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The U.S. Dollar's Role as an International Reserve Currency and the Developing Nations (Also Called Less Developed Nations)

The U.S. dollar was made a major reserve currency of the world by the Bretton Woods Agreement in July 1944. Nowadays, many countries in the world base their currencies mainly on the value of the U.S. dollar and to a lesser extent of the euro. It is true that we have locally minted and printed currencies in each country with different names like dollar, euro, British pound, Malaysian ringgit, dinar (Kuwait), “geneeh” (meaning a pound in Egypt and Sudan), lira (Turkey, Lebanon, and Syria), peso (Mexico, Argentina, and some Latin American nations), rand (South Africa), riyal (Iran and Saudi Arabia), dirham (extracted from drachma; used in the United Arab Emirates), and drachma (in Greece). The banknotes of the developing currencies are all designed to look unique and different from the way the U.S. dollar and the euro banknotes look. However, many world currencies are in fact tied (pegged) to the U.S. dollar and the euro depending on the local economies and how these economies developed historically, especially in former colonies of European countries, trade relationships, and monetary policies of the particular central bank of the country involved. This reliance on the U.S. dollar (and to a lesser extent the euro) as a reference currency made the U.S. dollar (and the euro to a lesser extent) the currencies of choice in many countries in the world. Transactions in many Asian, African, and some European countries are conducted directly and openly among the public in local currencies and also in U.S. dollars and in euros. That means that the velocity and the money supply of the U.S. dollar and the euro in the world at large have been greatly enhanced because of their status as recognized world reserve or reference currencies by hundreds of million people in the world, in excess of the local populations in the United States and European Zone.

Applying the Equation of Exchange stated earlier once for a developed country (D, such as the United States) and another for a developing country (U, such as the Central African Republic), and dividing the equation for D by that of U, one gets:

P(D) /PU) = V (D) /V(U)×M(D) /M(U)×Q(U) / Q(D)

If we assume that the velocity-of-money ratio of a developed country to a developing country (V(D)/V(U)) can reach a value of 10 (in fact, it can be much higher), the money supply ratio between a developed country like the United States ($11,000 billion in 2012) and that of a developing country like Egypt ($195 billion in 2012) (M(D)/M(U)) is 56; and the quantity- of-production ratio (ratio of GDP in the United States to that of Egypt) (Q(D)/Q(U)) is 16,000/195 = 82, then we calculate the ratio of prices in the developed country P(D) to the prices in a developing country P(U) one gets the following:

P(D) / P(U) = (V(D) / V(U)) × (M(D) / M(U))]56 × 1 / 82 (Q(U) / Q(D))

That is, if we assume that the velocity of money in the United States is 5 times that in Egypt, which is an extremely conservative assumption, then the ratio of prices P(D)/P(U) = 3.4 times. That indicates how the U.S. business- person evaluates the value of local currency in Egypt and the corresponding goods and services supplied there. If the velocity in the United States is 10 times that of Egypt, then prices in Egypt would be one-seventh of that in the United States.

There is one exception to this unfortunate state of affairs in countries like Egypt that does not enjoy a significant natural resources base. If the developing country is endowed with a rich natural resource base (e.g., oil, gas and/or minerals) the situation will be different. In this case, most of the production ratio Q(D)/Q(U) will be much lower than in case of a resources-poor developing country. Let us take the example of Saudi Arabia . In 2012, the Saudi money supply (М2) reached approximately $90 billion while its GDP reached approximately $580 billion (due to the value of the natural resources — oil — on the international market). In this case, the quantity of production ratio for the United States and Saudi Arabia is 16,000/580 = 27, compared to 56 in the case of Egypt, despite the fact that the population of Egypt is almost 90 million compared to almost 25 million in Saudi Arabia. The money supply ratio in Saudi Arabia is 11,000/190 = 58, compared to a ratio of 16 in the case of Egypt. This indicates that the Saudi money supply figures may only reflect the supply in Saudi riyal (tied to the dollar) to meet the liquidity needs of its 25 million citizens. Please note that these figures do not include the vast quantities of dollars transacted in oil sales, military and arms purchases, investments by Saudi Arabia in U.S.-issued government and corporate bonds and other imports by Saudi Arabia and trading in general. In this case and by applying the same Equation of Exchange, we find that at a velocity ratio of 2 (that means the ratio of money velocity in the United States is 2 times that of Saudi Arabia), the ratio of prices in the United States to prices in Saudi Arabia would be a ratio of 1. Please note that if we assume a velocity ratio of 1 to reflect the huge number of transactions in oil only, then the price ratio goes to 2. That is, prices in Saudi Arabia would be half prices seen in the United States. The velocity of money, assumed here to be same as that of the United States, does not have an impact on the domestic Saudi economy because a major portion of the transactions is done outside the domestic economy.

These concepts can be tied up with the recommendation for more creative research to develop an RF Commodity Indexation Discipline, based on the embryonic concepts described in Chapters 3 and 6 to develop a fair value of the domestic currency on the international markets. This RF Commodity Indexation Discipline can be applied to the domestic economy in a matrix that will reflect the domestic production of staple food products and natural resources. This way, the real value of the domestic currency, in addition to being partially tied to the U.S. dollar or the euro, will also be tied to the matrix of products in that country's economy. This way, the fluctuations in U.S. or European monetary policy can be disengaged, and the value of the domestic currency is tied up to domestic production and/or demand depending on strategic issues. This approach may signal the beginning of an RF Monetary Discipline that can be applied as a navigation compass that can be used by economic planners and central bank monetary policymakers to strategically plan for the future of the economy in a particular country by adjusting and fine-tuning the country's products matrix in light of its production, consumption, international trading partners, and its strategic objectives.

Government Taxation Policy and Economic Development

It is a known fact that if a government taxes its citizens excessively, the citizens' reaction would be to either not participate in the economy because there would be no economic incentive to do so and/or to try to evade taxes resulting in an unhealthy social fabric in that country. If a citizen decides not to participate in the economy and/or to evade taxes (which is usually coupled with sending money abroad to avoid taxes), this will lead to less money velocity because the currency will travel less. In order to explain this in a simple way, let us consider two countries with a money supply level (M in the exchange equation discussed earlier) of $1 million. Country A, because of its low taxes, has a velocity of money of 10, while country B has a velocity of 2:

1. Country A charges 25 percent in taxes. Every time a dollar is transacted in a business, a tax of 25 cents is charged. In this case, the country will have a GDP of $1 million x 10, or $10 million. The tax collected here is $2.5 million. This would be the money that will be used by Government A to meet its maintenance and growth plans.

2. Country B charges 50 percent in taxes. Every time a dollar is transacted in business, the government keeps 50 cents. In this case, the country will have money velocity of, say, 2, which results in a GDP of $1 million x 2, or $2 million. The tax collected in this case is $1 million.

In this example, one can find that the country that charged less in taxes collected more income than that with higher taxes. Of course, there is an optimization process that must be pursued by planners in economic and monetary policy in order to decide on the most appropriate tax rate that would help achieve government goals and objectives.

Readers who are interested in more details on this subject can search the Web and many of the books and articles in the field of monetary theory for:

The Laffer Curve (named after Arthur Laffer, who is one of the leading pioneers of supply-side economics in the United $tates).

The General Theory of Employment, Interest Rates, and Money, published in 1936, by economist John M. Keynes. In this book, Keynes developed his theory of money demand, known as the liquidity preference theory.

The books and writings of Nobel Prize-winning economist James Tobin (1918-2002).

The rich contributions of the prominent Nobel Prize winner Professor Milton Friedman (1912-2006), who pioneered the modern quantity theory of money.

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