Exchange rate concepts

[yota691]

Exchange rate concepts

 

Dr. Muhannad Talib Al-Hamdi

Articles Dr. Muhannad Talib Al-Hamdi Use works that are open and operating in one country , the local currency to pay for the costs of production and wages of employees, and accrued interest on loans, and perhaps the distribution of profits to partners. However, companies that operate in multiple countries may sell their products in different currencies and pay their suppliers spread across far-flung countries in the currencies of those countries, and therefore they need to change the local currency to many foreign currencies.     It is also well known that companies and countries use the international financial system to borrow in foreign currencies. The best example of this is the Iraqi government issuing treasury bonds denominated in dollars that it sells in the American and European financial markets to borrow amounts in dollars to fill the Iraqi budget deficit. When countries and companies use foreign currencies, they have to deal with changes in the exchange rate.     In this article, we will review some basic concepts related to the exchange rate, the change in the currency rate, the nominal and real exchange rate, as the beginning of a series of articles related to this vital matter, so that the reader is better informed about concepts that have been mixed in the media, which causes distortions in the understanding of the topic and its effects on the economy.     The nominal exchange rate     Also called the exchange rate for convenience, it is the price of one unit of one currency in the equivalent in another country's currency. For ease of use, we express the nominal exchange rate as the ratio of the number of units of foreign currency against one unit of local currency. For example, we say one dollar for 1,450 Iraqi dinars. On the other hand, we express the nominal exchange rate in Iraq by saying that every Iraqi dinar can be exchanged for 0.0007 dollars.     Fluctuations in the exchange rate can play an important role in determining the ability of companies to sell their products to other countries and on the prices that local consumers pay for imported goods and commodities. Take, for example, a bag of rice that is exported from the United States to Iraq. If the price of a bag of rice in the United States was 50 dollars, then its price in Iraq would be  72,500   dinars, if the exchange rate was 1,450 dinars per dollar. But if the exchange rate of the dinar decreased against the dollar and became 1,600 dinars per dollar, the price of a bag of rice would be 80,000 Iraqi dinars. Although the price of the bag of rice has not changed in the United States, the decrease in the Iraqi dinar exchange rate (about 10%) will cause the American exporter to lose some of his sales in the Iraqi market due to the high domestic price of the goods he exports to Iraq.     Likewise, due to the depreciation of the dollar's exchange rate against the Japanese yen between 2008 and 2012, many Japanese automakers faced a decrease in their sales of cars exported to the US market. In order to avoid the risks that include selling cars against the dollar while bearing the cost of production in Japanese yen, these cars have established factories to produce their cars in the United States itself.     As exports have become a large part of the gross domestic product of most countries of the world, fluctuations in the exchange rate increasingly affect local economies. It can result in any increase in the exchange rate resulting in a significant decline in exports to reduce domestic production companies and laying off some workers. It is not surprising that important economic publications around the world publish exchange rate data and articles on the effect of exchange rate movement on corporate sales and production. Economists and policymakers are closely watching the movement in the exchange rate due to its effect on the economy in general.     The immediate exchange is made between two currencies according to the current exchange rate or what is called the spot exchange rate. Buyers and sellers of currencies can also agree today to exchange currencies at a later date based on a forward exchange rate. The agreements to exchange currencies in future times are called futures swaps and futures swaps.     Forward swap contracts are negotiated between two financial institutions, usually commercial banks. For example, the Bank of Baghdad agrees with a US bank today that after 90 days, it will buy $ 100 million for Iraqi dinars at an exchange rate of 1,450 dinars to the dollar. Whereas futures exchange contracts are made to exchange financial products such as stocks and bonds by people in the markets for exchanging those products, such as the Chicago Mercantile Exchange. Details of futures contracts, such as the amount of currency that each contract contains and the time that the contract expires, are formulated by the management of the market in which the contract is made. The existence of futures and futures contracts allows companies to hedge or reduce the risk of losses that can result from exchange rate fluctuations.     For example, the Iraqi Oil Export Company (SOMO) might suffer some losses if the exchange rate of the dinar rose against the dollar. Suppose that SOMO sells an oil shipment to an American company for an amount of 50 million dollars, and it is agreed that the American company will pay the amount after 90 days when the shipment is delivered. SOMO faces some risks, or the so-called exchange rate risk, as the exchange rate of the dinar may rise against the dollar in the ninety days between the agreement to sell and the receipt of the payment. If that were to happen, SOMO would receive less Iraqi dinars for the $ 50 million. By entering into a forward exchange rate contract at the time of the sale agreement, SOMO can fix the exchange rate to a certain percentage in which it can exchange the dollars that you will receive after 90 days for it, and accordingly reduces the exchange rate risk. Usually companies do not write forward exchange contracts themselves, but rather rely on specific banks to provide these services for a fee.     Each currency has an immediate exchange rate against every other currency, or what is called the binary exchange rate. Economists and policymakers see more benefit in looking at the multiple exchange rate, which shows the price of one country's currency against a group of other countries' currencies. This group of currencies is called the basket of currencies and usually includes the US dollar, the British pound, the euro, the Swiss franc, the Japanese yen, the Canadian dollar, and possibly other currencies. Each currency in this basket is given a weight according to the amount of trade exchange between the countries of those currencies and the country of origin. In this case the exchange rate is referred to as a semantic number, not a direct price. And like any other indicator, what matters is the movements of the multiple exchange rate over time rather than its value at a specific time. The dollar’s exchange rate fluctuated greatly since 1973. It increased during the eighties against many other currencies, which created great difficulties for American companies to export their products to other countries of the world. However, since 2001, the exchange rate of the dollar in the market witnessed a decline compared to other currencies, which helped American exporting companies to increase their sales around the world.     Real exchange rate     The nominal exchange rate tells us how many units of foreign currency can be exchanged for one unit of local currency. But economists and policymakers are more interested in the prices of foreign commodities and goods as opposed to domestic goods and goods. In other words, they are concerned with the terms of trade, that is, the ratio in which domestic goods and goods can be exchanged for foreign goods and goods. That exchange ratio is called the real exchange rate. The real exchange rate provides a better measure of the change in the prices of goods and commodities in a country compared to foreign goods and commodities than the nominal exchange rate provides. Therefore, when economists and policy makers try to estimate the effect of a change in the exchange rate on exports and imports, they rely on the real exchange rate and not the nominal exchange rate.     Measuring the real exchange rate using a single commodity: the PVC Mac Index     The Economist in Britain introduced the use of the PCMAC index in September 1986 as an index of purchasing power parity of currencies. The index is based on the logical assumption that two different processes should naturally adapt until the cost of an identical basket of goods and commodities becomes the same in the two currencies. Accordingly, the McDonald's company called Your Mac sandwich was chosen to represent this basket of goods and similar goods because it is available in a largely identical way in many countries of the world. Therefore, the index helps to compare the currencies of two different countries.     If we take, for example, the price of a sandwich in the United States is five dollars, for example, and in Iraq, seven thousand dinars. Meanwhile, the nominal exchange rate between the two currencies is 1,750 dinars to the dollar. In order to calculate the real exchange rate, we have to find the number of Iraqi sandwiches that can be exchanged for one American sandwich. We can achieve this in two steps. First, we use the nominal exchange rate to convert the price of the US sandwich into Iraqi dinars. The second step is to divide that by the price of the sandwich in Iraq in Iraqi dinars, to get to the number of Iraqi sandwiches that buy one American sandwich.      Which:The real exchange rate = 1750 dinars per dollar * 5 dollars for the American sandwich / 7000 dinars for an Iraqi sandwich = 1.25 Iraqi sandwiches for every American sandwich     That is, your Mac sandwich in the United States, given the prices in the two countries and the nominal exchange rate in mind, can buy a sandwich and a quarter of similar sandwiches produced in Iraq. It is worth noting that the real exchange rate tells us how much foreign goods and commodities one unit of domestic goods and commodities can buy. That is, we can measure the real exchange rate through the exchange of goods and commodities instead of currencies.     Usually we do not measure the real exchange rate using the price of a single commodity but using the average price, or the general price level, in each country. Accordingly, a simple equation can be constructed to compare the local rate and the average prices in the other country with the nominal exchange rate to determine the real exchange rate as follows:     Real exchange rate = nominal exchange rate * (domestic rate / foreign rate)     For example, if the real exchange rate of the Iraqi dinar is 1,500 dinars per dollar, then that value indicates that an ordinary commodity produced in the United States could buy 1,500 units of a similar ordinary good produced in Iraq.     The real exchange rate and the nominal exchange rate move symmetrically only if the ratio of the domestic price rate to the foreign rate rate is nearly constant. This clearly indicates the risks of a large rise in domestic prices, that is, inflation, compared to inflation in the other country on a change in the real exchange rate.     * Professor of Economics and Political Science, Kansas State University, USA.

Number of observations 636   Date added 01/07/2021

[rvmydinar]

6 hours ago, yota691 said:

 

 

for example, a bag of rice that is exported from the United States to Iraq. If the price of a bag of rice in the United States was 50 dollars, then its price in Iraq would be  72,500   dinars, if the exchange rate was 1,450 dinars per dollar. But if the exchange rate of the dinar decreased against the dollar and became 1,600 dinars per dollar, the price of a bag of rice would be 80,000 Iraqi dinars. Although the price of the bag of rice has not changed in the United States, the decrease in the Iraqi dinar exchange rate (about 10%) will cause the American exporter to lose some of his sales in the Iraqi market due to the high domestic price of the goods he exports to Iraq.

if a bag of rice in the us=50isd. if $1=1450 iqd, then a bag of rice=50usd x 1450 iqd=72,500 iqd. if the cbi will decrease the iqd, let's say 1,600 iqd, then 1 bag of rice=80,00 dinar. so the point is if the value of iqd go down and down the toilet, then the price of goods in iraq will be very expensive. and, the only solution to make the prices of goods are cheap in iraq, then the cbi has to icrease the value of the iqd or rv the iqd at least 1:1. let's say if the rate is 1:1, and the bag of rice in the us is 50usd, then the bag of rice in iraq is only 50 dinar. it is very cheap, isn't it. this is win-win solution to both iraqi citizens and dinar investors. because when the rate is at least 1:1, the iraqi citizens can buy the goods, like a bag of rice, very cheaper than the bag of rice when the rate 1:1450 right now and dinar investors are also very happy when the rate is 1:1 too.i think the government of cbi and minister of finance are smart enough to decide what is best for iraqi citizens. hopefully, the cbi and minister of finance will make the right decision to increase or rv the iqd as soon as possible before the riots and the protests are getting worse and out of control. only time will tell. hopefully sooner and closer.  

[alreis]

Would really be nice if Iraq develops a CBDC, then we could buy xrp with our Dinar and then exchange it for USDC and save the exchange fees. Draw of USDC as we need it in the fiat currency of our choice.

One can hope right?

[Spoey]

I like that idea Alreis, Iraqi finance ministers should br talking to Ripple.

 

[WISKY291]

I thought that the Dinar had to be internationally traded before they can do that.. Maybe I'm wrong..

[yota691]

Foreign exchange markets and exchange rates

 

 

 

Dr. Muhannad Talib Al-Hamdi

Articles Muhannad Talib Al-Hamdi * The foreign exchange market is a very active market around the world. The value of exchanges in it is nearly five trillion dollars a day. The exchange rates of the currencies that result from those exchanges are announced by many important economic and financial institutions in various countries of the world.   Banks and financial institutions around the world employ people to deal in currencies or what are called currency dealers. They buy and sell deposits in banks instead of exchanging large amounts of fiat currencies, as banks around the world keep deposits in different currencies depending on the country in which they operate. For example, if a bank in France wanted to sell US dollars in order to buy Japanese yen, the bank might exchange dollar deposits it had for deposits in Japanese yen with a bank in Germany. But companies and individuals obtain foreign currency directly from banks and exchange agencies.   Exchange rates are determined by the currency markets all over the world. A variety of factors can influence these exchange rates, including import and export quantities, GDP, market expectations and inflation. For example, if the gross domestic product decreases in a particular country, then that country is likely to import less quantities and vice versa as well, causing a change in the amount of local currency exchanged for foreign currencies. These fluctuations also cause a shift in the currency exchange markets. For example, if Iraq enters an economic recession, the Iraqi GDP will decrease and Iraq will import fewer goods from the United States. Consequently, the demand for dollars in the Iraqi market decreases and the dollar price against the dinar decreases. In other words, the Iraqi dinar is gaining a higher price compared to the dollar.   The currency exchange market includes companies, families, and investors who buy goods, services, and foreign assets (or who sell goods, services, and assets to foreigners). As a result, they demand (or offer) foreign (or local) currencies to complete their dealings. For example, some households buy imported goods that need foreign currencies to pay for. Likewise, wealthy individuals or companies make investments in foreign countries where they also need foreign currencies.   The exchange rate in the market is determined by the interaction of the forces of supply and demand for a particular currency, like any other commodity in the market. And like any other currency in the world, there are three sources that determine the demand for the Iraqi dinar:   First: Foreign companies and persons (including foreign visitors) who want to buy goods and commodities produced in Iraq, including tourism activities,   Second: Foreign companies and people who want to invest in Iraq through foreign direct investment, that is, establishing and managing projects in Iraq, or through investing in the foreign portfolio, that is, buying stocks and bonds that are issued by Iraqi institutions,   And third, currency traders who believe that the price of the dinar will rise in the future compared to its price today.   When the exchange rate of the dinar is high, the quantity demanded of it decreases. For example, when the exchange rate of a dinar is 1,200 dinars to a dollar, the quantity required to buy from it will be less than if its exchange rate was 1,450 dinars to a dollar by companies that want to buy Iraqi goods and goods, as well as for foreign investors who want to invest in the country. For example, when a foreign person wants to buy an Iraqi commodity worth a thousand dollars, he will need to buy an amount of one million two hundred thousand Iraqi dinars according to the exchange rate of 1,200 dinars to the dollar, but he will need to buy one million and 450 thousand dinars if the exchange rate becomes 1,450 dinars to the dollar. That is, the inverse relationship between the required quantity of the dinar and the change in the exchange rate, the decrease in the price of the dinar leads to the purchase of larger quantities of it. That is, the demand curve for the currency (the Iraqi dinar here) is a negatively sloping curve.   As for supply, it is normal for there to be a positive relationship between the exchange rate and the amount of supply of the dinar. When the exchange rate of a dinar rises, a larger amount is displayed.  When the exchange rate changes from 1,200 dinars to a dollar to 1,450 dinars to a dollar, people and institutions that own the dinar will have to offer larger amounts of it to get one dollar that you use for the purposes you want, such as buying foreign products denominated in dollars. Therefore, the currency supply curve is positively sloping.   And like any other market, equilibrium occurs in the currency exchange market when the forces of supply and demand meet, that is, the quantity supplied is equal to the quantity demanded at the equilibrium point through which the equilibrium exchange rate is determined. When the exchange rate in the market, for any reason, is higher than the equilibrium price, there will be a surplus of the local currency, which causes pressure to the lowest on the exchange rate and this will continue until the equilibrium price is reached. Likewise, if the market exchange rate is lower than the equilibrium exchange rate, there will be a scarcity in the local currency, which puts upward pressure on the exchange rate until the equilibrium price is reached.   The surplus and scarcity in the currency exchange market is removed very quickly due to the huge volume of exchanges in the major global currencies and currency dealers communicate with each other in real time through the Internet.   Shifts in the supply and demand for a currency cause a change in the exchange rate. The primary factors causing shifts in the supply and demand for a currency include, but are not limited to this:   Changes in demand for domestic products and changes in demand for foreign goods and commodities. The change in the desire to invest in the country compared to the desire to invest outside the country. A change in the expectations of currency dealers about the future price of the local currency versus the future price of the foreign currency. Shifts in the supply and demand curves of a currency:   Any change in any market factor other than the exchange rate leads to shifts in the supply curve, the demand curve for the currency, or the two curves together, which leads as a result to a change in the exchange rate.   For example, if a country that is considered a trading partner of Iraq achieves significant economic growth, the incomes of families in that country will increase, and the demand for Iraqi goods and goods by the residents of that country will increase. At a certain exchange rate, the demand for the Iraqi dinar will rise, and the demand curve for the Iraqi dinar will shift to the right (i.e. the increase in demand), which will raise its exchange rate against the currency of that country. Likewise, if interest increases on deposits and bonds in Iraq, the demand curve for the dinar will shift to the right as the desire to invest in Iraqi financial assets increases. Currency dealers also play an important role in the currency exchange markets because the currency exchanges they carry out increase the volume of transactions and liquidity in the market. If currency dealers become convinced that the future price of the dinar will be lower than its current price, the demand for the dinar will now decrease, the demand curve will shift to the left, and the exchange rate of the dinar will decrease against other currencies under the condition that all other factors remain constant.   The factors that affect shifts in the currency supply curve are similar to those that affect shifts in the demand curve. An economic growth in Iraq leads to an increase in the incomes of the families who live in it, and an increase in their demand for goods and commodities, including foreign goods and commodities, and companies spend more on purchasing foreign raw materials for use in their domestic production. To achieve this, they must supply larger quantities of Iraqi dinars to replace them with foreign currencies, which leads to a shift in the dinar supply curve to the right (i.e., an increase in the dinar supply). Likewise, if the interest rate rose in the United States, for example, financial assets in that country would become more attractive to the Iraqi investor, which would make him offer more Iraqi dinars to obtain dollars to be used in the purchase of American financial assets.   Market adjustment to arrive at a new equilibrium exchange rate The factors affecting the forces of supply and demand for a currency are constantly changing. Whether the exchange rate changes up or down depends on the shifts in the supply and demand curves. For example, if the demand curve for the Iraqi dinar to switch dollars to the right is shifted at a level greater than the shift in the supply level, this will lead to a rise in the exchange rate of the dinar against the dollar.   Changes in the exchange rate may have two types of effect on the demand for the local currency: the wealth effect and the exchange effect. We are interested in the second type of effect. Exchange rate movements may generate a currency substitution effect, as investor expectations play a crucial role. If people expect that the exchange rate is likely to decline further after an initial decline (and this appears to be what is happening in Iraq now), they will respond to this by increasing the share of foreign assets in their holdings of funds. This increases the supply of local currency to obtain foreign currency due to the high opportunity cost of holding the local currency, which means a lower exchange rate of the local currency. Therefore, currency exchange can be used to hedge this risk. In this regard, a lower exchange rate would reduce the demand for the local currency.   * Professor of Economics and Political Science, Kansas State University, USA.

Number of observations 130   Date added 01/10/2021

[yota691]

Exchange rate regulations and policies

 

Dr. Muhannad Talib Al-Hamdi

Articles Muhannad Talib Al-Hamdi * In order to finance international trade and financial exchanges across borders, banks and financial institutions around the world exchange no less than $ 5 trillion in currencies every day in the foreign exchange markets. That amount represents about $ 600 for every person who lives on Earth. The currency exchange market is a market that is transacted 24 hours a day without stopping and almost universally.   Usually banks exchange their deposits in exchange for real large amounts of currency. For example, a US bank might exchange dollar-denominated deposits it has with deposits held by an Iraqi bank that are denominated in dinars. In fact, the foreign exchange market is characterized as a hypothetical market (or what economists call across the table), meaning that most transactions in it take place between major banks through computer networks that link them instead of physical exchanges. Despite the enormous size of these exchanges, most of them are concentrated in limited places and within a relatively small number of currencies. More than half of the world's foreign exchange exchanges involve financial institutions in the United States or the United Kingdom. About 85% of the exchanges are made using the US dollar, 39% of the euro, 19% of the Japanese yen, and 13% of the British pound sterling.   Exchange rate policies:   Different countries have different exchange policies for their currencies. Some countries, such as the United States and Canada, allow the exchange rate to be determined by the forces of the foreign exchange market, as is the case with the prices of most other goods and commodities. Countries that take this approach have a floating exchange rate. Other countries prefer a fixed exchange rate, or what is also called a pegged exchange rate, between a country's currency and another country's currency. For example, Iraq has a fixed exchange rate of 1,450 dinars to the dollar. When countries adopt certain exchange rate policies, economists say there is regulation of the exchange market, or exchange rate regime.   Countries around the world usually follow one of three exchange rate regimes: Fixed exchange rate system. Floating exchange rate system. Managed Floating Exchange Rate System (or Intermediate Exchange Rate System) In a fixed exchange rate system, the exchange rate is set at certain levels and maintained by the monetary authority in the country, i.e. the central bank. Historically, the two most important fixed exchange rate regimes were the gold cap and Bretton Woods system.   Under the gold cap system, which lasted from the nineteenth century to the thirties of the last century, countries ’currencies contained quantities of gold and paper currencies that governments committed to repurchase in exchange for gold if their holders so desired. The gold cap system was a  fixed exchange rate system because the currency exchange rates were determined by the amount of gold that each country had to cover its currency. Under the gold cap system, the size of a country's money supply depends on the amount of gold available. In order to achieve an expansion in the amount of currency used in the economy during periods of wars or economic recession, any country must abandon the gold cap system.   During the Great Depression in the thirties of the last century, many countries, especially the United States of America, decided to abandon the gold cap system in order to increase the flexibility of exchange rates for their currencies and to achieve greater control over the money supply. However, some policymakers in several countries around the world are still calling for a return to the gold cap system, as US presidential candidate Ron Paul demanded in 2012 because he believes that the money supply should depend on something, gold, for example, so that the government does not control the money supply. Completely. But the truth is said that there are no serious attempts to return to the gold cap system for several reasons, including the great restrictions that this system places on the use of monetary policy to deal with economic recessions.   Towards the end of World War II, many economists and policymakers argued that a return to a fixed exchange rate regime would help the global economy to recover from the effects of fifteen years of depression and war. The result of this was the Bretton Woods Conference in New Hampshire in 1944, which laid the foundations for a new exchange system in which the United States pledged to buy or sell gold at a fixed price of $ 35 per ounce. The central banks of the other countries that participated in the drafting of the Bretton Woods system pledged to sell or buy their countries ’currencies at a fixed exchange rate against the US dollar. By fixing the exchange rate of currencies against the dollar, these countries have practically fixed the exchange rate of their currencies against each other.     A fixed exchange system can face real problems because the exchange rate is not free to adapt quickly to respond to changes in the demand for currencies. By the early 1970s, the difficulties encountered in attempts to maintain a fixed exchange rate led to the collapse and then abandonment of the Bretton Woods system.   After the collapse of the Bretton Woods system, most countries of the world allowed their currencies to float, meaning that exchange rates became determined by the forces of buying and selling currencies in the foreign exchange markets. However, some countries saw that the floating exchange rate regime that resulted from those operations led to much instability in exchange rates. As a result, some central banks intervened from time to time in order to influence the exchange rate of their countries' currencies by selling or buying currencies in the foreign exchange markets.   When the central bank of any country sometimes intervenes in the currency exchange market to affect the exchange rate, that exchange rate system is called the administered floating exchange rate system (or the intermediate exchange rate system). Under this system, sellers and buyers in the foreign exchange market determine currency rates in most cases. Sometimes, with the intervention of the monetary authority. Many economists question the effectiveness of that intervention to determine the exchange rate by the monetary authority in relation to the currencies that are widely exchanged. For example, the Bank of Japan can try to influence the exchange rate between the Japanese yen and the US dollar by buying and selling quantities of the yen. However, these operations are small compared to the total quantities bought and sold from these two currencies in the foreign exchange markets. Therefore, it is unlikely that the central bank will be able to influence the exchange rate through its intervention in the market for currencies that are widely exchanged for more than a short period.   Policy options in relation to exchange rate regimes:   Current exchange rate regimes reflect three options in countries ’policies:   The United States and other developed countries such as the United Kingdom, Canada, and Switzerland allow their currencies to float against other major currencies. Nineteen countries in Europe have adopted the euro as a single currency. Some developing countries fix the exchange rate of their currencies against the dollar or other major currencies. Since the collapse of the Bretton Woods system, the Federal Reserve (the central bank of the United States) has rarely intervened in the foreign exchange market in an attempt to influence the exchange rate of the dollar. As a result, we could see large fluctuations in the dollar’s exchange rate against other major currencies since 1973. Because of this, countries that export their products to the United States argue that US monetary policy has made the dollar exchange rate unrealistically low. But it is well known that the Fed does not intentionally achieve a fixed exchange rate for the dollar.   What has now become known as the European Union began as an entity with the six European states signing the Treaty of Rome in 1957, and has grown to now include twenty-seven countries, including many of the formerly communist Eastern Europe. In 1999, the European Union decided to go ahead with a single currency, and on January 1, 2002, the euro currency was launched. By 2012, seventeen member states of the European Union, including all major economies in Europe except the United Kingdom, had adopted the euro. The European Central Bank was established in 1998. Although the central banks of the member states of the European Union are still operating, the European Central Bank is responsible for monetary policy and the issuance of the European currency. The euro suffered great difficulties, especially in 2012, when its fate became unknown when some European Union countries, such as Greece, Spain and Ireland, began to suffer from severe financial crises and became unable to pay the debts of their governments.   Many developing countries have tried to keep their exchange rates fixed or pegged to the US dollar or other major currencies. A fixed exchange rate can provide significant benefits to a country that has trade links with the other country. When the exchange rate is fixed, business performance planning becomes much easier. For example, if Iraq raised the exchange rate of the Iraqi dinar against the dollar, Iraqi companies that export goods to the United States might be forced to raise the prices of their dollar-denominated goods that they export to that country, leading to a decrease in their sales. Whereas if the dinar had a fixed exchange rate against the dollar, planning these Iraqi companies to perform their business would be much easier.   In the 1980s and 1990s, there was another reason for stabilizing the exchange rate for some countries. During that period, the influx of foreign investment to developing countries, especially the countries of the continent of Asia, increased dramatically. It is now possible for companies from countries such as South Korea, Thailand, Malaysia, and Indonesia to borrow dollars directly from foreign investors or indirectly from foreign banks. For example, a Thai company might borrow dollars from a Japanese bank. If the company wanted to use that money to set up a new factory in Thailand, it would have to change those dollars into the equivalent in Thai currency, the baht. When the company starts selling the plant's production, it will get additional units of baht that it needs to exchange for dollars in order to pay the interest due on the loan.   The problem arises if the baht depreciates against the dollar. Suppose the exchange rate is 25 baht per dollar when the company borrowed the amount. In order for the company to pay the monthly interest on the loan, and let's say it is 100 thousand dollars, the company must buy those dollars at 2.5 million baht. If the baht exchange rate drops to 40 baht per dollar, the company will need 4 million baht to pay the monthly interest on the loan. These high payments could be a fatal burden for the Thai company. Therefore, the Thai government had strong incentives to avoid these problems by keeping the baht exchange rate constant against the dollar.   In the 1980s and 1990s some countries feared the inflationary consequences of the floating exchange rate regime. When the price of the local currency falls, the prices of imports rise. If imports constitute a large part of the goods and commodities that local consumers buy, then a depreciation of the local currency may cause significant inflation. In the 1990s, a key component of Brazil and Argentina's anti-inflationary policy was to establish a fixed exchange rate for their currencies against the dollar. However, there are many difficulties to follow a fixed exchange rate system because the central bank must be constantly prepared to buy and sell local currency against the dollar or other hard currencies at a fixed price, which exhausts the hard currency reserves it has.   Suppose that the Central Bank decided to peg the Iraqi dinar to the dollar, as most Gulf countries do. If there were currency dealers who want to sell quantities of dinars in order to obtain more dollars than the amounts of dinars that other currency dealers want to buy against the dollar, then the Central Bank of Iraq will have to buy the surplus dinars in exchange for dollars from its cash reserve. In the opposite case, the Central Bank of Iraq must buy the surplus dollar in exchange for Iraqi dinars. In real practice, central banks often find it real difficulties to maintain the peg for long periods because, ultimately, they will face a decline in their hard currency reserves. Another downside of a fixed exchange rate is that it cancels out an important means that countries can use to recover from recessions. During a recession, the exchange rate can depreciate   If the country were to adopt a flexible exchange rate, which would increase the country's exports and reduce its imports. In the past two decades, there were a number of countries around the world, including many countries in Asia, Africa and South America that adopted the fixed exchange rate system, but found it unsustainable, which led them to eventually abandon it.   The table below shows the advantages and disadvantages of the different drainage systems.

Exchange rate system Preferences Disadvantages  Fixed exchange rate It makes it easier for businesses to plan to borrow in other currencies It is easy for a central bank to control inflation It is very difficult to maintain Eliminates the possibility of a drop in the local currency exchange rate in recessions Floating exchange rate The monetary authority does not need to intervene The exchange rate is allowed to reflect the interaction of market demand and supply forces It can make business planning difficult It could make inflation worse if import prices rise rapidly Rounded floating exchange rate (intermediate exchange rate) It allows for greater stability in the exchange rate than the floating exchange rate Central bank intervention is likely to be ineffective in dealing with widely traded foreign currencies                *  Professor of Economics and Political Science, Kansas State University, USA.

Number of observations 79   Date added 01/12/2021

[yota691]

The economic effects of devaluation of the currency exchange rate

 

Dr. Muhannad Talib Al-Hamdi

Articles Muhannad Talib Al-Hamdi * An exchange rate devaluation is an intentional devaluation of the official exchange rate of a country's currency and the setting of a new rate in relation to a foreign currency reference such as the US dollar. The devaluation of the currency exchange rate is made by the monetary authority of the country (the central bank) and this is often done in cases of fixed exchange rate currencies. The devaluation of the currency should not be confused with the natural devaluation of the currency in the market compared to other major currency standards resulting from the interaction of supply and demand forces. The process of reducing the exchange rate of the foreign currency makes the foreign currency more expensive compared to the local currency.   Reasons for devaluing the currency :   Countries often use devaluation to achieve some economic policy goals. Lowering the price of a country's currency compared to foreign currencies could improve exports, reduce the trade deficit, and reduce the country's debt burden. When the local currency is cheaper than the foreign currency, exports will be encouraged and imports discouraged. Because foreign countries will find commodity prices cheaper in the country whose currency is lowered. However, countries are cautious to avoid a significant increase in exports, as this may cause a disturbance in the forces of domestic supply and demand, which may lead to upward pressure on prices and cause inflation, thus robbing the currency exchange rate devaluation of its expected effect . The devaluation of the exchange rate also helps reduce the impact of the trade deficit because it will improve the balance of payments because the value of exports will be higher than the value of imports.   Reasons for reducing the currency exchange rate.   1. To increase exports and discourage imports: A trade war is a common occurrence in the global market nowadays. In the global market, every country wants its products to be in demand and to be traded across countries. Every country wants its products to be competitive with those of other countries. For example, mobile phone makers in South Korea may compete with cell phone makers in the United States. If the Korean won depreciates against the dollar, then the Samsung US phone that was previously available at a certain price is now cheaper in dollars, making US imports from South Korea cheaper. And vice versa as well. In other words, a depreciation of the currency exchange rate makes exports more profitable and discourages imports . The lowering of the exchange rate makes exports more competitive and appears cheaper to foreign buyers, and this increases demand for exports. Also, after the devaluation of the dinar exchange rate, Iraqi assets could become more attractive. For example, real estate in Iraq may seem cheaper for those who live outside the country and thus increase their demand for it. The lowering of the exchange rate also means that imports such as cars, food and raw materials will become more expensive. This will reduce the demand for imports, and may also encourage Iraqi tourists to spend their vacations inside Iraq, instead of traveling to other countries that now seem more expensive.    2. To narrow the trade deficit: The trade deficit is the difference between the value of a country's exports and the value of its imports. The trade deficit is linked to the country's net exports.  Net exports = value of exports - value of imports.   There is a trade deficit if the value of exports is less than the value of imports. The trade deficit could have negative effects on the country's economy and could lead to huge debt levels, which would cripple the economy. This was a matter of grave concern to the Iraqi government. Thus, depressing the exchange rate can help boost exports by making exports cheaper and reducing imports by making them more expensive for the country's population. Thus a balance of trade (equaling the value of exports and imports) or a trade surplus (the value of exports is greater than the value of imports) can be achieved by reducing the exchange rate of the currency .   With increasing competitiveness of exports and increasing the cost of imports, the economy should witness higher exports and lower imports, thus reducing the trade balance deficit. Since 2010, the Iraqi trade deficit has recorded record numbers compared to the gross domestic product, so the devaluation of the dinar may be considered necessary to reduce the size of the deficit.   3 - Reducing the burden of sovereign debt: If a country issues several sovereign bonds to raise money, the state may have an incentive to reduce the currency exchange rate. In other words, a devaluated currency helps reduce the systematic service burden of the sovereign debt (i.e. interest paid on debt) issued by a country if investments are high by foreign investors and the interest to be paid is fixed. For example, if the government of Iraq issued sovereign debt, most of it was purchased by American investors. Let us assume that the government of Iraq must pay 500 million Iraqi dinars per month to these investors and that interest charges are fixed at this amount. If the exchange rate of the dinar were reduced from 1,200 dinars to 1,450 dinars per dollar, the monthly service burden would drop from 416.66 thousand dollars to 344.83 thousand dollars.   4. Increasing aggregate demand: A depreciation of the currency exchange rate can lead to higher economic growth. Part of aggregate demand is the difference between the value of exports and imports. Therefore, increasing exports and decreasing imports (assuming that demand is relatively elastic) increases the overall demand for domestic goods and commodities. Under normal circumstances, a rise in aggregate demand is likely to cause real GDP and inflation to rise as well. 5. Inflation is likely to occur after devaluation for the following reasons. Imports become more expensive, which creates inflation driven by increased import costs. The rise in aggregate demand raises the level of inflation driven by the increase in demand. And with the lower cost of exports, local manufacturers may have less incentive to cut costs and increase efficiency. Therefore, production costs can increase over time. In the short term, a devaluation of the currency exchange rate leads to inflation, higher growth and increased demand for the country's exports. Exports become cheaper for foreign customers and imports are more expensive. 6. Wages: Lowering the exchange rate of the dinar makes Iraq less attractive to foreign workers. For example, with the lowering of the dinar exchange rate, migrant workers from Asia may prefer to work in Kuwait or the United Arab Emirates rather than in Iraq. In the service sector, for example, many workers are of Asian nationalities, and their Iraqi employers may have to raise their wages to keep them. Likewise, getting a job outside Iraq becomes more attractive to Iraqi workers because the wage they will receive in foreign currencies will earn them more Iraqi dinars than it serves their purposes (or their families) inside Iraq. 7.  Decline in real wages: In a period of stagnant nominal wage growth, a depreciation of the currency exchange rate can lower real wages, that is, how much goods and commodities wages buy. And because the devaluation causes inflation, real wages only decrease if the rate of inflation is higher than the increases in nominal wages. The impact of a devaluation depends on a combination of factors, including :   1. Elasticity of demand for exports and imports: If the demand for goods and commodities is inelastic in relation to prices, then the fall in the price of exports will only lead to a slight rise in the quantity of goods and commodities exported. Therefore, the value of exports may actually decrease. The improvement of the trade balance depends on the state of elasticity of demand for exports and imports. If the difference in the value of exports and imports is positive, then lowering the exchange rate will improve the trade balance. 2. The devaluation of the currency exchange rate may take some time to affect the local economy. In the short run, demand may be inelastic, but over time the demand may become more price elastic and have a greater impact. 3. The state of the global economy: If the global economy is in a recession, as it is now due to the Corona pandemic, then devaluing the exchange rate may not be sufficient to boost export demand. If global economic growth became robust after a vaccine becomes available, there will be an even greater increase in demand. In a boom, however, a devaluation is likely to exacerbate inflation. 4.  Inflation: The effect of inflation depends on factors such as :  The economy's surplus production capacity. For example, in a recession, a devaluation is unlikely to cause inflation because there is an excess of output above demand. Whether or not importing companies pass the increased import costs on the consumers. Importing companies may reduce their profit margins, at least in the short term in the hope that they will develop their operations in the future by not losing market share. Import prices are not the only determinant of inflation. There may be other factors affecting inflation such as increased wages, or a decrease in domestic productivity, among others. 5. The reason behind reducing the currency exchange rate.    If it is due to loss of competitiveness, a depreciation of the currency exchange rate can help restore competitiveness and economic growth. But if the exchange rate devaluation aims to achieve a certain currency rate, then it may be inappropriate for the economy if it is not compatible with structural changes to the economy. . The winners and losers from the devaluation of the currency:   Winners: exporters, the domestic tourism industry, and those working in export industries. Economic growth may increase, and the trade deficit should improve. The Losers: Consumers who buy imported goods, residents who want to travel abroad, companies that import foreign raw materials for production, people with fixed incomes who will suffer from inflation, foreign exporters and the foreign tourism industry.   The effects of devaluing the currency exchange rate   An increase in foreign demand for exported domestic goods can create inflation. When this happens, the government can raise domestic interest rates but that will slow the growth of the country's economy. The devaluation of the currency exchange rate can also cause psychological damage to foreign investors because it may cause investors to view the weaker currency as an indicator of the country's economic weakness and thus make them afraid to invest and get their money out of the country quickly. Another effect of devaluation is that it may lead to fears by neighboring countries, which leads them to reduce the exchange rate of their currencies also in a "race to the bottom" and thus cause financial instability in neighboring markets, or what is called currency war.   Although the devaluation of the currency exchange rate might help reduce the trade deficit, there is a potential downside to it. Most developing countries have foreign currency loans. Thus, a devaluation of the currency exchange rate may increase the debt burden when loans are priced in local currency. Failure to service such debts may project a negative image of the country among foreign investors. The devaluation of the currency exchange rate is most often used as a monetary policy tool to boost a country's trade. However, there are multiple limitations to these policies.   Moreover, a country may have to make devaluations in the currency exchange rate when it is not able to maintain the official exchange rate. For example, the case of Russia after the collapse of the Soviet Union. In the early days after Russia emerged as a separate country, the Russian Bank tried to maintain the ruble exchange rate compared to the dollar. During that time there were large operations of buying the ruble and selling the dollar. The markets noticed this and currency traders realized that it was not sustainable, and therefore the ruble was sold, which posed a threat to the central bank regarding the possibility of losing reserves of the dollar. Consequently, the Central Bank of Russia had no choice but to let the ruble sale continue and watch its exchange rate drop against the dollar .   Why is the reduction important?   The most important benefit of lowering the exchange rate of the local currency, whether deliberately or as a result of the market climate, is to reduce the price of the country's GDP. This has the potential to benefit the economy by helping to increase the volume of exports. Conversely, import volumes are shrinking as the prices of foreign goods and services rise dramatically . * Professor of Economics and Political Science, Kansas State University, USA.

Number of observations 17   Date added 01/17/2021

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What is money and why do we need it?

 

  
 
Muhannad Talib Al-Hamdi *

 

In this article, we review a topic that was most important, but it did not receive the attention it deserves because people take it as if it were an obvious thing. We will talk about the meaning of money, its role in the economy, and what are its uses, among other topics.

 

Can the economy run without money?

 

There are historical examples of economies in which people exchanged goods and commodities in exchange for goods and other goods. In Iraq, for example, when the Bedouins came to the cities, they would exchange their products of carpets, wool and other products in exchange for urban products such as tobacco, sugar, rice and others. But modern economies use cash to carry out trade. Money is defined as any asset that people own and accept by others in exchange for the goods and commodities that they sell or use for financial exchanges. An asset here is everything of value owned by a person or company.

 

Barter system and the invention of money:

 

For a better understanding of the importance of money, let us look at the case of an economy that does not use money. The economies in which goods and commodities are exchanged for goods and other commodities are called barter economies. These economies have major fundamental shortcomings. The exchange of goods and commodities in these economies needs to have a bilateral reciprocal desire. That is, meaning that you need what the other person has, and at the same time the other person needs what you have. It may take a long time and a lot of effort on the part of people for this mutual desire to materialize. This renders the barter system an inefficient system and limits commercial exchanges and thus reduces the size of the economy significantly. Therefore, it is not surprising that the peoples who use this system live in a deplorable economic situation.

 

In order to get rid of the problems associated with the barter system, societies have incentives to create a commodity that most people will accept in exchange for the goods and goods they exchange. For example, Iraqis used gold and silver as a means of exchanging goods and commodities before the concept of modern money developed. Historically, when a certain commodity began to be widely accepted as money, people would start accepting it even if they had no other use for it.

 

Selling and buying goods and commodities becomes much easier when the cash is available. People just need to sell what they have for cash and use that cash to buy what they want. When cash is available, families are more likely to specialize in producing specific things rather than producing everything they need.  

In modern economies people are highly specialized. They only produce one thing, such as being a doctor, teacher, or accountant, and they use the money they get from their work to buy everything they need. People become more efficient in production when they specialize because they will gain comparative advantage in production.

 

The high incomes that people achieve in modern economies derive from the specialization in production made possible by the presence of money. Therefore, the answer to the question of why we need money, is that it makes commercial exchange easy and gives people an opportunity to specialize and become more productive and achieve higher incomes.

 

Functions of money:

 

Anything that is used as money, for example gold, salt in North Africa, cigarettes in prisons, dinars or dollars must perform four functions:

 

1. Exchange broker:

Money serves the function of a medium of exchange when the sellers are ready to accept it in exchange for the goods and commodities they sell. When a food store accepts a banknote in exchange for some bread and milk, that paper acts as an exchange. Through the medium of exchange, people can sell goods and goods for cash and use the cash to buy what they want. An economy becomes more efficient when people accept a single commodity as a medium of exchange for goods and commodities.

 

2. Measuring unit:

In a barter system, each commodity has a very large number of prices. Maybe the price of a cow is fifty chickens, or 200 eggs, or 2 tons of wheat or other things. When one commodity is used as money, each commodity will have one price instead of multiple prices. This function of money gives buyers and sellers a unit of measure, that is, a means of measuring the value of a good in the economy using money. And because the Iraqi economy uses dinars as money, all goods and commodities have a fixed price in dinars. 

 

3. Stock value:

Money allows people to store the value of their money with the money itself. That is, if you did not spend all of your money to buy goods and commodities, you could keep part of the money with you for future use. It is not just money that can be a store of value. Any asset of value, such as a plot of land, a painting, or a piece of carpet, for example can be a store of value. Financial assets, such as stocks and bonds, have an important benefit compared to keeping cash as store value because they yield higher interest or may increase in value in the future. You also have other assets over money for this job because it provides some services: for example, your house provides you with housing service. So why do people keep some cash with them? The answer is simply liquidity, that is, the ease of transferring assets to an exchange broker. Because money acts as a direct medium of exchange, it is the most liquid asset. If you want to buy something and need to sell an asset you own in order to do so, it is very likely that it will cost you some costs. For example, if you want to buy a house and you want to sell gold items owned by the family, you may have to sell them at a lower price now. To avoid such costs, people are prepared to keep a portion of their wealth in the form of cash. There are at least two problems with using cash as a store of value. The first is that money loses some of its value over time due to inflation. Second, there is a physical risk like fire, theft, or maybe mice.

 

4. Deferred Payment Standard:

Money is useful because it provides a standard for deferred payments in borrowing and lending matters. It can facilitate exchanges at a given moment in time by providing exchange broker function and unit of measure. But it can also facilitate exchanges over time by providing a valuable stockpile function and standard deferred payments. For example, you could buy a car today and pay in deferred installments over a period of time with cash.

 

How important is it for cash to act as a store of value and a reliable deferred payment standard?

 

People care about what their dinars can buy in terms of food, clothing, commodities, and other goods. In other words, the value of money depends on its purchasing power, that is, its ability to purchase goods and commodities. Inflation causes a decrease in the purchasing power of money because higher prices make the same amount of money able to buy fewer goods and commodities. When inflation reaches very high levels, the money becomes a store of value and an unreliable deferred payment standard.

 

What can be used as money?

 

When something can be used as a medium of exchange that makes commercial exchanges easier, the economy can operate more efficiently. So the question is, what are the assets that can be used as a medium of exchange? And as we indicated earlier that for anything to be used as money it must be, at least, generally accepted as a method of financial payments. But in practice there are other requirements.

 

There are five criteria for any asset to be used as a broker:

 

1.The original has to be accepted by the majority of people.

2. It should be of modular quality, that is, every two units of it are identical. Hence, the use of precious metals as money becomes a difficult process due to concerns about the different purity of different metal pieces.

3. It should continue to exist for a long time so that it does not lose its value as a result of continuous use.

4. It should be of comparable value to its weight so that large quantities of it can be transported easily in order to be useful for commercial use.

5. It should be divisible so that people can use it to buy goods and commodities of less than its value and receive the remainder at a value less than the asset itself. (Unless you're a cowboy hero like John Wayne or Clint Eastwood who walk into the bar and shoot, drink, eat, pay and don't take the rest.)
 

The Iraqi Dinar has these characteristics. What makes the Iraqi dinar acceptable as a medium of exchange? Simply, it stems from personal expectations. You regard an asset as money if you believe that others will accept it in exchange for goods and commodities they give you. Society's acceptance of the use of dinars as money is what makes it acceptable as a medium of exchange.

 

From here emerges the need to differentiate between the different types of money. We focus here on two types of money.

 

Commodity money:

They are assets that have intrinsic value separate from their use as money. For example, gold has value in the manufacture of jewelry, dental fillings, and most importantly in the manufacture of microelectronics. But using gold as money is a big problem. The money supply will face great difficulties for the government to control because it depends on the quantities of gold present or that are being discovered.

 

Paper money (including coins):

The economy would be inefficient if it relied on gold as money. Transporting quantities of gold for use as a medium of exchange for commercial transactions would be difficult, dangerous and costly. In order to avoid this, people in Britain began and by the year 1500 to store gold with goldsmiths and goldsmiths began to issue papers proving the holder's ownership of a certain amount of gold. People took to exchange these papers to meet their needs from purchases. Governments and companies in Europe took notice and began issuing documents that could be bought back for gold. As long as people had confidence that the gold backing up those securities was there and available when they asked for it, those documents remained in circulation as an exchange medium. As a matter of fact, paper money was invented.

 

In modern economies, paper money is issued by the central bank of the state which is one of the state institutions responsible for regulating money supply. The Central Bank of Iraq was established in 1947 by royal will and was previously called the National Bank of Iraq until 1956. At present, there is no country in the world that issues paper money covered with a gold cap. Paper money has no value except that it is used as money and therefore it is not commodity money. Paper money is a currency issued by the monetary authority with a decision to consider paper as a currency only.

 

If you look at the Iraqi dinar, you will see some words that say "a banknote issued by law," meaning that the Central Bank officially issued the note to be used as money. The Central Bank of Iraq is not required to exchange the dinar for gold if the holder of the dinars so desires. The banknotes issued by the central bank are a legal document in Iraq, meaning that the Iraqi government imposes its acceptance by people and companies in their dealings and the payment of government fees. Although it is a legal document, it will not be of much use to use as a medium of exchange and it will not work as money if people stop accepting it in general. The key to accepting cash is that families and companies have confidence that if they accept these papers in exchange for the goods and services they sell, they will not lose their value while they hold it before using it again. Without this trust, the banknotes will not function as an exchange.

 

* Professor of Economics and Political Science, Kansas State University, USA.

 

 

Number of observations 73   Date added 01/19/2021

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Fiscal policy

 

Dr. Muhannad Talib Al-Hamdi

Articles Muhannad Talib Al-Hamdi * Both fiscal and monetary policy play a large role in managing the economy and each has direct and indirect impacts on personal and public finances. Fiscal policy includes tax decisions, state revenues and expenditures determined by the government, and affects the amount of taxes paid by individuals and companies and the possibility of providing job opportunities in government projects.   What is fiscal policy?   Fiscal policy refers to the use of government spending and tax policies to influence economic conditions, especially macroeconomic conditions, including aggregate demand for goods and services, employment, inflation, and economic growth. In general, the goal of most government fiscal policies is to target the total level of spending, the components of total spending, or both of the economy. The two most common means of influencing fiscal policy are changes in government spending policies or in government tax policies and managing a country's resources.   If the government believes there is not enough business activity in the economy, it can increase the amount of money it spends, often referred to as stimulus spending. If there is not enough government revenue to pay for increases in spending, governments borrow money by issuing debt securities such as government bonds, and in the process, the debt accumulates. This is referred to as deficit spending . By raising taxes, governments are withdrawing money from the economy and slowing down business activity. Usually, fiscal policy is used when the government seeks to stimulate the economy. It may lower taxes or offer tax breaks in an effort to encourage economic growth. Influencing economic outcomes through fiscal policy is one of the basic tenets of Keynesian economics .   Before the Great Depression, which lasted from October 29, 1929, to the beginning of the United States' involvement in World War II, the US government's approach to the economy was laissez-faire. After World War II, it was decided that government must play a proactive role in the economy to regulate unemployment, business cycles, inflation and the cost of money. By using a mixture of monetary and fiscal policies (depending on the political orientations and philosophies of those in power at a given time, one policy may dominate another), governments can steer economic phenomena in some direction.   Understand fiscal policy   Fiscal policy relies to a large extent on the ideas of the British economist John Maynard Keynes (1883-1946), who argued that economic recessions resulted from deficiencies in consumer spending and the commercial investment components of aggregate demand. Keynes believed that governments could work to stabilize the business cycle and regulate economic production by adjusting spending and taxation policies to make up for the shortfall in the private sector. His theories were developed in response to the Great Depression, which challenged the assumptions of classical economics that economic fluctuations were self-correcting. Keynes’s ideas were very influential and led to a new economic policy called the "New Deal" in the United States, which included massive government spending on public works projects and social welfare programs .   In the Keynesian economy, aggregate demand or spending drives the growth of the economy. Aggregate demand consists of consumer spending, business investment spending, government spending, and net exports. According to Keynesian economists, the private sector components of aggregate demand are highly variable and rely heavily on psychological factors as well as economic expectations to maintain sustainable growth in the economy . Pessimism, fear and uncertainty among consumers and businesses can lead to recessions and economic recessions, and excessive exuberance in the good times can lead to a frenzied economy and inflation. However, according to Keynesian economists, taxes and government spending can be managed rationally and used to counter the excesses and shortcomings of private sector consumption and investment spending in order to stabilize the economy .   When private sector spending decreases, the government can spend more and / or impose less taxes in order to directly increase aggregate demand. When the private sector is more optimistic and spends more, and too quickly, on consumption and new investment projects, the government can spend less and / or impose more taxes in order to reduce aggregate demand . This means that to help stabilize the economy, the government will face large budget deficits during recessions and it must manage budget surpluses as the economy grows. These policies are known as expansionary or contractionary fiscal policies, respectively .   Expansive fiscal policies   If the economy is in recession, the government may decide to grant incentive tax breaks to increase aggregate demand and support economic growth. The logic behind this approach is that when people pay less taxes, they have more money to spend or invest, which leads to higher demand. This demand leads companies to hire more workers, which reduces unemployment. This, in turn, raises wages and provides consumers with more income to spend and invest. It is a virtuous cycle, or a positive feedback loop . Instead of lowering taxes, the government might seek economic expansion by increasing spending (without corresponding tax increases). By building more highways, bridges, buildings and schools for example, this can lead to increased employment, increased demand and growth . An expansionary fiscal policy is usually characterized by deficit spending as government expenditures exceed revenues from taxes and other sources. In practice, deficit spending tends to result in a combination of tax cuts and spending increases .   Downsides of financial expansion   Rising deficits are among the problems facing expansionary fiscal policy, with critics arguing that an influx of government funds could affect growth and ultimately create the need for destructive austerity. Many economists simply question the effectiveness of expansionary fiscal policies, and say government spending crowds out private sector investments and pushes them out of the market.   Basically, fiscal policy targets aggregate demand. Businesses also benefit from increased revenues. However, if the economy is close to full production capacity, then expansionary fiscal policy is a risk that could fuel inflation. This inflation is eating into the profit margins of some firms in competitive industries that may not be able to easily transfer costs to customers; It also eats away the money of people with fixed income.   The expansionary policy is dangerously popular, some economists say. It is politically difficult to reverse the fiscal stimulus. Whether or not they achieve the desired macroeconomic impacts, voters love lower taxes and increased public spending. Because of the political incentives that policymakers face, there is a persistent tendency to engage in somewhat persistent deficit spending that can be partly justified as "good for the economy ".   Ultimately, fiscal expansion can get out of control, rising wages lead to inflation, and asset bubbles begin to form. High inflation and the risk of widespread default when debt bubbles burst can seriously damage the economy and this risk in turn pushes governments (or their central banks) to reverse course and attempt to "deflate" the economy .   Contractionary fiscal policies   In the face of rising inflation and other symptoms of expansionary fiscal policy, the government can pursue a contractionary fiscal policy, perhaps even to the point of inducing a short recession in order to restore balance to the economic cycle. The government does this by increasing taxes, cutting public spending, and cutting public sector wages or jobs .   If the expansionary fiscal policy involves a deficit, then contractionary fiscal policy is characterized by a budget surplus. This policy is rarely used, as it is not very popular at the political level. Thus, public policy makers face significant asymmetry in their incentives to engage in expansionary or contractionary fiscal policy. Instead, the preferred tool to curb unsustainable growth is usually deflationary monetary policy, or raising interest rates and restricting the money supply and credit in order to curb inflation .   When inflation is very strong, the economy may need to slow down. In such a situation, the government can use the fiscal policy to raise taxes to absorb money from the economy. Fiscal policy can also dictate lower government spending and thus reduce money in circulation. Of course, in the long run the potential negative effects of such a policy could be a slowdown in the economy and higher levels of unemployment. However, the process continues as the government uses its fiscal policy to regulate spending and tax levels, with the goal of regulating business cycles .   Who does fiscal policy affect?   Unfortunately, the effects of any fiscal policy are not the same for everyone. Depending on policy orientations and fiscal policy-makers' goals, a tax cut could only affect the middle class, which is usually the largest economic group. In times of economic decline and high taxes, this same class may have to pay more taxes than the wealthier upper class .   Likewise, when a government decides to adjust its spending, its policy may only affect a certain group of people. The decision to build a new bridge, for example, would provide more jobs and income for hundreds of construction workers. On the other hand, the decision to spend money on building a new space shuttle benefits only a small, specialized group of experts, which will do little to increase overall operating levels .   Whenever government spends money or changes tax policy, it should choose where to spend or change tax. In doing so, government fiscal policy can target specific societies, industries, investments, or commodities either in favor of or discouraging production. Sometimes the government's actions are based on considerations that are not entirely economic. For this reason, fiscal policy is often the subject of heated debate among economists and government policymakers.   One of the biggest hurdles facing policymakers is determining the extent of government involvement in the economy. In fact, there have been various degrees of interference by the government over the years. But for the most part, it is accepted that a degree of government involvement is necessary to maintain an active economy, on which the economic well-being of the population depends .   Fiscal Policy in Iraq: What is the Challenge?   The long-term goal of fiscal policy in most oil-producing countries is to take advantage of the depleted oil wealth to promote sustainable economic development. This includes making strategic choices about the share of oil revenues to be diverted to other forms of assets (real or financial) or to be depreciated, taking into account long-term financial sustainability and considerations of intergenerational equity. The options should reflect the economic and social priorities of the government, its ability to spend efficiently, as well as the rate of return and risks associated with each asset type.   Iraq has one of the most immersive revenue bases in the world and is therefore more vulnerable than most countries to oil price movements. In 2018, oil revenues accounted for about 92% of total budget revenues. Rising oil production has amplified this dependence. For example, at current production levels, every dollar of change in oil prices leads to a change in total revenues of 1.1% of non-oil GDP ($ 1.5 billion), compared to 0.6% in other oil exporting countries in the Middle East region. And North Africa. On the other hand, the non-oil tax base is tight and eroded by poor tax compliance. In 2018, tax revenues represented less than 5% of non-oil GDP .   The volatility and unpredictability of oil prices in recent years have posed major challenges for fiscal policymakers. Oil price shocks are often large and persistent, with booms and busts that involve price movements of up to 40-80% for up to a decade. Oil price volatility increased sharply, particularly during the commodity price shock of 2014-2015, and showed renewed volatility since the fourth quarter of 2018. Hence, forecasting commodity prices has proven very difficult in recent years. An additional factor of volatility in Iraq is the difference with international prices, which have fluctuated significantly since 2004, reflecting security-related changes in shipping costs, mixes of light and heavy crude, and delivery risks .   Iraqi policy frameworks and institutions are ill-equipped to deal with these challenges. A directed fiscal policy is a short-term policy and is conducted largely in the context of the annual budget, while financial planning in the medium to long term supported by a policy to build adequate buffers was lacking. Revenue projections generally reflect oil prices prevailing at the time of budget preparation, while spending allocations typically follow a bottom-up approach, leading to rising trends without sufficient consideration to alter government or fiscal priorities.   Moreover, weaknesses in the legal framework allowed for spending outside the budget process to be approved, and insufficient compliance monitoring and cash management processes undermined the integrity of the annual budget, which became a poor indicator of fiscal results. Together, these factors led to a largely pro-cyclical fiscal policy and an unbalanced spending structure, which negatively affected growth and development. Government spending has been closely linked to changes in oil prices. The correlation between government spending growth and oil prices was 70% during the period 2003-2018. The negative impact of spending volatility on long-term growth is well documented and exacerbated by asymmetric fiscal policy responses to changes in oil prices. Current spending, particularly the cost of wages, was increased during booms, while sudden cuts in capital spending and accumulating arrears were the first line of defense when oil prices fell. This disparity skewed the spending structure towards current spending, as non-oil capital expenditures accounted for only 4% of total spending in 2018, and resulted in severe spending rigidity and limited reserves. As a result, Iraq has witnessed greater economic volatility than comparative countries, and lower investment rates, which have translated over time into reduced human and material capital accumulation.   Iraq’s short to medium term goal is to meet urgent demands after periods of conflict and address infrastructure gaps while maintaining macroeconomic stability. The investment space is constrained by the volatility of international oil prices and the lack of fiscal buffers, while modest debt sustainability and incomplete access to capital markets limit the scope for financing spending through borrowing. Therefore, fiscal policy should aim to  create space within the budget, through strict control over current spending and increasing taxes and revenues, to expand the required infrastructure and social spending, manage fluctuations in oil revenues and avoid the pro-cyclical fiscal policy by building adequate financial reserves (which can be used To protect capital spending during recessions) .   Developing a medium-term approach to budgeting should help ease the cyclical trend and ensure that oil revenues are spent in a sustainable manner. Medium-term financial planning helps prevent volatile annual revenues from translating into spending fluctuations that could destabilize the economy and reduce the quality of spending .

* Professor of Economics and Political Science, Kansas State University, USA.

Number of observations 601   Date added 02/04/2021