The Affection of Monetary Base to Gold Reserve Ratio on the US Dollar Exchange Rate in Egyptian Pounds

Abstract

This research try to answer the question: Are currency exchange rates separated from gold under the flexible exchange system? it dealt with the impact of the monetary base (MB) to gold reserve (GR) ratio on the exchange rate of the US dollar in Egyptian pounds, from 2001 – 2021, by calculating what this research call it the Natural Golden Exchange Rate (NGER) by dividing the ratio (MB/GR) in USA to its counterpart in Egypt. The research estimates a statistical model to analyze its impact on the Official Market Exchange Rate (OMER), during this period. Where the correlation test was conducted and a simple linear regression model was estimated and the research hypothesis was found to be correct, where NGER is the basic exchange rate on which the OMER is determined in light of the supply and demand for the dollar in Egypt and the outcome of the Egyptian government policies affecting the foreign exchange market.

Introduction

Despite the world’s exit of the gold standard, Central banks still maintain a golden reserve for the monetary base. We can calculate the monetary base to the gold reserve ratio (MB/GR), by dividing the value of the monetary base (MB) of the country’s currency by the amount of gold reserves for this country. This ratio expresses the equivalent to each gram of gold reserve in monetary base units. If we compare the MB/GR ratio in two different countries, it will give us the exchange rate based on gold reserves only, which the researcher will call it the Natural Golden Exchange Rate (NGER). If the result of market forces; demand (D), and supply (S) have no influence on currency exchange rates, and governments stop interfering in determining it, the NGER will be equal to the Official Market Exchange Rate (OMER). The researcher thinks that if the world returns to the gold standard, NGER will become the prevailing exchange rate.

To express these ideas, the researcher set the following two equations:

This will be applied depending on Egyptian and American data during the period from 2001 to 2021 to know the impact of the MB/GR ratio (NGER) on the official exchange rate (OMER) of the US dollar in Egyptian pounds. This is important in predicting the long-term exchange rate.

1. Gold and fixed exchange rates

Under the gold standard, the exchange rate system was known as the fixed system, where the exchange rate of each currency is estimated in relation to others on the basis of the amount of gold each of them contains. (E.M.Bernstein, 1940) Therefore, the role of the exchange rate adjustment on the basis of the current account of the balance of payments was insignificant during the gold system. (Guha, 2007)

At the beginning of the paper money system, the gold reserve was covering each unit of issued currency; later countries use a partial gold cover. “Canterbery” concluded that the greater the gold cover, the lower the fluctuations in the exchange rate and the effect of speculation was small, and vice versa, The smaller the gold cover, the greater the fluctuations in the exchange rate and the greater the impact of speculators on currencies. (Canterbery, 1971)

2. fixed vs. flexible exchange rates

The fixed exchange system has been replaced by a system of flexible exchange rates that are determined on the basis of foreign exchange market forces; currency supply and demand. many theories have emerged to analyze the various factors that affect market forces and thus determine the exchange rate, in the short and long term. (Lindbeck, 1976) This includes the effect of macro policies on exchange rates. (Dornbusch, 1976) Purchasing power parity theory has gained wide popularity, but it often fails to explain changes in exchange rates nor predicting their fluctuations. Therefore, attempts have emerged to address its shortcomings. (Stockman, 1980,)

Some believe that flexible exchange rates are more effective than fixed exchange rates, and there are others who disagree. “Paul Davidson” has discuss this issue and sided with the opponents of the flexible exchange system as an unstable system that experienced many fluctuations. (Davidson, 2003)

3. Gold, Money Supply and Flexible Exchange Rate

The question that prompted me to conduct this research is: Are currency exchange rates really separated from gold reserves under the flexible exchange system? During my research, I found researchers who linking the production of gold to the money supply, and linking the money supply with inflation and the exchange rates. Although this is different from my perception, it is useful to know these two points of view as follows:

1. Under the gold standard, an increase in gold production meant a higher ability to increase the money supply, which consumed about 70 percent of gold production during the period from 1835 to 1952, according to Busschau’s study. (Busschau, 1954) But because of the high rates of population growth and the large increase in production as a result of technological improvement and economic expansion, The belief that gold is unable to meet monetary needs has increased, which eventually led to a transfer from the gold standard with a fixed exchange system toward a paper money system with a flexible exchange system. (Carter, 1963)
2. If the money supply in a country increases at a rate greater than the GDP growth rate, this will lead to inflation. Under the flexible exchange system, the exchange rate of this country’s currency will depreciate. Among the most prominent reasons for this are the rise in imports and the decline in exports, and the decrease in the real interest rate and consequently the decrease in foreign demand for deposits in local currency. (Levin, 1997)
3. US dollar OMER in Egyptian pounds (2001-2021)

During the study period, which extended from 2001 to 2021, the Egyptian government took two decisions to float the exchange rate of the Egyptian pound, the first was on January 29, 2003, and the second was on November 3, 2016. The following table shows the evolution of the official market exchange rate for selling US dollars in Egyptian pounds during the study period.

Table (1): US dollar OMER in Egyptian pounds (2001-2021)

Source: (Egypt, 2021)

The US dollar exchange rate data presented in the previous table can be represented in the following graph:

Figure (1): US dollar OMER in Egyptian pounds (2001-2021)

It is clear from the previous table and figure, the official market exchange rate (OMER) of selling the US dollar in Egyptian pounds fluctuated during the study period around a general upward trend, after it reached an average of 3.85 pounds in 2001, it rose to 15.75 pounds in 2021, with an annual average growth rate of 9%. It rose significantly after the first float in 2003, reaching an average growth rate of about 33%, and after the second float in 2016, its rise was severe and averaged about 104%.

5. Gold reserves in Egypt and USA

Despite deviating from the gold standard, countries still maintain a cover of gold or gold reserves in its central banks, and the following table shows the amount of gold reserves in tons (million grams), in both Egypt and the United States of America during the study period.

Table (2): Gold reserves in Egypt and USA (2001-2021)

Source: (goldhub, 2021)

It is clear from the previous table that the gold reserves in Egypt during the study period tended to be stable, it was about 75.6 tons in 2001, and rising in 2021 to be 80.6 tons, and its annual average growth rate approximately was 0.32%. It is also clear that the American gold reserves tend to remain stable during the study period, it was about 8149 tons, and decreased slightly to be 8133.5 tons in 2021, with an annual average change rate of almost zero%. The gold reserves in Egypt throughout the study period did not exceed 1% of the gold reserves in the United States of America, which explains the vast difference between the monetary and economic capabilities of the two countries in general.

6. Monetary base in Egypt and USA

The monetary base (MB) is defined as the sum of cash circulating outside the central bank in addition to the cash kept in central bank. The following table shows the value of the MB in Egypt and the United States of America during the study period.

Table (3): MB in Egypt and USA (2001-2021)

Sources: (*) (Fred Economic Data, 2021), (**)  (Egypt C. b., 2021)

from the previous table, we find the value of MB in Egypt took a general upward trend during the study period, rising from about 41 billion pounds in 2001 to about 719 billion pounds in 2021, with an annual average growth rate of 15%. It also took a general upward trend in the United States of America as well, rising from about $609 billion in 2001 to about $6 trillion in 2021, with an annual average growth rate of 14%. This indicates the extent of convergence between the average growth rate of money supply in Egypt and the United States of America during the study period.

7. MB/GR Ratio in Egypt and USA (2001-2021)

We can calculate the ratio of the monetary base MB to the gold reserve GR by dividing the first by the second, then get the amount of units of monetary base corresponding to each gram of gold reserve MB/GR, in other words we will get the price of each gram of gold reserves denominated in a monetary base units.

Table (4): MB/GR ratio in Egypt and USA (2001-2021)

Source: Prepared by the researcher based on the data of the second and third tables.

From the previous table, the ratio of the monetary base to gold reserves in Egypt, MB/GR_EGT, has taken a general upward trend, rising from 542 pounds per gram in 2001 to about 8925 pounds per gram in 2021, with an annual average growth rate of 15%. Its counterpart in the United States, MB/GR_USA, also took a general upward trend, rising from about $75 per gram in 2001 to about $741 per gram in 2021, with an annual average growth rate of 14%, which is almost identical to the rate in Egypt during the study period.

8. US dollar NGER in Egyptian pounds

We can calculate the natural golden exchange rate of the dollar in Egyptian pounds depending on the ratio of the monetary base of the gold reserve MB/GR by dividing this ratio in Egypt by its counterpart in the United States of America, to find amount of the Egyptian pound corresponding to each dollar, which can be clarified in the following table.

Table (5): US dollar NGER in Egyptian Pounds (2001-2021)

Source: Prepared by the researcher based on the data of the first and fourth tables.

For further clarification, the data of NGER and OMER is represented through the following graph.

Figure (2): OMER and NGER of US dollar in egyptian pounds (2001-2021)

As its clear from the previous figure, the natural golden exchange rate NGER fluctuated around a general upward trend, rising from 5.04 pounds to the dollar in 2001, to 12.04 pounds to the dollar in 2021, with an annual average growth rate of 4.1%. the ratio of the official market exchange rate OMER to the natural golden exchange rate NGER fluctuated around an average of 82%, which means that OMER was less than NGER during the study period, and the researcher believes that the reason for this is the government intervention to support the Egyptian pound vs. US dollar during most of the study period.

It is noted that the convergence between OMER and NGER after the flotation decisions. During most of the study period NGER was higher than OMER, which means that the egyptian government supports the pound, Even after the first flotation decision in 2003, Therefore, it is described as managed flotation. But after the second flotation decision in 2016, the OMER became greater NGER Which means almost complete flotation of the pound exchange rate.

9. The estimated statistical model

The purpose of this study is estimating the impact of monetary base to gold reserve ratio on US dollar exchange rate in Egyptian pounds. Simple statistical techniques were used to tabulate the results of this research, include: descriptive statistics and simple linear regression analysis. SPSS was used for analysis the data, (SPSS outputs are contained in Appendix). The data is consisted of 21 observations, where, NGER is the independent variable and OMER is the dependent variable. The following table shows the descriptive statistics for the two variables.

Table (6): Descriptive Statistics

9.1. The relationship between the variables

Form the above table the Pearson’s sample correlation coefficient . This implies a strong, direct (positive) statistical association between the two variables. The coefficient of determination is This means that, , explains  of the variation in . The following Figure show both the direction and strength of a correlation coefficient associated with scatter plots of the two variables.

Figure (3): direction and strength of a correlation coefficient

9.2. The Estimated Regression Model:

Simple linear regression is used to develop an equation showing how the variables are related. The Estimated Regression Equation is,

Where,

• : official market exchange rate
• : nature golden exchange rate
• Estimated, or predicted,  value
• The estimate of the regression intercept = 4.267
• The estimate of the regression slope =

9.3. The 95% confidence interval estimate of regression slope:

This gives a lower and an upper confidence limit about regression slope:

• Lower 95% confidence limit =
• Upper 95% confidence limit = 1.828

9.4. The (t) test for significance:

To test the significance of the simple linear regression slope coefficient, we are interested in determining whether  (implies that there is no linear relationship between x and y).

Since  sig

Reject   at the 5% level of significance.

9.5. The (t) test for significance:

To test the significance of the simple linear regression intercept, we are interested in determining whether .

Since  sig

Accept  at the 5% level of significance. 

Conclusion

The research aimed to know the extent of the impact of gold on exchange rates under the flexible system, and this was applied to the relationship between the currencies of the US dollar and the Egyptian pound, by comparing the ratio of the monetary base (MB) to gold reserves (GR) in Egypt and the United States of America, and the research named the exchange rate in this case The Natural Golden Exchange Rate (NGER) and by comparing it with the Official Market Exchange Rate (OMER).

Statistically it was found significant positive corellation between OMER and NGER, and it was found that NGER explains more than half of the change in OMER, and the regression slope Which represents the ratio of demand for a dollar to its supply (D/S), ranged between 0.706 and 1.828, Where the lower slope represents the Egyptian government’s support for the pound exchange rate, while the upper slope represents the almost complete flotation of the Egyptian pound exchange rate.

Appendix

SPSS correlation and regression outputs

Bibliography

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