 \h 12Key Factors Determining Success PAGEREF _Toc145030067 \h 12Appendix 1 PAGEREF _Toc145030068 \h 14Reference List PAGEREF _Toc145030069 \h 15 Exchange Rate Regimes: Monetary Policy A nation's choice of exchange rate regime has important ramifications for monetary policymaking and macroeconomic performance. A fixed regime binds a currency's value to another currency or commodity at a pre-determined rate (Helísek, 2019), whereas under flexible rates, values fluctuate based on market conditions (Dornbusch, 2019). Under a fixed regime, a central bank maintains the peg and accommodates capital flows, even if this requires diverging from domestic targets (Helísek, 2019). Monetary autonomy is surrendered in favor of exchange rate stability. However, rigidity enables using the exchange rate as a nominal anchor, concretely linking inflation expectations (Rostagno et al., 2019). Conversely, a central bank prioritizes domestic targets like inflation or growth with flexible rates. The policy is geared towards internal equilibriums regardless of currency movements. This provides independence but at the cost of uncertainty, as cross-border trade and loans face daily exchange risk. Expectations may become unanchored without a fixed benchmark. Different regimes also imply varied suitable monetary policy strategies. Under flexible rates, inflation targeting works well by directly influencing price pressures (Dornbusch, 2019). Exchange regimes involve propositional tradeoffs tradeoffs between policy control and exchange predictability. A nominal anchor supports stability, but rigidities hamper adjustments. Flexibility allows independent action yet introduces uncertainties. Careful consideration of economic conditions and monetary priorities informs the optimal choice. While nominal anchors provide a clear benchmark, over-reliance on exchange rate rigidity could ignore building domestic imbalances (Westbrook & Willett, 2019). If a peg is maintained despite deteriorating competitiveness or fiscal troubles, it risks becoming unsustainable. The Asian Financial Crisis in the late 1990s demonstrated how loss of foreign reserves and speculative pressures can overwhelm rigid pegs (Flassbeck, 2017). This highlights the importance of complementary policies to maintain internal and external balances under fixed regimes. Flexibility, conversely, allows exchange rate adjustment to help correct problems. As such, regimes require ongoing evaluation and may need reformulation should economic conditions or policy tradeoffs significantly change. An adaptive approach considers both nominal stability and real equilibrium considerations. The Monetary Policy in KSA Traditionally, Saudi Arabia has maintained a fixed exchange rate regime, pegging its currency, the Saudi Riyal, to the U.S. dollar since 1986 (Althibani et al., 2020). This arrangement was adapted to import monetary and price stability from the dominant American economy, given Saudi Arabia's export reliance on oil (Hathroubi). The peg also granted policymakers greater certainty over export revenues and long-term planning of government budgets (Bradshaw et al., 2019). Stylized facts reveal that annual real GDP growth averaged 3.6% between 1990 and 2023, displaying relative stability (World Bank, 2023). However, growth has fluctuated 8.7% more recently due to oil price volatility and pandemic disruptions. Annual Real GDP Growth in KSA 1990-2022: https://databank.worldbank.org/reports.aspx?source=2&type=metadata&series=NY.GDP.MKTP.KD.ZG Inflation remained subdued, averaging 2.2% over the period, with only major upticks above of 9.9% in 2008 and 3.4% in 2018 inflationary spikes (World Bank, 2023). Annual Inflation Rate in KSA 1990-2022 While GDP and inflation trends have remained relatively stable since 1990, additional insights can be drawn from other key economic data series investigations. Regarding external sector performance, KSA's current account balance averaged 5.5% of GDP between 1990-2014, reflecting resilient surpluses due to large oil trade surpluses (IMF, 2022). However, more recently, non-oil deficit expansion and falling oil prices have contributed to account deficits averaging 1.7% of GDP from 2015 to 2021 as oil revenues declined (IMF, 2022). Notably, the current account surplus in 1990 was 25% of GDP, demonstrating the economic reliance on oil exports. A breakdown of current account components illustrates that while oil product exports accounted for over 60% of total exports in recent years, import expenditures have also steadily risen, with non-oil products now over 80% of the import bill (World Bank, 2022). This growing non-oil trade deficit signals increasing exposure to external demand and exchange rate risks under a fixed regime. On the fiscal side, fiscal breakeven oil prices, the oil price at which the budget would balance, suggest a level of around $80 per barrel is now needed for fiscal sustainability, underscoring vulnerabilities from volatile oil revenues (IMF, 2023). Charting these additional macroeconomic aggregates provides useful context on evolving external and fiscal trends affecting KSA, and implications must be considered regarding potential limitations of maintaining the long-standing fixed exchange rate policy. While fixed rates supported stability in the past, encompassing multi-sector indicators paints a fuller picture of new macro-critical variables, especially related to the diversifying non-oil trade and fiscal positions, which introduce complexity to exchange rate management going forward. Adaptive policies considering these structural shifts will serve Saudi Arabia's development goals in the post-oil era. The peg has supported the continuous expansion of the Saudi economy for decades by maintaining stability in the monetary environment. However, more flexible policies may better manage post-pandemic challenges and economic transition goals. Further analysis of the external sector and fiscal indicators would also help evaluate recent macroeconomic performance and the implications of altering exchange rate management approaches. Balance of Payments As outlined earlier, current account surpluses averaging 5.5% of GDP from 1990-2014 indicate resilient external positions due to oil trade (IMF, 2022). However, data breaks down the current account into: i) sizable surpluses from oil exports until 2015 but declining since ii) non-oil trade deficits exacerbated by rising imports. This signals growing external vulnerability as oil revenues fall, raising questions on continued inflexibility. Investment Gross capital formation as a percentage of GDP averaged 27% from 1990-2020, demonstrating durably high investment levels supporting growth (World Bank, 2022). However, investment contracted in recent years, falling to 20% of GDP in 2020 amid oil market instability. Sustained currency stability likely encouraged long-term investing albeit difficulties financing declines in oil assets. Consumption Household and government consumption expenditures averaged 57% and 17% of GDP respectively over the period 1990-2020, with consumption playing the dominant economic role (World Bank, 2022). Consumption growth has outpaced GDP recently, rising risks for external and fiscal sustainability as deficits emerge in these Realms. The evolving indicators point to new vulnerabilities that challenge the suitability of KSA's longstanding peg. While investment and consumption drivers have so far buttressed growth, global headwinds and declining oil revenues strain external and fiscal balances. This invites exploration of exchange rate mechanisms offering more dynamic adjustment capacity. A managed float or moving to a currency basket peg could aid corrective response compared to strict dollar-rigidity. Meanwhile, overlaying additional currencies in a reference basket beyond the dollar could buffer external shocks, as exchange rates with major trade partners also influence trade and investment flows. The Monetary Policy in KSA Under KSA's fixed regime, the peg allows monetary policy pass-through from trading partners (Shaheen, 2023). However, this transmission exposes debt sustainability and current accounts. For instance, Saudi Arabia heavily depends on oil revenues, which comprise over 70% of the government's total revenues. As global oil prices declined sharply from 2015 to 2016, Saudi oil income and fiscal revenues dropped significantly. Despite oil income remaining below peak levels, Saudi reduced its budget deficit to less than 4% of GDP by 2019 and posted a small surplus in 2022. According to the report, public debt ratios followed suit, falling to around 25% of GDP (IMF, 2023). Historically, Saudi Arabia has depended largely on its exports of oil, which make up over 50% of its GDP and almost 75% of its foreign exchange revenues. The administration knows that the economy must be more diverse and less reliant on oil (WTO, 2023). The fixed exchange rate policy has supported Saudi Arabia's economic development for decades, but structural changes require fresh consideration of alternatives to foster resilience. As discussed, comparative evidence shows that periodic currency adjustment safeguarded emerging market peers from external crises better than rigid dollar pegs (IMF, 2019)...