The effect of exchange rate on inflation in Egypt During the period 1990-2020

 

Prepared by the researcher : Mariam Samir Farouq , Omnya Fawzy Mohamed , Rania Alhm Awny Sara Mahsob Taher , Yahia Ali Mohamed

Academic Supervisor: Prof. Mosaad El Ghaish

Democratic Arab Center

Abstract

The research dealt with the problem of changing the exchange rate system in Egypt and its impact on inflation. Egypt was a case study and used data from the World Bank from 1990 to 2020. The study aims to show how inflation was affected by changing exchange rate regimes in Egypt during the target period. It has been hypothesized that inflation is positively affected by a change in the exchange rate. The ARDL model was adopted to clarify the effect of the independent variables (exchange rate, money supply, interest rate, and trade) on the dependent variable (inflation). The study concluded that the exchange rate positively affects inflation by 20.8% and it recommended that inflation should be controlled through exchange rate policies.

1. Introduction

Egypt recently decided to make price stability an explicit monetary policy goal. The Central Bank of Egypt has taken several steps to develop its monetary policy framework since June 2005, to implement an inflation-targeting regime in the medium term. Exchange rate fluctuations have become an important on-hand issue in economic policy debates under this regime. On the one hand, a floating nominal exchange rate is, at least theoretically, a requirement for a pure inflation-targeting regime. The idea is that even with good planning and economic management, the central bank will be unable to achieve free capital mobility, independent monetary policy, and a fixed exchange rate at the same time. On the other hand, one of the costs of fully floating in developing economies with greater financial and real vulnerabilities is higher exchange rate volatility. This can lead to the issue of a high inflationary effect on the exchange rate, known as exchange rate pass-through (ERPT). Because of the lack of credibility of their monetary authorities, developing countries may suffer even more than developed countries. As a result, agents generally believe that any temporary fluctuation in exchange rate behavior is permanent. This issue is at the root of the fear of floating behavior, which entails interventions in the foreign exchange market via changes in international reserves and interest rates. (AL-Mashat, 2007)

The high ERPT is a source of concern for developing countries considering implementing an inflation-targeting regime. This is due to the risk of the exchange rate becoming the central bank’s primary goal, thus dominating the monetary authorities’ ostensibly primary goal, the inflation rate. In Egypt’s case, realizing this problem in its developing economy. The current challenge is figuring out how to strike a balance between the monetary policy goal of price stability and the high volatility of the exchange rate. In other words, it must choose between meeting the theoretical conditions of “strict inflation targeting,” which imply a fully flexible exchange rate, and applying “flexible inflation targeting,” which entails a de facto managed floating exchange rate. (Nabil, 2012)

• Research problem:

The research problem mainly lies in the rise in prices that leads to inflation. By studying the case of (Egypt) in the period from 1990 to 2020, it was found that the exchange rate has a significant impact on the Egyptian economy, especially on inflation. This was noticed in the year 2016 when a managed floatation of the exchange rate took place, and the objectives of the study will be verified by answering the following questions:

1. What is inflation and its theories?
2. To what extent does the inflation rate effect on the economy?
3. what is the exchange rate and its functions?

And the main question is:

• To what extent does the exchange rate affect inflation?

• Research objectives:

The research aims to know the effect of the exchange rate on inflation throughout, testing the hypothesis and answering the research questions to know how we can deal with this phenomenon.

• Research importance:

This research highlights the role of the exchange rate is affecting inflation in Egypt.

• Research Limits:

In this research, our study limited to Egypt from 1990 to 2020.

• Hypothesis:

Based on the study problem and previous studies, the most important hypotheses of the study:

There is a positive relationship between the exchange rate and inflation in Egypt.

• Research methodology:

Through the research problem, hypotheses, and previous studies this research follows: The descriptive and analytical approach to explain the relations between inflation and independent variables (exchange rate, trade, money supply, interest rate). The data was collected for a certain period (1990-2020) from the world bank.

2. Previous studies

Several studies have subsequently analyzed the effect of exchange rate on inflation:

• In the study of Bahmani-Oskooee, (1991). Effects of exchange rate variability on inflation variability. In this study, they argue that, with the current floating exchange rate system, exchange rate volatility contributes to inflation volatility. They estimate their model using cross-country data from 20 developed and 76 developing countries after incorporating a measure of exchange rate volatility into a simple model with other variables. They concluded that their hypothesis is supported by the cross-sectional regression results.
• In another study of Egwaikhide, Chete, and Falokun, (1994). Exchange rate depression, budget deficit, and inflation – the Nigerian experience. This study investigated the quantitative effects of currency depreciation on inflation in Nigeria. Their objective was accomplished by employing a macro-econometric model. They relied on trends in the relationship between inflation and other economic variables. Evidence from trend analysis suggests that domestic money supply, real output, the shadow price of the exchange rate, the parallel market exchange rate, and, more recently, the official exchange rate cannot be ignored in determining the proximate causes of inflation in Nigeria. In terms of exchange rates, graphical representation reveals that the parallel market exchange rate appears to correlate with inflation more than the official rate. The inflation equation results show that the official exchange rate is a significant determinant of price inflation, with a one-year lag.
• And in the study of McCarthy, J. (2000). Pass through of Exchange Rates and import Prices to Domestic Inflation in Some Industrialized Economies. This study examines how responsive the exchange rate is to the pricing of the top 10 imported commodities. It employs monthly and quarterly datasets for the years 2002 to 2014 and for the US, UK, India, and China to evaluate the hypothesis. It employs an autoregressive distributed lag model (ARDL).  It determines the degree to which commodity prices are responsive to the import index and discovers that non-ferrous metal has a high level of responsiveness, followed by metallic tools, metals, whereas organic chemical, machinery electrical, and plastic exhibits a negative sign compared to short term outcomes, practically every commodity exhibits a high level of reactivity over time.
• Another study about Rutasitara, 2004, Exchange rate regimes and inflation in Tanzania. The study examines the impact of major determinants of inflation, with a special emphasis on the role of exchange rate policy changes. It concluded that the exchange rate had a significant effect on Tanzania’s high inflation rate. Inflation was discouraged and limited by the fixed exchange rate.
• Fifth study about Nkunde and Mwase, 2006, An Empirical Investigation of the Exchange Rate Pass-Through to Inflation in Tanzania. The research uses structural vector autoregression (VAR) models to investigate how changes in the exchange rate affect consumer prices in Tanzania. The study finds that, despite the currency depreciation in the late 1990s, the exchange rate’s pass-through to inflation decreased from 1990 to 2005. This may be partially due to the structural and macroeconomic reforms carried out during this time. It is not a given that the fall in pass-through means that exchange rate variations are less important in explaining macroeconomic volatility. The recent growth in the economy’s import share raises the possibility that the pass-through will expand in the medium run.
• Sixth study about Hossein, Lotfali, and Azhdar, 2007, The relationships between interest rate rates and inflation changes, this study examines the causal relationship between the interest rate and inflation rate in a panel of 40 selected Islamic countries using a new causality approach and applying panel data methodology over the 2002 – 2005 periods. They use the Hsiaosiao causality test to determine the relationship between interest rate and inflation. They reached to:

• There is unidirectional causality from interest rate to inflation rate in 40 Islamic countries.
• The interest rate is affected by many components such as Inflation rate, economic stability, and monetary policy.
  • Seventh study about Ca’Zorzi. M, Hahn. E, and Sánchez. M, (2007). Exchange Rate Pass-Through in Emerging Markets. This study looks at how much the prices in 12 developing economies in Asia, Latin America, and Central and Eastern Europe have been affected by exchange rate pass-through (ERPT). Our findings somewhat refute the conventional wisdom that ERPT into import and consumer prices are always higher in “developing” than in “developed” countries. Our findings are based on three different vector autoregressive models. For emerging markets with inflation in the single digits (particularly the Asian nations)
• Another study of Zakaria (2010): Openness and inflation: evidence from time series data. The paper empirically investigates the relationship between trade openness and inflation in Pakistan using annual time series data from 1947 to 2007. According to the empirical analysis, there is a positive relationship between trade openness and inflation in Pakistan. The results are robust when other inflation-determining variables are controlled for, and sensitivity analysis is performed. Domestic inflation is inflated by a flexible exchange rate regime and an increase in the level of development. Money supply, fiscal deficit, exchange rate depreciation, foreign inflation, terms of trade, foreign debt, and democracy all have a significant impact on inflation in the expected direction.
• Other study about Selim, Hoda (2012). Exploring the role of the exchange rate in monetary policy in Egypt. Characterizing the systematic behavior of Egyptian monetary policy. Data methodology between 2000 and 2008. Empirical results of a baseline model in which the Central Bank does not take into account the exchange rate allow us to examine whether interest rate setting responds to inflation, the output gap, and a lagged interest rate. The results are then compared with those of a model in which the exchange rate is added as an explanatory variable.
• Another Study about Nabil, Aliaa (2012) Towards inflation targeting in Egypt: the relationship between exchange rate and inflation. the study aims to analyze the relevance of inflation with the exchange rate by using the Granger-causality test for monthly data from 1990 to 2008. Two indicators of inflation were used, the consumer price index (CPI) and wholesale price index (WPI). In general, the results show a strong relationship between exchange rate changes and inflation. Both indicators of inflation succeeded in reflecting a clear ERPT phenomenon, but WPI showed a faster response to exchange rate changes than CPI.
• In addition to a study by Burke, Mary, and Ali, (2013), Household inflation expectations and consumer spending, they examined the relationship between a household’s inflation expectations and current spending, this study reached to that the estimated effects are small negative and statistically insignificant by using survey panel data from April 2009 to November 2012
• Twelfth study about Verena, )2013(. Does Exchange Rate Volatility Harm Exports? The study examines the extent and degree of currency rate pass through to prices at various levels of distribution, specifically from import prices to producer prices up to consumer prices. The Structural Vector Autoregressive (SVAR) model and quarterly data from 1999 to 2010 are used. The study also examines the existence and strength of the relationship between the exchange rate and domestic prices. Third, exchange rate pass-through elasticity is determined using the impulse response functions. To determine the significance of external shocks in explaining changes in import and domestic prices, forecast error variance decomposition is also produced from the SVAR.
• Another study by Ali A. Massoud (2014), “Through of exchange rate and import prices to domestic inflation” data methodology from 2000. This model is built on pricing along a distribution chain that has three stages: import, producer, and consumer, and used to assess the pass-through from exchange rate and import prices’ movements to domestic inflation. Empirical results: both exchange rate and import price have modest effects on domestic prices in Egypt after the CBE floats the ER for the Egyptian Pound. that the pass-through of both exchange rate and import prices to domestic inflation in Egypt, following the floating of the ER of the Egyptian pound, is more likely to be incomplete.
• Another study by Abdurehman and Hacilar (2016). the relationship between exchange rate and inflation: an empirical study of Turkey. Turkey has long experienced high rates of inflation. Following the 2001 crisis, the nation succeeded in bringing its inflation rate down to one digit by taking significant action to combat the problem. They applied regression analysis to historical exchange rates and inflation differentials using a streamlined econometric model. The exchange rate between Turkish Lira and British Pound is of particular interest. They concluded that a variety of reasons, including transaction costs, governmental restrictions, product specialization, and other relevant issues, may be responsible for the PPP’s divergence.
• Another study by Abu Rashid, Sami, (2017), The Impacts of Inflation and interest rate on Performance and Solvency of Conventional and Islamic Banks in Pakistan, the study aimed to determine the role of financial performance and financial soundness of conventional and Islamic banks during inflation and interest rate, the results show that inflation uncertainty associated with the real interest rate has a significant positive impact on the solvency of Islamic banks. They used a white test (GLS estimator) and applied a linear paramedic restriction test for testing the joint significance of macroeconomic uncertainties for determining a bank’s performance and solvency.
• Another study by Duca, Geoff, and Reuter, (2018), inflation expectations, consumption, and the lower bound, the study aimed to show the relationship between inflation expectations and consumer spending, we find that the effects to be economically relevant, especially when the lower bound is pending. They used the model of times series data, they reached to that there is a statistically significant and positive effect of our measure of the expected change in subjective inflation on the probability of being ready to spend.
• Another study of Helmy, Fayed, Hussien, (2018), exchange rate pass-through to inflation in Egypt: a structural VAR approach. The purpose of this paper is to examine the underlying relationship between the exchange rate and prices, which is known as the exchange rate pass-through by using a structural vector auto-regression (SVAR) mode. According to monthly data from 2003 to 2015, Egypt’s exchange rate pass-through is fairly substantial but incomplete and slow in the three price indices [the IMP, the PPI, and the CPI]. However, the impact on consumer prices is greater than on any other price index.
• In addition to a study by Lee Yoon (2018). Impact of demographic changes on inflation and the macroeconomics. From an empirical viewpoint, this paper illustrates how demographic variables change over time and analyses how they influence macroeconomic variables such as economic growth, inflation, savings and investment, and fiscal balances. Based on empirical findings, particularly those regarding inflation. They discuss the implications of their findings for macroeconomic policies, including monetary policy. It was discovered that population growth has a positive impact on inflation because a larger population implies more aggregate demand, while the elderly share has a significantly negative impact.
• Last study by Joshi (2021). Effect of money supply on inflation in Nepal: empirical evidence from ARDL Bounds Test. This study looks at the long-run and short-run relationships between money supply and inflation in Nepal. To obtain the relationship, data were extracted from the Nepal Economic Survey from 1964/65 to 2018/19. To estimate the model, the ARDL Bounds test is used with inflation as the dependent variable and money supply and Indian inflation as independent variables. The long-run cointegration of the variables reveals a long-run relationship, and the error correction term is found to be negative (-0.98) and significant (p 0.02). According to the study, policymakers can reduce the impact of money supply on inflation by focusing on inflation control through monetary and fiscal policy mechanisms.

3. Inflation:
4. Implies a continued increase in product and service prices that leads to a decrease in the currency. A chronic increase in average prices over time as a nation’s purchasing power decreases due to a rise in overall prices reduces the value of money and makes buying goods and services more costly. In other words, for your money you can get less than you used to. The objective of measuring inflation is to determine the overall effect of changes in price for a variety of goods and services. It enables a single value representation of the rise in the cost of goods and services over time in an economy. (Akinsola, 2017)
   • Types of inflation:

Figure1: Types of inflation:

Source: prepared by the researcher based on word

1. 1. Types of Inflation on Coverage

• Comprehensive Inflation: When the prices of all commodities upward push throughout the economic system it is regarded as Comprehensive Inflation. Another name for comprehensive inflation is economy wide inflation.
• Sporadic Inflation: When prices of solely few commodities in few regions rise, it is regarded as Sporadic Inflation. It is sectional in nature. For example, upward jostle in meals fees due to bad monsoon winds bringing seasonal rains in India. (Gordon, 1975)

2. Types of Inflation on Government Reaction:

• Open Inflation: When authorities do no longer try to restrict inflation, it is recognized as Open Inflation. In a free market economy, where expenditures are allowed to take its personal course, open inflation occurs.
• Suppressed Inflation: When government prevents charge upward jostle thru charge controls, rationing, it is acknowledged as Suppressed Inflation. It is additionally referred as Repressed Inflation. However, when authorities’ controls are removed, suppressed inflation will become open inflation. (Johnson, 1967)

3. Types of Inflation on Rising Prices:

• Creeping Inflation: When expenditures are gently rising, it is referred as Creeping Inflation. It is the mildest shape of inflation and also recognized as a Mild Inflation or Low Inflation, when expenses upward push by no longer greater than up to 3% per annum year, it is known as Creeping Inflation.
• Chronic Inflation: If creeping inflation persist continues to increase for a longer duration of time, then it is regularly referred to as Chronic or Secular Inflation. Chronic Creeping Inflation can be both Continuous which remains steady barring any downward movement or Intermittent which happens at ordinary intervals It is referred to as chronic because if an inflation fee continues to develop for a longer length without any downturn, then it perchance leads to hyperinflation. (Solow, 1968)
• Walking Inflation: When the charge of rising prices is greater than the Creeping Inflation, it is known as Walking Inflation. When prices upward jostle by greater than 3% but less than 10% per annum between 3% and 10% per annum, it is referred to as Walking Inflation. According to some economists, walking inflation should be taken significantly as it offers a cautionary signal for the prevalence of Running inflation. Furthermore, if strolling inflation is now not checked in due time it can subsequently end result in galloping inflation. (Ihrig & Gretchen ,2020)
• Moderate Inflation: It is a steady inflation and no longer a serious monetary problem. Prof. Samuelson clubbed together notion of creping and walking inflation into Moderate Inflation. When fees upward shove with the aid of less than 10% per annum single digit inflation rate it is recognized as moderate inflation. (Phelps, 1967)

4. Types of Inflation related to Causes of Inflation: –

• Deficit Inflation: Deficit inflation takes vicinity due to deficit financing.
• Credit Inflation: Credit inflation takes location due to excessive bank credit or money provide in the economy.
• Profit Inflation: When entrepreneurs are involved in boosting their income margins, prices rise.
• Pricing Power Inflation: It is often referred as Administered Price inflation. It happens when industries and business homes expand the charge of their goods and offerings with a goal to increase their income margins. It does now not appear all through a monetary disaster and monetary depression and is no longer viewed when there is a downturn in the economy. (Albanesi, 2007)
• Demand-Pull Inflation: Inflation which arises due to a number of elements like rising income, exploding population, leads to combination demand and exceeds combination supply, and tends to elevate prices of items and services. This is recognized as demand Pull or excess demand inflation.
• Cost-Push Inflation: When fees upward shove due to growing fee of production of goods and services, it is recognized as Cost-Push Supply-side Inflation. For e.g. If wages of workers are raised, then the unit cost of manufacturing also increases. As a result, the fees of end-products or end-services being produced and provided are hence hiked. (Anand and Zhang, 2015)

5. Types of Inflation on Expectation: –

• Anticipated Inflation: If the fee of inflation corresponds to what the majority of human beings are watching for or predicting, then is known as Anticipated Inflation. It is also referred as Expected Inflation.
• Unanticipated Inflation: If the charge of inflation corresponds to what the majority of human beings are not anticipating or predicting, then is called Unanticipated Inflation. It is additionally referred as Unexpected Inflation. Powered by way of Create your own special. (Ball, 2014)

• Types of Price Indexes

Several types of baskets of commodities are calculated and tracked as price indices depending on the chosen set of goods and services used. The most used price indexes are Consumer Price Index (CPI) and Wholesale Price Index (WPI).

• Consumer Price Index (CPI)

CPI is a measure that examines the weighted average of costs for a selection of products and services that are essential to meeting consumer requirements. These consist of lodging, supper, and medical attention. By averaging the price changes for each item in the preset basket of products according to their proportional weight in the entire basket, consumer price index (CPI) is derived. The costs taken into account are the retail costs per item as they are offered for sale to private people. One of the most often used statistics for determining periods of inflation or deflation, changes in CPI are used to measure price changes related to cost of living changes. CPI was first estimated in 1913 and is reported monthly in the US by the Bureau of Labor Statistics (BLS).  (Dotsey & Sarte, 2000)

• Wholesale Price Index (WPI)

Another well-liked index of inflation is WPI. It measures and monitors changes in product prices prior to the retail level. While WPI commodities vary from nation to nation, they typically consist of wholesale or producer-level goods. For instance, it contains cotton apparel pricing as well as raw cotton, cotton yarn, and cotton grey items prices. WPI is used by many nations and organizations, although the producer price index is also used by several nations.

• Producer Price Index (PPI)

A collection of indexes known as PPI tracks the average trend in selling prices received over time by domestic producers of intermediate products and services. In contrast to CPI, which measures price increases from the viewpoint of the buyer, PPI monitors price changes from the seller’s perspective. In all variations, it is feasible that the price increase of one component, such as oil, will partially offset the price decrease of another, such as wheat. Overall, each index reflects the average weighted price change for the specified constituents, which may be relevant at the level of the entire economy, a specific industry, or a particular product. (Fischer, 1993)

• The Formula for Measuring Inflation

The price index variations indicated above can be used to determine the amount of inflation between two specific months or years. Although there are many pre-made inflation calculators already available on numerous financial portals and websites, it is always preferable to be aware of the underlying approach in order to assure accuracy with a clear understanding of the calculations.

• Mathematically,

Percent Inflation Rate = (Final CPI Index Value/Initial CPI Value) x 100

 

• Advantages and Disadvantages of Inflation

Depending on which side one takes and how quickly the shift happens, inflation can be viewed as either a good or a bad thing.

• Advantages of inflation

Those who own tangible assets that are valued in their home currency may prefer to see some inflation since it will increase the value of their possessions, which they can then sell for more money. Due to the expectation of higher returns than inflation, firms and individual investors frequently speculate on hazardous business ventures as a result of inflation. It is frequently encouraged to have inflation at a set level to stimulate spending rather than saving. As money’s purchasing power decreases with time, there can be more of a reason to spend now rather than save and spend later. Spending could rise as a result, which would help an economy. It is believed that a balanced strategy will keep the inflation rate in an ideal and acceptable range. (Al-Amin and Pasha,1983)

• Disadvantages of inflation

The fact that they will have to pay more money due to inflation may not make buyers of these assets happy. Individuals who own assets such as cash or bonds that are valued in their home currency might not enjoy inflation since it reduces the true value of their holdings. So, those wishing to hedge their portfolios against inflation should think about investing in commodities, real estate investment trusts, gold, and other inflation-hedged asset classes. Another well liked way for investors to profit from inflation is through bonds that are inflation indexed. High and erratic inflation rates can have a significant negative impact on an economy. While making purchasing, selling, and planning decisions, businesses, employees, and customers must all take the effects of generally rising costs into consideration. This adds another element of uncertainty to the economy because they run the risk of estimating future inflation rates incorrectly. It is anticipated that the amount of time and money spent on studying, estimating, and modifying economic behavior will increase to the general level of pricing. Real economic fundamentals, on the other hand, invariably entail a cost to the economy as a whole. (Gomme,1993)

Even a low rate of inflation that is consistent and simple to predict, which some people would ordinarily consider ideal, can cause significant issues for the economy. This is due to the manner, setting, and timing of the new money’s entry into the economy. Every time new money and credit enter the economy, they inevitably end up in the hands of particular people or businesses. When individuals spend the new money and it moves from hand to hand and account to account throughout the economy, the process of price level adjustments to the new money supply continues. (Ebeling, 2008)

• Theories of inflation: –

1. Demand pull or monetary theory of inflation:

Demand pull or extra demand inflation is the normal and most common type of inflation. it is a situation in which combination demand at the present fee level far exceeds combination supply. Goods possibly in short furnish either due to the fact resources are entirely utilized or production cannot be increased hastily to meet the increasing demand.

 According to demand pull inflation, the widely wide spread price level rises due to the fact the demand for goods and offerings exceeds the grant on hand at current prices. (Chari & Rodolfo,1996)

2. Cost push inflation

It is precipitated by means of wage increases by unions and profit increase by using employers. it is also acknowledged as new inflation. The basic motive of fee push inflation is the rise in money wages more rapidly than the productiveness of labor.

Causes cost push inflation: –

1. Wage induced inflation: Wage increase lead to increase in cost of production which lead to fall in supply & hence price rise.
2. Profit induced inflation: Imperfect competition leads to fall in production and to increase profit producers increase prices.
3. Increase in the cost of inputs and raw materials. (Ghosh & Steven, 1998)
4. Monetary Theory of Inflation

The monetary idea of inflation asserts that money supply growth is the motive of inflation. Faster money provide growth causes quicker inflation. In particular, 1% faster money supply growth motives 1% greater inflation. With different matters constant, the charge stage is proportional to the money supply. Doubling the cash grant would double prices.

4. Market Power Theory of Inflation:

The market power precept of inflation represents one excessive give up of inflation. According to this thought inflation exists even when there is no more in demand. On the other end, the conventional demand-pull theorists believed that the completely reason of inflation is the excess of combination demand over combination supply. (Gillman & Michal, 2000)

5. Conventional Demand-Pull Inflation:

The market electricity idea of inflation represents one severe cease of inflation. According to this idea inflation exists even when there is no extra in demand. On the other end, the conventional demand-pull theorists believed that the only purpose of inflation is the excess of aggregate demand over mixture supply. In full employment equilibrium condition, when demand increases, inflation will become unavoidable. In addition, in full employment condition, the economy reaches to its most manufacturing capacity. At this point, the supply of items and offerings cannot be improved further whilst the demand of products and services increases rapidly. Due to this imbalance between demand and supply, inflation takes place in the economy. (Gomme,1993)

6. Structural Theories of Inflation:

Apart from the two extreme ends referred to in the above, there is a middle group of economists called structural economists. According to structural idea of inflation, market power is one of the elements that motive inflation, however it is no longer the solely factor. The supporters of structural theories believed that the inflation arises due to structural maladjustments in the county or some of the institutional points of business environment. They have furnished two sorts of theories to explain the motives of inflation the extraordinary sorts of structural theories of inflation. (Hsiao, 1986)

7. Quantity Theory of Money

Quantity Theory of Money is an idea that variants in price relate to variants in the cash supply. It is most normally expressed and taught the use of the equation of exchange and is a key foundation of the monetary theory of monetarism. This theory assumes that the volume of cash in an economy has a massive impact on its stage of financial activity. So, an alternate in the cash furnish outcomes in both an exchange in the price tiers or a change in the supply of items and services or both. In addition, the theory assumes that modifications in the cash furnish are the important purpose for changes in spending.

In the quantity idea of money, inflation is explained the use of the easy trade equation:                 MV = PT popularized by the American economist Fischer.

M=Money Supply

V=Velocity of circulation (the quantity of time money adjustments hands)

P=Average Price Level

T=Volume of transactions of items and services. (Heymann,1995)

8. Keynesian theory

Keynes supposed investment to be fairly touchy to the charge of interest.  he supposed to be negatively related, up to a point, to the stocks of idle cash in existence, however, the Keynesian approach does no longer provide tons insight into actions of the charge level. Keynesian believes that authority’s intervention can assist an economy that is experiencing a recession or inflation. When the economic system is in a recession, lower taxes and higher government spending will assist extend combination demand to close the negative output hole this is regarded as expansionary fiscal policy. While the economic system is experiencing inflation, higher taxes and decrease authorities spending will help reduce combination demand to close the effective output gap this is recognized as contractionary fiscal policy. According to Keynes, an increase in general price levels or inflation due to increase in the aggregate demand which is over the increase in aggregate supply. If a given economy is at its full employment output level, an increase in government expenditure, an increase in private consumption, and an increase in private investment will create an increase in aggregate demand. (Kumar,2020)

9. Classical Theory:

The classical theory of inflation attributes sustained fee inflation to excessive increase in the volume of cash in circulation. For this reason, the classical theory is every so often called the quantity idea of money, even though it is a concept of inflation, now not a theory of money. More specifically, the classical principle of inflation explains how the combination price degree gets decided via the interaction between cash grant and money demand. As a rely of fact, due to the fact it traces the conduct of a vital economy-wide variable inflation back to the simplest forces of supply and demand, the classical theory must qualify as one of the oldest micro founded fashions in all of macroeconomics. (Lahiri,2010)

10. Neoclassical theory:

Neoclassical economics definition refers to a find out about of economics that values the ideas of providing and demand in the functioning of an economy. It relates to how customers manage market demand and furnish due to the focus on efficacy and patron satisfaction. Neoclassical theory is typically regarded the most frequent frame of reference for economists and is frequently contrasted with Keynesian economics. The study is mainly applicable to free market practices that area substantial emphasis on the forces of provide and demand. This specially applies to the fact that the theory’s founding fathers have been laissez faire capitalists. Neoclassical is a dominant monetary theory that argues, as the shoppers aim is utility maximization and the organizations’ purpose is income maximization, the client is in the end in manage of market forces such as rate and demand. The idea relates the supply and demand to an individual’s rationality and capacity to maximize utility. (Kumar,2020)

• Inflation policies

1. Monetary Policy to Curb Inflation

Inflation can be controlled by a contractionary monetary policy is one common method of managing inflation. A contractionary policy aims to reduce the supply of money within an economy by lowering the prices of bonds and rising interest rates. Thus, consumption falls, prices fall, and inflation slows down. A contractionary monetary policy is one common method of managing inflation. A contractionary policy aims to reduce the supply of money within an economy by lowering the prices of bonds and rising interest rates. Thus, consumption falls, prices fall, and inflation slows down. (Samuelson& Solow, 1960)

2. Fiscal Measure to Control Inflation:

Government spending, public borrowing, and taxes comprise the Fiscal Policies to Combat Inflation. The Keynesian economists often referred to as “Fiscal,” argue that due to an excess of aggregate demand over aggregate supply, demand-pull inflation is induced.  Owing to spending by individuals, companies, and the government, aggregate demand rises. This rise in demand due to the government or household spending can be effectively regulated by fiscal policies. Fiscal policy and fiscal initiatives are thus effective weapons of demand-pull inflation management. If the key trigger behind demand pull inflation is government spending, then it can be regulated by reducing public expenditure. The public demand for goods and services declines with a decline in public spending, along with a decrease in private income and consumption expenditure. In cases where demand increases due to an increase in private spending, the most effective way to manage inflation is by taxing profits. The taxation of private income decreases the disposable income in question, and also reduces consumer spending. This has the effect of reducing aggregate demand. In the event of a very high persistent inflation rate, both such steps may be taken simultaneously by the government to contain inflation. In the case of a decrease in public spending, the rate of taxes on private income is increased to keep demand under control. This form of policy of concurrently using both measures is called the Surplus budgeting Policy. (Gordon, 1976)

• ways to measure inflation:

A measure from the source, which is sampling the prices of goods and pricing them from the first producer It is possible to know the direction of the price line from the amount of price the producer sets for his goods and the total prices. It is important to know the cause of inflation because the rate for one commodity is not taken into account, even though the value of some commodities decreases.

• The mechanism for inflation:

The dynamic relationship that the quantity theory gives to money on the effect of change in the quantity of money on the price level is not as simple as the theory envisions, according to some researchers The mechanism of inflation, which is the quantity of money and the speed of circulation or demand for it, and the volume of production are not independent of each other, is attributed to the theory in explaining the mechanism of inflation Some of them indicate that the change in the general level of prices affects the quantity of money because the price movements themselves often cause changes in the monetary factors A rise in prices would lead to an increase in the quantity of money at the end and an increase in the speed of money circulation. (Al-Bazai,1997)

• The mechanism of inflation is no longer explained by the quantitative theory:

The growth of governments in the issuance of money, the adoption of inexpensive money insurance in the midst of wars, and the tangible waves of inflation related with it had been some of the crucial pretexts that the proponents of the quantitative questioning relied upon. The mechanism of inflation does no longer take one route in practice, even though theories and colleges grant a clarification for it the diploma of socio- financial improvement and the structural composition of the large economic gadget are some of the matters that vary from one to another. (Mohamed,2019)

• The development of inflation in Egypt

Figure2: Inflation rate in Egypt from 1990 to 2020

Source: prepared by the researcher based on excel by using world bank data

During the period 1990-2021, the Egyptian economy witnessed a sharp wave of rising prices and increasing inflation rates. Undoubtedly, this rise in inflation rates witnessed by the Egyptian economy is partly due to monetary excess, which led to an increase in aggregate demand at a faster rate than the increase in production, and in another part to the structural imbalances that the economy suffered from. In addition to the foregoing, the state’s increasing interference in economic and social affairs has led to an increase in the financial burdens borne by the general budget year after year, especially in light of the state’s tendency to bear the financial burdens of economic units and the expansion of social, health and cultural services resulting from population increase, as well as the increasing burdens Defense, security and transfer expenditures such as subsidies and raising the standard of living, in addition to the state setting a social price for some commodities in order to mitigate the rise in prices.

-The results of this are an increase in public expenditure figures in the budget, and then an increase in the deficit in the state’s general budget and fueling inflationary pressures and increasing their severity. Therefore, reducing inflation rates and stabilizing prices are among the pivotal goals of the economic reform program. A decline in inflation rates in general is one of the indications of the success of the economic reform program in Egypt.

• The evolution of inflation rates in Egypt from 1990 to 2002

Figure3: Inflation rate in Egypt from 1990 to 2002

Source: prepared by the researcher based on excel by using world bank data

That inflation rates tended to decrease in general during the period of economic reform in Egypt from 1991 to 2001, as for the increases in this rate during the period from (1991) to 2002. It was as follows:

• The inflation rate rose during the fiscal year 1992/1993 to 12.09%, compared to 13.64% in the previous year; This is due to the fact that this year has witnessed many price corrections with the aim of a gradual transition from social prices to prices Economic.
• The rate of inflation increased during the fiscal year 1994/1995 to 15.74%, compared to 8.15% in the previous year.
• The inflation rate increased during the fiscal year 2001/2002 to 2.74%compared to 2.27% in the previous year. (Ali,2011)

The second period: the evolution of inflation rates in Egypt during the period from 2003 to 2012, which represents a fluctuation in inflation rates in general in Egypt.

• Evolution of inflation rates in Egypt from 2003 to 2012:

Figure4: Inflation rate in Egypt from 2003 to 2012

Source: prepared by the researcher based on excel by using world bank data

• The inflation rate increased during the fiscal year 2002/2003 to reach 4.51%, and this is due in part to the effect of floating the exchange rate of the Egyptian pound as of 29/1/2002, in addition to the rise in the prices of many imported commodities.
• The inflation rate continued to rise during the fiscal year 2003/2004, reaching 11.27% at the end of June 2004. Among the factors that helped fuel inflation in this year was the high cost of borrowing to 15% and the increase in domestic public debt levels to finance the increasing public spending on infrastructure, spending without revenues. Except after a long period of time, which fueled price inflation and the rise in production costs due to the low exchange rate of the Egyptian pound, in addition to the high rates of private spending.
• According to the report of the Central Bank of Egypt, the inflation rate rose during the fiscal year 2005/2006 to 7.64%, compared to 4.87% in the previous year. Because of the escalation in the prices of the sections that make up the index of urban consumer prices), especially the food and beverage section, which represents about 40% of the general number: its prices increased at a rate of 11.6% compared to 4.1% in the previous year as a main result of an increase in the prices of vegetables by 21.3% compared to a decline of 0.5% in the previous year for seasonal reasons and an increase in exports of some products such as potatoes which led to a decrease in the domestic supply and an increase in Prices of milk, cheese, eggs and meat due to the decrease in supply as a result of avian influenza and red meat affected by the increase in poultry prices. The success of the economic reform program relatively  in reducing inflation rates during most of the study period is due to the adoption of deflationary monetary policies that led to a state of economic stagnation starting from the fiscal year 1995/1996 accompanied by inflation (stagflation), which distorted this success and even made it a failure to manage Economy.
• An increase in the inflation rate during the fiscal year 2006/2007 to 9.32%, compared to 7.64% in the previous year. Shortage of supply and escalation of their prices, and this escalation extended to include the prices of meat and fish, as well as the prices of many other commodities, in addition to the rise in prices associated with the improvement in the rate of economic growth.
• The upward trend of the inflation rate continued during the fiscal year 2007/2008 to reach 18.32% its highest level since the early nineties, compared to 9.32% in the previous year. The noticeable escalation in the inflation rate is mainly due to several factors, perhaps the most important of which is the successive increases in the prices of food commodities affected by the continued escalation of their international prices, in addition to the transmission of the effect of the increase in the prices of those commodities to many other commodities. This was helped by the low degree of self-sufficiency in foodstuffs and, consequently, the increase in imports from them.
• The fiscal year 2008/2009 witnessed a remarkable decline in the annual inflation rate, as it was limited to about 11.76%, compared to 18.32% in the previous year. The significant decline in inflation rates is mainly due to the decrease in the contribution of the food and beverage group (representing43.9% of the total general figure in the overall inflation rate, to be limited to 5.7 points percentage, compared to 12.1 points during the previous fiscal year.
• An increase in the inflation rate during the fiscal year 2009/2010 to 11.27%, compared to 11.76% in the previous year. Contribution of the food and beverage group to an increase in its inflation rate, reaching 18.5% during the reporting year, compared to 12.2% during the previous fiscal year. Despite the decrease in international food prices during the reporting year by a rate of 4.8, this did not limit the increase in the inflation rate in that year, which reflects the weak response of local markets to changes in international food prices, especially in the event of a decline.
• The upward trend of the inflation rate continued during the fiscal year 2010/2011, reaching 10.6%, compared to 11.7% percent in the previous year.
• The fiscal year (2011/2012) witnessed a decrease in the annual inflation rate, reaching about 7.11%, compared to 10.6% in the previous year. This decline was mainly concentrated in the decrease in the contribution of the food and beverage group to the overall inflation rate, to reach 4.1 percentage points. Compared to 7.8 percentage points. (Abdel-Ghaffar ,2007)
  • Development of inflation rates, in Egypt from 2013 to 2021:

Figure5: Inflation rate in Egypt from 2013 to 2020

Source: prepared by the researcher based on excel by using world bank data

• The fiscal year 2012/2013 witnessed a rise in the annual inflation rate, reaching about 9.47%, compared to 7.11% in the previous year. What contributed to the escalation of the inflation rate during the fiscal year 2012/2013 was the rise in the exchange rate of the US dollar against the Egyptian pound, and thus the increase in the cost of imports. In addition to the political and security unrest in the country, which negatively affected the supply of commodities in the local markets, especially fuel and butane gas cylinders, which witnessed several crises in the year of the report.
• The fiscal year 2013/2014 witnessed a decrease in the annual inflation rate. 10.07% compared to 9.47% in the previous year. This decrease is mainly due to the decrease in the contributions of some major departments to the inflation rate.
• An increase in the inflation rate during the fiscal year 2014/2015 to 10.34%, compared to 10.07% In the previous year.
• An increase in the inflation rate during the fiscal year 2015/2016 to 13.81%, compared to 10.34% in the previous year. In the interest of the Central Bank to confirm confidence in the Egyptian economy and achieve monetary stability, targeting levels below inflation in the medium term. On November 2, 2016, the Central Bank decided (during the preparation of the report) to take several measures to correct the foreign exchange trading policy by liberalizing exchange rates to give flexibility to public banks in Egypt to price the purchase and sale of foreign exchange with the aim of restoring its circulation within legal channels and ending the parallel market, in line with the system. The integrated reform program that includes the program of structural reforms of the government’s public finances. The liberalization of the exchange rate regime is considered an essential step towards restoring confidence in the Egyptian economy, overcoming the shortage of foreign currency and building foreign exchange reserves. It will also support exports and tourism, improve Egypt’s foreign competitiveness, and help attract foreign investment, which will reflect positively on the balance of payments situation.
• The inflation rate increased during the fiscal year 2016/2017 to 29.51%, compared to 13.81% in the previous year. This increase is due to the measures taken by the state within the framework of the economic reform program, especially the liberalization of the exchange rate of the Egyptian pound and application the value-added tax law and raising fuel prices within the framework of reforming the subsidy system. As a result of these procedures, the contributions of most of the main components of the general price index increased.
• The annual rate of general inflation declined thanks to the adoption of a prudent monetary policy by the Central Bank of Egypt, to be limited to about 14.40% in May 2018, compared to 29.51% in 2017. This is consistent with the Central Bank of Egypt’s goal of reducing inflation to a rate of less than 10% in the medium term.
• The Central Bank adopted a restrictive monetary policy, in a proactive and temporary manner, in order to contain the inflationary pressures that the Egyptian economy faced after the liberalization of the exchange rate. In May 2017, the Central Bank of Egypt announced, for the first time in its history, the target inflation rate and the timing of its achievement, which is 13 %in the last quarter of 2018. Recent inflation data indicates the success of monetary policy in containing inflationary pressures, as the main annual inflation rates declined in Egypt. to be limited to about 14.40% in 2018. Monetary policy, through the liberalization of the exchange rate, has contributed to enhancing the competitiveness of domestic goods and services, and thus increasing the external demand for the domestic product, so that net exports become one of the main factors in the high rate of economic growth. Then we reduce the annual rate of basic inflation prepared by the Central Bank of Egypt to reach 9.15 %in June2019, then the rate decreased to 5.04% in June 2020. (Abdel Wahab,2021)

4. Exchange rate:

The exchange rate mechanism is the pivotal element in the international financial economy, and it is also the pole element in modern financial thought, and it has great importance in adjusting and settling the balance of payments of the state, especially those developing countries. We are all familiar with foreign trade, in this cycle involves the use of different national currencies. Each country has its own currency that is used in internal payment operations, and the need to use foreign currencies appears when commercial or financial relations are established between companies operating within the country with companies operating outside it, and importing companies need the currency of the exporting country to pay the value of imported goods.  Exchange rate adjustment may have a modest effect on current account imbalances in the short run, but even that modest claim is not firmly established in the evidence. It is important to recognise that evidence on the long run effects of the terms of trade on imports and exports is not particularly relevant to the issue of which nominal exchange rate regime is appropriate. The nominal exchange rate regime only can influence real prices at the horizon of price adjustment. Once enough time has passed for nominal prices to adjust, relative price changes can occur under any nominal exchange rate regime. (Shalaby,2022)

Like most other prices, foreign exchange rates vary from week to week and month to month according to the forces of supply and demand. When supply and demand or speculation determine exchange rates, the exchange rate is floating. When a nation imports a lot of products, the demand will drive up the country’s exchange rate, increasing the cost of the imported products for domestic consumers. When nations employ gold or another accepted standard, and each currency is worth a particular amount of the metal or other standard, the exchange rate is fixed. The foreign exchange rate is determined in the foreign exchange market where different currencies are treated. (Samuelson, 1951)

The currency of any country is treated like a commodity that can be bought and sold against any other currency, and the exchange rate between one currency and another is called the exchange rate. A currency’s relative value expressed in terms of another currency (or group of currencies). Is used to determine the value of various currencies in relation to each other and is important in determining trade and capital flow dynamics. Exchange rates are defined as the price that one nation or economic zone’s currency can be exchanged for another currency. (Manners,2005)

• Types of Exchange Rate

1. Nominal exchange rate: The nominal exchange rate is defined as the price of a foreign currency in terms of the number of local currency units.
2. Real exchange rate: It represents the relative price of commodities between two countries, as it shows the ratio according to which one’s commodities can be exchanged for the commodities of another country. It measures competitiveness; The higher the real exchange rate, the greater the country’s competitiveness, that is, it reflects the difference between the purchasing power between the domestic and foreign countries. It is also defined as the number of units of foreign commodities needed to purchase one unit of domestic commodities, as it rationalizes decision-making for economic dealers. (Manners,2005)
3. Effective exchange rate:This rate expresses the indicator that measures the average change in the exchange rate of one currency in relation to several other currencies over a period, and therefore the actual exchange rate index is equal to the average of several bilateral exchange rates, and it indicates the extent of improvement or improvement The evolution of a country’s currency relative to a group of other currencies.
4. The real effective exchange rate: It is an index of relative prices weighted by the real exchange rate index, which measures the change in the ability and competitiveness of local commodities with their counterparts abroad official country; That is, the real effective exchange rate combines the actual exchange rate with the real exchange rate. (Govil,2014)
5. The equilibrium exchange rate: The equilibrium exchange rate is the price determined by the forces of supply and demand when the required value equals the offered value of a currency, regardless of the impact of speculation and abnormal capital movements. The equilibrium exchange rate is like equilibrium for any commodity traded in free markets and in the presence of perfect competition, and this price coincides with the balance in the balance of payments. (Feyzioğlu,1997)
6. Cross exchange rate: The cross-exchange rate is defined as the price of one currency against another currency and the correlation of these two currencies with a common third currency between them. If we take, for example, a currency The dollar against the two currencies, it is possible to determine the intersection between these two currencies with each other with the availability of several conditions, including specifying the bank that calculates the type of currency sold and purchased, its price and the price of the third currency. (Govil,2014)

• What is the significance of the exchange rate?

The exchange rate is important for a several reasons: 

It serves as the primary link between the domestic and international markets for various goods, services, and financial assets. We can compare the prices of goods, services, and assets quoted in different currencies by using the exchange rate. Exchange rate movements can influence both actual inflation and future price movements. Exchange rate fluctuations have a direct impact on domestic prices of imported goods and services. Exchange rate movements can have an impact on the country’s external sector by affecting foreign trade. The exchange rate influences the cost of servicing the country’s foreign debt (principal and interest payments). (Karakostas, 2021)

The importance of the exchange rate also lies in the extent to which the strength of the national economy is achieved in influencing the outside world, and not the other way around.  As the weaker the economy, the outside world will be controlled through the exchange rate index; Because the weak (dependent) economy will need to deal with the outside world to meet its needs.

The extent to which the national economy depends on the outside world is measured by: “Dependent Rate” It is the ratio of imports of goods M to GDP Y

                                                     DR = (M/Y) x 100 

• Function of exchange rate 

1. Evaluation function: The exchange rate is used by local producers of goods and services to measure and compare domestic prices with international prices in the international market.
2. Developmental function: That stimulates the growth of exports by working to increase production while keeping in mind the low price that can compete in the global market, and thus the exchange rate affects the commodity structure of foreign trade.
3. Function of distribution: The exchange rate serves another purpose because it is linked to international trade, redistributing international income and national wealth among the world’s countries through exports and imports.

• Factors affecting the exchange rate:

Figure6: Factors affecting the exchange rate:

Source: prepared by the researcher based on Canva

Other factors affecting the exchange rate such as:

• Interest Rate

 Interest rate changes have an impact on currency value and exchange rates. All other things being equal, a higher interest rate in a domestic country will increase demand for a domestic currency because more foreign investors will seek to invest at the higher interest rate, thereby investing foreign capital into the domestic currency. In practise, however, inflationary pressures balance it out. (Akter, 2021)

• Government Debt

The amount of debt owed by the federal government is referred to as government debt. It has an effect on currency value and exchange rates because a country with more debt is less likely to acquire foreign capital, which leads to inflation. It puts downward pressure on the domestic currency and reduces its exchange rate value.

• Political Stability

The political state of a country affects currency value and exchange rates because a country in political turmoil is less likely to attract foreign investors. Political instability increases risk for investors because they are unsure whether their investments will be protected by fair market practises or a strong legal system.  (Yelesh, 2017)

• Change in the balance of payments:

 There is a close relationship between the balance of payments and the exchange rate of a country, given that the balance of payments is the image of the country’s relationship with the outside world. In the event of a deficit in the balance of payments, the demand for foreign currencies increases to fill that deficit, and on the other hand, the decrease in foreign demand for the local currency means the deterioration of the exchange rate of this country, Conversely, in the event of a surplus in the balance of payments, it leads to more foreign currency inflows and a boom in the local currency exchange rate. What can be concluded is that the exchange rate is directly related to the trade balance, so the greater the export is than the import, the more this leads to an improvement in the trade balance in favor of the exporting country and an increase in the state’s reserves of foreign currencies.

• Speculation

If a country’s currency is expected to rise for any reason, investors will demand more of it in order to profit from the expected rise. It has the potential to cause an immediate increase in demand for domestic currency relative to foreign currency. (CFI, 2022)

• Exchange rate systems:

Because the exchange rate is the price of one country’s money in terms of another country’s money, governments and central banks must have an exchange rate policy.

Figure7: Exchange rate systems

Source: prepared by the researcher based on word

1. Fixed Exchange Rate

A fixed exchange rate is one that is determined by a government or central bank decision and is achieved through central bank intervention in the foreign exchange market to counteract the unregulated forces of demand and supply. From the end of World War II to the early 1970s, the global economy was governed by a fixed exchange rate regime. Until recently, China had a fixed exchange rate. Hong Kong has had a fixed exchange rate policy for many years and continues to do so today. To achieve a fixed exchange rate, active intervention in the foreign exchange market is required.

2. Managed Flexible Exchange Rate System

In this system, the monetary authority influences exchange rate movements through effective interventions and establishes a maximum limit for the exchange rate to move, and it can refer to a standard basket of foreign currencies without committing to any official exchange rate.

3. Flexible exchange rate 

A flexible exchange rate is one that is determined by demand and supply in the foreign exchange market without direct intervention by the central bank. When the central bank changes interest rates in a flexible exchange rate regime, it is usually not to influence the exchange rate, but to achieve some other monetary policy goal. (IMF, 2003)

• Foreign Exchange Market 

The foreign exchange market is an over the counter (OTC) global marketplace that determines currency exchange rates worldwide. This foreign exchange market is also known as the currency market, Forex, or FX. Participants in this market have the ability to buy, sell, exchange, and speculate on currencies. Banks, forex dealers, commercial companies, central banks, investment management firms, hedge funds, retail forex dealers, and investors participate in these foreign exchange markets. (Nordstrom, 2022)

Source: prepared by the researcher based on word, using data from (lyons, 2002)

• Characteristics of the foreign exchange market
• Elements of the foreign exchange market

Source: prepared by the researcher based on word, using data from (Bangkok, 2014)

• Types of Foreign Exchange Market: The Foreign Exchange Market has its own varieties.

Figure8: Types of Foreign Exchange Market

Source: Prepared by the researcher using canva and data from (Bangkok, 2014)

Foreign exchange market Functions 

• Settlement and Transfer Function: The primary and most obvious function of the foreign exchange market is to transfer funds or foreign currencies from one country to another in order to settle payments. The market converts one currency into another.
• Credit Function: Providing credit for foreign trade.
• Coverage and Hedging Function: Foreign exchange participants are often worried about currency fluctuations. Coverage is intended as a precaution to avoid loss in exchange rates, in the sense of covering dealers’ open positions in the foreign exchange markets through an agreement to buy and sell foreign exchange in the exchange markets through the commercial bank.(Bangkok, 2014)
  • Theories of exchange rate:

1. The Purchasing Power Parity Theory: A unit of currency from one country must have the same purchasing power in another country, according to the amusingly straightforward theory of purchasing power parity (PPP), which states that the nominal exchange rate between the two currencies must be equal to the ratio of the aggregate price levels between the two countries. To calculate purchasing power parity, the price of a common good that is the same in both countries is measured and compared. (Mwange,2022)

If there is a gap, demand ought to shift from one country to the next, bringing prices together. For example, a comparable product of the same size and quality is made in both China and India. According to the theory, prices for items in China and India will be equal when expressed in the same currency. However, demand will increase in China and decrease in India if the product is more reasonably priced there. Due to the decreasing demand, prices in India will gradually drop until they are equal. (Abuaf & Jorion, 2014)

2. Interest rate parity theory: The relation between interest rates and currency exchange rates is governed by the interest rate parity theory. The difference between the forward and spot exchange rates is similar to the difference in interest rates between two countries, according to the interest rate parity (IRP) theory. The basic principle of the theory is that, regardless of the interest rates associated with such investments, hedged returns from assets in several currencies should be constant. The idea of no-arbitrage in the foreign exchange markets (the simultaneous purchase and selling of an asset to profit from a difference in price) is interest rate parity. Investors cannot buy one currency at a lower exchange rate than the market rate and then buy another currency from a nation with a higher exchange rate. According to the Interest Rate Parity (IRP) hypothesis, national interest rates, inflation rates, and currency exchange rates are all interrelated and mutually determined in a free-floating exchange system. Each of these elements tends to have a proportionate impact on the others. (Chinn & Frankel, 2012)
3. The Balance of Payments Theory (BOP): The theory of exchange rates states that variables other than internal price level and money supply impact the rate at which one currency is exchanged for another. It emphasizes how heavily a country’s balance of payments condition affects the exchange rate. When the demand for foreign currency exceeds the supply at a particular exchange rate, the balance of payments of a nation is said to be in deficit. A desire for products and services offered overseas fuels the demand for foreign currency. Contrarily, the source of foreign exchange is the transmission of products and services to the foreign country by the domestic economy. A balance of payments surplus is the result of their being more foreign currency available than there is demand for it. In this case, the value of foreign currencies falls while the value of the local currency rises. The equilibrium rate of exchange is reached when the BOP is neither in deficit nor in surplus. In other words, the equilibrium exchange rate and BOP equilibrium of a nation are same. (Bigman,2012)
4. The Monetary Approach to Rate of Exchange: The monetary approach determines exchange rates by balancing the overall supply and demand of each country’s national currency. This theory contends that real income, general price levels, and interest rates all affect the desire for money. Real income, the level of prices, and the need for money are all closely tied. Contrarily, the link between it and the interest rate is negative. The monetary authorities of each country independently determine how much money is in circulation. (Chinn & Frankel, 2012)
5. The Portfolio Balance Theory: The portfolio balance approach to exchange rate analysis specifically takes trading into account. It considers domestic and international bonds and other financial assets to be inferior substitutes. The fundamental premise of this theory is that the exchange rate is determined by the process of equilibrating or balancing the supply and demand of financial assets, of which money is only one form. The domestic currency increases as a result, appearing to have a trade surplus, partially offsetting the initial devaluation. As a result, the portfolio balancing technique also explains exchange overshooting. (Black, 2013)
6. International Fisher Effect (IFE) Theory: The International Fisher Effect (IFE), a hypothesis of economics, states that the predicted difference between the exchange values of two currencies is fundamentally equivalent to the projected difference between their respective nominal interest rates. The analysis of interest rates linked to current and potential risk-free assets, such as Treasury securities, is the basis of the hypothesis, which forecasts currency swings. This approach links inflation and interest rates to a currency’s appreciation or depreciation, in contrast to earlier approaches that solely used inflation rates to forecast exchange rate fluctuations. (Coppock &Poitras,2010)
   • Risks of exchange rate:

Exchange rate fluctuations have a significant impact on businesses’ operations and profitability. Small and medium-sized firms, even those that only do business in their native country, are similarly impacted by exchange rate volatility in addition to multinational corporations, huge corporations, and businesses that conduct business in international markets. Investors should be aware of exchange rate risk as well because of the significant impact it can have on their assets, even if business owners are naturally interested in understanding and managing it. (Papaioannou,2006)

A company running worldwide business runs the danger of losing money as a result of currency swings, which is known as foreign exchange risk. It is also referred to as currency risk, FX risk, and exchange rate risk. It refers to the likelihood that changes in the relative values of the currencies involved could cause the value of an investment to decline. When two parties enter into a contract that details the precise costs of goods or services as well as the dates of delivery, there is a risk. One of the parties may suffer a loss if the value of a currency changes between the time the contract is signed and the delivery date. (Spinney, 2022)

• Types of Foreign Exchange Risk:

Foreign exchange risk, usually referred to as foreign exchange exposure, can be divided into three categories: transaction risk, translation risk, and economic risk. A fourth risk, known as jurisdiction risk, appears when regulations in the nation in which the exporter is conducting business abruptly change. This is less frequent and is more prevalent in unstable nations.

Companies are exposed to three types of risks caused by currency volatility: transaction risk, translation risk, and economic or operating risk.

1. transaction risk:

It is the exchange rate, or currency risk associated specifically with the time delay between entering into a trade or contract and then settling it. Occurs when a business purchases goods from a supplier in another country and is given a price in the currency of the supplier. The buyer will have to pay more in its base currency to achieve the agreed upon price if the supplier’s currency appreciates relative to the buyer’s currency. (Rahnema,1990)

The business that completes the transaction in a foreign currency is often the side of a transaction that is most affected by the risk of transaction exposure. The risk is not the same for the corporation that receives or pays a bill in its own currency. Transaction risk may result in unforeseen gains and losses from the open transaction. Forex, futures, options contracts, and other derivatives are frequently used by institutional investors, including hedge funds, mutual funds, and multinational organizations, to manage this risk. Transaction risk increases with the length of time between the start of a trade or contract and its settlement since there is more time for the exchange rate to vary. Deal risk will always benefit one side to the deal, but businesses must take proactive measures to protect the money they anticipate receiving. (Papaioannou, 2006)

• Common Transaction Risks:
• Some of the most common transaction risks that can affect the deal or transaction value include the following:

1. Foreign Exchange Risk: Deals with nations that have relatively high currency volatility or cross-border transactions should pay particular attention to this risk.
2. Interest Rate Risk: Interest rate risk investigates how changes in interest rates may impact the value of a transaction. This risk may have an influence on the purchasing party’s ability to secure the required financing for the transaction as well as the selling party’s debt obligations. (Rahnema, 1990)
3. Counterparty Risk: There is a risk involved when engaging in transactions that the counterparty won’t fulfil the contractual commitments made in the transaction.
4. Commodity Risk: Commodity risk takes into account unforeseen changes in price. While commodity volatility has an impact on all industries, it is particularly important for the Oil & Gas and Mining sectors.
5. Time Risk: As market conditions and companies change with time, there is a higher probability that the initial transaction agreement conditions will become unfavourable the longer the negotiation process is extended. (CFI,2022)
6. Translation Risk:

One of the different kinds of FX risk is translation risk. Refers to the risk faced by a company headquartered domestically but conducting business in a foreign jurisdiction, and of which the company’s financial performance is denoted in its domestic currency. Translation risk is higher when a company holds a greater portion of its assets, liabilities, or equities in a foreign currency. It is a risk of ownership rather than one of trading since it results from having trading firms or branches based abroad or from a company or branch operating entirely in a foreign currency. One characteristic of this risk is that it only manifests itself when consolidated financial statements are prepared for whatever purpose. The risk of translation cannot be reduced. According to changes in the exchange rate, reported results for a company that is susceptible to translation risk may be higher or lower than the actual result. The translation industry is plagued by a number of issues; some are translators’ problems, some are clients’ problems, and some could be termed structural issues because they affect translation itself. The profit and loss account, balance sheet, and cash flow statements, which are the cornerstone ratios on which credit ratings, loan covenants, and credit fundamentals are based, can all be impacted by translation risk. In fact, changes in currency could cause a corporation to break a covenant or get downgraded. (Spinney,2022)

3. Economic or operating risk:

The impact of unanticipated currency swings on a company’s future cash flows, overseas investments, and earnings constitutes an economic risk, a sort of foreign exchange exposure. Economic risk often referred to as operating exposure, has long-term implications and can have a significant impact on a company’s market value. By engaging in foreign exchange trading, businesses can protect themselves from unforeseen currency changes. Is a sort of currency vulnerability brought on by unforeseen currency changes. A risk for multinational corporations with multiple abroad operations and frequent currency exchanges. Exposure rises as foreign exchange volatility does and lessens as volatility declines. Economic exposure has become a source of greater risk for all businesses and consumers as a result of growing globalization. Multinational corporations that have multiple subsidiaries abroad and engage in a significant amount of transactions in foreign currencies obviously face greater economic risk. (CFI,2023)

• The development of exchange rate in Egypt

Figure9: exchange rate in Egypt from 1990 to 2020

Source: prepared by the researcher based on excel by using world bank data

• In 1990, the Egyptian economy suffered from a large deficit in the balance of payments, which was estimated at about $2 billion, which led to an increase in foreign debts, as well as a rise in the inflation rate to reach about 20%. Therefore, it was necessary to implement another exchange rate policy based on linking the Egyptian pound to the US dollar and this is what the Central Bank did in 1991 when it decided to unify the exchange rate, and thus the real exchange rate in 1991 witnessed a remarkable rise as a result of this decision, while the period from 1991 to 1997 witnessed relative stability. (El-Bagoury,2016)
• In 1997, the Asian financial crisis occurred, and its roots began in the middle of 1995, as a result of the deterioration of the value of debt and the trend of the dollar towards an increase. The current account suffered from a large deficit as a result of a decline in exports and an increase in the price of imports, as well as a decrease in the foreign exchange reserves in the country due to entering into unsuccessful projects, all of which led to instability in the exchange rate, so the Central Bank used its international reserves to try addressing the decline in the exchange rate of the Egyptian pound against the US dollar (as the US dollar was increasing), which led to a decrease in the state’s balance of foreign exchange until it reached $13.1 billion in 2000. (Ezzat,2018)
• In 2001, the value of the Egyptian pound was reduced to about 3.86 pounds, then it was reduced again to 4.15 pounds, due to many internal and external events that affected the exchange rate, such as the events of September 11, which affected many sectors of the Egyptian economy, such as the tourism sector and investments, which negatively affected the Egyptian trade balance and the exchange rate.
• In 2002, the Egyptian pound was reduced again to become 4.51 pounds for the US dollar, due to the emergence of the black market for foreign exchange, as it was one of the largest business activities in Egypt in that period, this market focused on attracting remittances from Egyptians working abroad, as well as tourists spending in response to the differences between official exchange rates and black market exchange rates.
• In 2003, the decision-makers began at this time to switch from the fixed link to the crawler, and then to the floating system for the Egyptian pound, and abandoning the currency peg system that had been used since the beginning of the financial liberalization program in Egypt, and as soon as the floating system was announced, the value of the currency was reduced to 6.11 pounds to the dollar.
• In 2004, the devaluation of the Egyptian pound continued, as a result of the government’s implementation of the policy of managed floating of the exchange rate, the currency depreciated to 6.20 pounds per dollar in 2004, then the cash reserves rose with the banking reform program implemented by the Central Bank and in line with the stage of increase in rates Economic growth, which reached 7% in 2007, as the price of the US dollar fell to 5.697 pounds at the end of 2007, and this decline continued until 2010. (Al-Agouza,2017)
• With the repercussions of the January 2011 revolution, which negatively affected the Egyptian economy through a significant decrease in foreign reserves (Egypt lost 21 billion dollars) and the depreciation of the pound against the dollar to reach 5.99 pounds per dollar by the end of 2011, then to 6.89 pounds per US dollar in 2013, according to the reports of the Central Bank, and there were also waves of decline in the volume of foreign currency cash reserves as an inevitable result of the state of political and economic instability in Egypt, and the cash reserves reached about 15 billion in 2014. (Kishk,2017)
• In July 2016, the Central Bank adopted a more flexible exchange policy, in order to overcome all the distortions that occurred, so it devalued the Egyptian pound at a rate of 12.7%, bringing the average exchange rate to about 10.03 pounds, then it reached its maximum value in 2017, which is about 17.78 pounds, then it returned to decrease again in 2019, to reach about 16.77 pounds.
• In the years 2020 and 2021, the Central Bank of Egypt, under the leadership of its former governor, Tariq Amer, restored the policy of fixing the exchange rate of the pound, and raised its value by 15% against the dollar to become about 15.7 pounds instead of about 18 pounds. (Hamad,2018)

5. The relationship between inflation and independent variables
   • The relationship between exchange rate and inflation:

One of the most fascinating subjects for economics has always been the relationship between inflation and exchange rates Particularly in emerging economies, the link between the currency rate and inflation is crucial. Exchange rate changes in these economies have a considerable impact on the general level of pricing. The worth of a nation’s currency and the exchange rates it has with the currencies of other countries can both be significantly impacted by the rate of inflation in that nation. However, inflation is one of a number of variables that work together to affect a nation’s exchange rate. Countries attempt to balance interest rates and inflation, but the interrelationship between the two is complex and often difficult to manage. (Dornbuch,1976)

The fact that the exchange rate, as an asset price, is a future variable and an anticipating variable is the second crucial point regarding the exchange rate’s function in the inflation targeting method. So, it plays a key role in the formation of expectations that have an impact on monetary policy. Both manufacturing costs and the prices of imported goods, which will fluctuate along with exchange rates, will be impacted by changes in exchange rates. Because of this, it is plausible to assert that the exchange rate and inflation are closely related. Thus, real exchange rate policies must be implemented in developing nations to account for domestic inflation and maintain stability in national output and global competition without becoming caught in the foreign exchange bottleneck. (Khamies, 2012).

The exchange rate changes can affect the inflation rate through different channels:

• The relative prices of imported and domestic goods are impacted by exchange rate fluctuations in an open economy, which increases domestic and international demand for domestic products. Net exports thus have an impact on overall demand as well as the rate of indirect inflation.
• In contrast, changes in the exchange rate have a direct impact on the prices of imported finished goods expressed in local currencies. As a result, it has an immediate impact on the consumer price index. Prices of imported final goods ultimately have an impact on the inflation rate, and this effect typically manifests itself sooner than the indirect impact of net exports. (Brooks, 2002)
• An open economy can directly affect the price of imported substitute goods and goods subject to trade.
• It can indirectly increase the price of the final goods through imported input prices.
• Due to fluctuations in the exchange rate, the uncertainties in foreign currency prices can affect domestic price makers and increase domestic prices.
• It increases the prices by the means of wages.
• Finally, changes in exchange rates have an impact on nominal salaries through the Consumer Price Index, which measures middle import prices in terms of national currency. Cost of domestic goods has an impact on the inflation rate when these two factors are combined. (Agenor &Montiel ,1996)

Higher inflation generally has a depressing effect on a nation’s currency’s worth. This is so because rising inflation devalues a currency’s purchasing power, which makes it less valuable in relation to other currencies. Increased inflation typically has a negative effect on money conversion rates. Fluctuations in factors like the rate of external inflation or international interest rates have a direct impact on the domestic demand that is brought about by exchange rates. Low interest rates spur consumer spending and economic growth, and generally, they have positive influences on currency value. If consumer spending increases to the point where demand exceeds supply, inflation may ensue, which is not necessarily a bad outcome. But low interest rates do not commonly attract foreign investment. (Massoud& Willett, 2014)

While higher interest rates tend to attract foreign investment, which is likely to increase the demand for a country’s currency. The ultimate determination of the value and exchange rate of a nation’s currency is the perceived desirability of holding that nation’s currency. That perception is influenced by a host of economic factors, such as the stability of a nation’s government and economy. Investors’ first consideration in regard to currency, before whatever profits they may realize, is the safety of holding cash assets in the currency. (Lowry,2022)

Exchange prices may be more erratic during times of rising inflation. This implies that international money transactions may become more expensive. You might begin to notice the effects of inflation on the amount of local currency received if you frequently send money overseas, perhaps the same number of dollars each month. Over this period, the dollar’s value relative to the rupee decreased, making each dollar more valuable in terms of rupees. Of course, the opposite is also possible. Your recipient would receive less local money if the dollar was strengthening against the currency they were receiving. Inflation does not have direct effects on the nominal exchange rate, but the underlying cause of inflation might. A nation’s currency loses value when inflation is excessive. This is because as products become more expensive, investing in businesses loses appeal to investors. The opposite is also accurate. A country’s money movement usually increases, the currency’s purchasing power increases, and the exchange rate becomes stronger when inflation is significantly reduced. The real exchange rate is undoubtedly impacted by inflation, but it also relies on whether and how the nominal exchange rate changes. In all other cases, if prices are higher overall, foreigners will pay more for products and services. However, the real exchange rate remains unchanged if the rise in the general price level is accompanied by a similar proportional decline in the local currency. (Chaushi,2016)

We can calculate real exchange rate with inflation through this formula:

Real exchange rate = Nominal exchange rate x (Domestic price index / Foreign price index)

Or

Real exchange rate = Nominal exchange rate x [(1 + Foreign inflation rate)/ (1+ Domestic inflation rate)]

Inflation often results in a delay in price adjustments for everything. Businesses may opt to absorb some of the cost increases if they find it expensive to raise prices. Prices that stay around are known as sticky prices. When a currency declines in value relative to other currencies but local costs do not rise significantly, goods in that nation become more affordable for visitors from other countries.

The inflation rate and exchange rate are very related and effect on each other through:

• If the rate of inflation abroad is greater than that in the country, the actual exchange rate will then be greater than the nominal exchange rate in that situation.
• Real and nominal exchange rates will be equal if domestic and international inflation rates are both equal.
• While if the inflation rate abroad is lower than the inflation rate at home,the actual exchange rate will then be less than the nominal exchange rate in that situation. (Washima,2022)
• Exchange rate and inflation in Egypt

1. During 1990-2000

Figure10: exchange rate and inflation in Egypt from 1990 to 2000

Source: prepared by the researcher based on excel by using world bank data

Relationship between inflation and exchange rate was negative relationship, exchange rate was increased from 1.6 in 1990 to 3.5 in 2000. The exchange rate remained stable until the early 1990s but was devalued with the start of economic reform programmes, bringing it to a rate of EGP 1.5 to the dollar in 1990.

In 1991, the dollar jumped to reach EGP 3.14, as the pound’s value continued to decline until it stabilized at EGP 3.39 to the dollar in 1994-1998. The pound remained higher than the currencies of the Gulf such as the Saudi and Qatari riyal, as well as the Emirati dirham.  And inflation was decreased from16.76% in 1990 to 8.15% in 1994 to 2.68% in 2000. (CBE, 1995)

1. In 2000-2015

Figure11: exchange rate and inflation in Egypt from 2000 to 2015

Source: prepared by the researcher based on excel by using world bank data

During this period exchange rate was continued in increased from 3.5 in 2000 to 6.1 in 2012 this raisin, 6.9 in 2013 to 7.1 in 2014 and, continued in increased to 7.7 in 2015 backed to. In the year 2003/2004, the exchange rate stability is retained, and the weighted average for US$ reached 620.23 piasters by the end of June 2004. Which implies that the value of the Egyptian pound declined to reach EGP 4 to the dollar in 2002 and collapsed with the decision to float it in 2003 reaching higher than EGP 7 to the dollar before it regained its strength to stabilize at EGP 5.85 For the first time, the pound became weaker than currencies in the Gulf. (CBE, 2003)

For the following years, the exchange rate dropped to EGP 6.06 to the dollar, before it rose again to EGP 5.43. With the January 25, 2011, uprising, the pound fluctuated to reach EGP 5.9 to the dollar, before it embarked on a downward trend until it was floated on November 3, 2016. After the 2011 uprising, the pound was devalued several times to the dollar to EGP 6.1, 7.1 and finally 7.7 in 2015 – lower than the Danish Krone, the Hong Kong dollar, the Venezuelan Bolívar and the Solomon Islands dollar. Inflation in this period was increased to 18.32% in 2008 and continued in increased to 10.6% in 2010 to 10.37% in 2015 The business enterprise considered this upward jab to be the largest in the month-to-month inflation charges for the reason that May 2008, which then recorded 4.7%, due to the upward push in the fees of strategic commodities in this month. the inflation rate on an annual foundation reached about 10.7% in July, in contrast to the same month last year, noting that it is the best charge recorded in view that ultimate January, when it reached 12.2%. that the high inflation rate is due to a wide variety of reasons, the most essential of which is maintaining pace with that length for the month of Ramadan and the enlarge in demand for many commodities, in addition to the increase in electricity expenses by using 27.9%, cigarettes by means of 16.1%, transport and communications by 11.2%, and traveller trips via 13.4%, in addition to the enlarge in the expenses of veggies at some point of the period. Last month in contrast to the previous month via 7.4% and fruits by way of 3% that the inflation price extended throughout the period from remaining January to ultimate July by means of 9.8% in contrast to the identical duration ultimate year, which is due to the extend in meals and drink fees during the aforementioned duration via about 14.2% compared to the equal duration remaining year. (CBE, 2013)

1. From 2016-2021

Figure12: exchange rate in Egypt from 2016 to 2020

Source: prepared by the researcher based on excel by using world bank data

Exchange rate was increased from 10 in 2016 to 17.8 in 2018 after decreased from 16.8 in 2019 to 15.6 in 2021 this decrease percent was low.

In March 2016, the official exchange rate was devalued to reach EGP 8.88 to the dollar Following Thursday’s decision to float the Egyptian pound, setting an initial guidance rate of EGP 13 to the dollar, the ailing Egyptian currency’s value inched closer to the South African rand and became weaker than the Seychellois rupee. Egypt has already witnessed EGP flotation a quantity of times on the grounds that November 2016, however it was no longer permanent. Although the United States was capable to have a financial restoration in fiscal year (FY) 2021/2022, it still witnessed countless imbalances with the stabilized alternate rate. An everlasting shift to a bendy change charge ability having no interference from the Central Bank of Egypt (CBE) to manage flotation. Eslam Abdelhamid, a Financial Consultant, Economic Researcher, and Financial Trainer tells Arab Finance: What I understand is that the IMF will display the CBE reserves that had been used to make the change charge floating, as the CBE was managing the flotation charge via imparting dollars in case of shortage or when the USD demand rather accelerated in the Egyptian market. Therefore, the CBE was pumping bucks to mitigate the change rate Accordingly, IMF group of workers document published on January tenth advised Egypt to put in force the long-lasting flexible change charge regime, in which the country’s forex charge would be decided according to the furnish and demand of unique currencies. (CBE, 2021)

The decision to go with the flow the foreign money is one of the necessary choices taken via the State on November 3, 2016; this date is viewed an important date for the Occurrence of many vital activities that affected people. Some see these effects as Negative and others see them as positive, however the real outcomes show up on the brief run and emerge as clear on the lengthy run, the high-quality results show up solely thru the Development of a long-run program. The nation should undertake this application to make bigger Exports of high value. Courageous insurance policies are required for this selection to succeed And for the state to reach what it aspires to, so in in this paper, the authors attempt  to shed light on the necessary results of floating the Egyptian pound, by studying the Effects of pricing the countrywide currency before and after the flotation, to discover out Whether this flotation has bad or fantastic impact on the financial increase of the Egyptian state. In a world full of fluctuations, international locations regularly desire to trade their policies to improve their economic capacity in the so-called economic increase rate. Therefore, in 2016, Egypt took an important step to promote financial growth. This learn about monitors one thing of the effects of that step, and the find out about wonders whether or not this step changed from the trends of economic boom in Egypt, will the step lead to prosperity in the long run, what are the feasible results of this step, applied the least squares method on the information of financial boom rates and the dollar trade fee from 2014 to 2019 to find out the break point endogenously and exogenously. (CBE, 2019)

There is a ruin in the selling price of greenback in Egypt, this break detected Indigenously and exogenously, and the chow mannequin showed that there is a smash in the Beginning of 2017, alternatively endogenous or exogenous. The outcomes of the find out about confirmed the existence of a long-term poor relationship Between alternate charges and the real increase charge earlier than 2017, additionally a negative Relationship on the short run after floating and a fantastic long-term relationship Between alternate fees and the actual boom price after 2017, so it harms on the brief Run, it can elevate inflation to unprecedented degrees, it can enlarge the intensity of Poverty, but in long run it seems to be positive and hopeful. Foreign Exchange Rate: Annual USD data was reported at 17.766 EGP/USD in 2017. This records an increase from the previous number of 10.018 EGP/USD for 2016. Foreign Exchange Rate: Annual: USD data is updated yearly, averaging 5.629 EGP/USD from Dec 1994 to 2017, with 24 observations. The data reached an all-time high of 17.766 EGP/USD in 2017 and a record low of 3.389 EGP/USD in 1994. (CBE, 2017)

Foreign Exchange Rate Average: was reported at 32.623 EUR/EGP in 2023. This records an increase from the previous number of 30.904 EUR/EGP for 2023. Foreign Exchange Rate Average is updated, averaging 7.946 EUR/EGP from 1998 to 2023, with 302 observations. The data reached an all-time high of 32.623 EUR/EGP in 2023 and a record low of 3.027 EUR/EGP in 2000. Foreign Exchange Rate Average remains active status in CEIC inflation in this period 2016-2021 was high increased from 13.81% in 2016 to 29.51% in 2017 this It’s jump period in inflation and 14.40% in 2018 after it was decreased to 5.21% in 2021. (CBE, 2023)

• The Relationship Between Inflation and Interest Rates

In the economic literature Fisher holds that the real interest rate is determined by the real forces of saving. Investment is the exchange rate between present and future commodities, but this price is not necessarily. It is what the borrower gets, so he borrows at the market rate or the nominal rate of interest, which is the interest rate. The exchange between present and future money, and in the absence of inflation, the real and nominal interest rate coincides, but the nominal interest rate is affected by the expected rate of inflation. And in the thought of the Keynesian school, where the interest rate corridor represents the main path to convey the impact of the monetary policy in the Keynesian model, where the impact of expansionary or contractionary monetary policy is transmitted to the real economy across the interest rate corridor, 2019. It is a remedy for example inflation that arises from excess demand is possible to follow a deflationary monetary policy by raising interest rates as one of the tools of monetary policy, as well as the owners of the monetary school, including Friedman when they dealt with the phenomenon of inflation, it is a purely monetary phenomenon due to the imbalance between the demand for money and money supply, and to treat it, a contractionary monetary policy must be followed, with a focus on the interest rate tool. By raising the interest rate to reduce inflation, where the inverse relationship between them. (Ihrig & et ,2020)

• The evolution of the inflation rates and interest rates in the Egyptian economy

Figure13: Interest rate and inflation in Egypt from 1990 to 2020

Source: prepared by the researcher based on excel by using world bank data

We note the fluctuation of inflation rates in Egypt between low and low and a rise, on the hand, the rates of the real interest rate during the period from 2000 to 2020 is between a decrease and an increase.

• Starting from 2.68% in 2000 and 2.3% in 2001 as inflation rates, the interest rate was 10.3%. The inflation rate rose until it reached 11.27% in 2004, while the interest rate was 1.5%. Inflation rate reached 18.31% in 2008, while interest rate was 0.10%. The reasons for this can be attributed to repeated devaluations, increased exposure to external shocks, and policy backtracking contraction and allowing the ratio of the budget deficit to the gross domestic product to increase. Then inflation rate decreased to 11.26% in 2010, while interest rate was 0.80%. During the first decade of the new millennium, the reasons for inflation can be traced back to inflation caused by demand and inflation expectations and supply-side shocks which was represented in the increases in food, meat and domestic oil prices due to the global food crisis. The spread of avian influenza and oil price adjustments in that period, and inflation expectations represent approx. 80% of the changes in inflation in this period. (Ali, 2011)

Then inflation rates fell due to the political events that Egypt was exposed to and the revolutions of January 25, 2011, and June 30, 2013, and the recession that followed, and then:

• Inflation rates continued to rise until they reached to 29.5% in 2017, while interest rate was -3.90%. Due to the liberalization of exchange rates in November 2016, inflation decreased to 9.15% in 2019 and 5.04% in 2020, while interest rates increased from 2.20% in 2019 to 4.80% in 2020. Inflation rate increased to 5.21% in 2021, while interest rate decreased to 4.40%. To face increasing inflation, both the government’s fiscal policy and the central bank’s monetary policy have reduced the liquidity in the market. As well as the prevention of monopoly, the state provides commodities in the market and lowers their prices, especially the prices of food and beverages also, the decline in the state’s general budget deficit, containment of inflationary pressures, and a positive impact for a period basis. (CBE, 2021)
• It is clear that the reasons for this fluctuation are due to the liberalization of the interest rate and letting it be determined according to demand and the offer to him without interference from the monetary authorities, except in certain circumstances and in the narrowest limits, and returns the reasons for the central bank to cut interest rates until they reached negative values are a desire to encourage the tendency of individuals to invest instead of saving is also one of the reasons for containing inflationary pressures the Demand Side and Secondary Effects of Supply Shocks. (CBE, 2019).

The reasons for the increase in interest rates in some years are the high rates of inflation and a desire to encourage savings and other reasons.

• Impact of money supply on inflation rate in Egypt:

Money supply is one of the key factors of inflation because the money supply of a country is a major contributor to whether inflation occurs, and many industrialized and emerging countries have faced and continue to face the enormous challenge of Inflation throughout history. When an economy’s money supply expands more quickly than its capacity to create goods and services, inflation results. The production of commodities and services remained constant in our auction economy, but the money supply increased from round one to round two. Inflation occurred in our economy because the money supply increased while the output of products and services did not. The theory most discussed when looking at the link between inflation and money supply is the quantity theory of money:

According to the quantity theory of money, the exchange value of money is established similarly to the worth of other goods through supply and demand. The number of transactions or revenue and the velocity of money in the economy are what determine the exchange value of money. The British economists David Hume and John Stuart Mill were the ones who first created the conceptual underpinnings of the quantity theory. The quantity theory of money states that if the total amount of money in the market doubles, the price level will do. Customers will spend twice as much for the same amount of goods and services as a result.  A rising level of inflation will be the outcome of this abrupt increase in price levels. Inflation is a measurement of how quickly the cost of products and services are rising in an economy. (Friedman, 1969)

It is calculated by using the Fisher equation on quantity theory of money.

The equation is:             M*V= P*T

Where,

M = Money supply                                     V = Velocity of money

P = Price level                                             T = volume of the transaction

The direct relationship in question is predicated on the idea that there is no compactness and velocity of money in circulation V, that the size of transactions stays constant in the short run, and that any increase in money supply directly affects spending. As a result, changes in the value of money are inversely proportional to changes in its quantity because spending and velocity of money in circulation are necessary for price stability. The proponents of the quantity theory believe that the actual and potential outputs are equal. They also objected to the economy being balanced at a level below full employment, with the exception of brief transitional times. They therefore believe that the ability to increase output at any moment is constrained by the available elements of production and the prevalent technology, which leads to the assumptions of the quantitative theory that real output is unaffected by changes in the money supply. Most demand theories disregarded the supply-side factors that contribute to inflation, such as general production costs and labor costs. As a result, other theories that focus on the supply side of inflation have developed, such as the cost push inflation theory, which assumes that the high cost of production is the primary driver of inflation. (AL Naif et al., 2018)

Figure14: Money supply and Inflation rate in Egypt from 1990 to 2020

Source: prepared by the researcher based on excel by using world bank data

The period from 1990 to 1996 witnessed large and continuous increases in the issuance of cash compared to previous periods, and the rate of increase during that period was 145.993 USD bn and inflation rate recorded 7.19%. In 2004, money supply was about 469.181 EGP Mn, so inflation rate became 11.27% and this was a noticeable increase in inflation rate in this year. In April 2017, as a result of this one-time action, there was an increase in inflation as the devaluation trickled down to buyer prices via an increase in import prices, so money supply recorded 3.658EGP Mn and that led to inflation rate reached to 29.51% and this was the sharpest inflation rate. (CAPMAS,2023)

In the year 2020, money supply was about 548.01 EGP Mn while that lead to inflation rate recorded 5.04%. The inflation rate fell again in December 2022 to 6.5% on an annual basis, according to the consumer price index and that was a result of the money supply that recorded 299.376 USD bn. However, with the series of crises that struck the world’s largest economies since the outbreak of the Russian war in Ukraine and the subsequent rises in energy and food prices that followed, in addition to the Egyptian government’s return to implementing new economic reforms, and with the government’s continued huge spending on national projects, Money supply was reported at 256.504 USD bn in Jan 2023 and so inflation rate jumped 25.8,  It was the sharpest inflation rate since 2017.  (Iacurci,2023)

• Inflation and Trade in Egypt from 1990 to 2020

Figure15: Trade and Inflation rate in Egypt from 1990 to 2020

 Source: prepared by the researcher based on excel by using world bank data

During period from 1990-1991 increase in the trade by about 10% in 1990 the trade rate was about 52.9% and 62.84 in 1992 lead to inflation rate was increase by 4% compared by previous year 1990 inflation rate was 16.76%. From 1992-2000 there were decrease in trade by 16 %, in 1992 the rate of trade was 55.93 and about 39.02 in 2000 and that impact on inflation rate decrease in this period that in 1992 was 13.64% and in 2000 was 2.68%. (CBE, 2003)

During period from 2004 there were an increase in trade which recorded 57.82% and the inflation rate was 11.27% in 2004 after two massive devaluations of the Egyptian pound in 2001 and 2002 and realizing that official tries to assist it had been being counterproductive, the Egyptian government announced in 2003 the floating of the Egyptian currency, leaving behind the managed peg system of the central rate to US dollar. The new floating overseas trade system was brought often because Of the unavailability of bucks at the legitimate price, which resulted in the increase of black market transactions in which the unfold between the black market and official fee was continuously increasing the floatation was once as a result expected to permit tough foreign money to go with the flow back into the banking System as a substitute than on to the black market. Following the floatation, the pound depreciated and lost 50% of its value. As a result, inflation quotes rose to 18% in 2004 according to legit statistics. This pass-through impact of the local foreign money depreciation had a poor effect on corporations and businesses, which commonly have their liabilities denominated in dollars, whilst their belongings and earnings are in Egyptian pounds. Besides, the excessive share of the excessive share of intermediate inputs and investment items in Egypt’s imports increases charge sensitivity to traits in the Exchange rate. For these reasons, it is believed that the Egyptian financial authorities are not allowing a definitely free-floating currency. During the rest of the transitional period until the application of inflation targeting, the CBE is persevering with to intervene on the market to manipulate the float in addition to focused on M2 boom rate. The introduction of the interbank currency exchange system in  2005 stabilized the Egyptian pound in opposition to different currencies, however liquid protection markets nonetheless have to be developed to limit the reliance on the central financial institution for intermediating transactions 2004 rate of trade about 61.52%  and that effect on inflation that was 7.64% from 2007 to 2011 there were decrease in trade which recorded 65.08% in 2007 and in 2011 45.26 %  lead to change in inflation from 9.32% in 2007 and became 10.06% in 2011. (CBE, 2008)

During the period 2011 to 2017, there was an increase in inflation about 29.51% in 2017 which was the worst rate in inflation that lead to an increase in trade by 5% which was 45. 13% in 2017. The inflationary impact of the decline in the value of the Egyptian pound in opposition to different currencies has generally disappeared. This blanketed the influence on commodities Such as Hajj and Umrah services in May, apparel expense and schooling offerings in or seasonally late services witnessed consumption in 2017. The decline in the standard index of purchaser expenditures is attributed to the decline in the costs of basic meal commodities, which is in part limited to a moderate increase in the expenditures of fresh fruit. This is while the fees of the rest of the CPI gadgets remained often beneath change. The decline in the prices of primary meal commodities is attributed to the decline in crimson meat prices for the first time the reason that 2015 Poultry fees endured to decline for the seventh consecutive month. Red meat fees fell in 2017 after it stabilized in 2017, after recording consecutive increases considering that in 2016 as costs of basic meals commodities fell, the parent fell whereas, the common decline in fees in 2017 was once driven through the base measure used to be 0.37% at a higher price than the declining price of the high widespread. (World Bank, 2023)

From 2018 to 2021 the inflation was 14.40% this rate in 2018, in 2019 was 9.15%, in 2020 about 5.04 %, and 2021 was 5.21 % leading to decrease in trade which recorded 48.28% in 2018 and reached 31.37% in 2021. (CBE, 2021)

6. Empirical Framework:

MODEL:

This research model is based on ARDL, it composes of one dependent and four independent variables from 1990 to 2020. The model equation is as follows:

The econometric form of the model:

CPI_t = β₀ + β₁ ΔER_t + β₃ ΔM2_t + β₄ IR_t + β₅ Trade_t + ε_t

Definition of study variables and sources:

The study relied on the database of global development indicators of the world bank to obtain annual time series data of the economic variables in the period (1990 – 2020) as shown in the following table:

Table 1: Definition of study variables and sources:

Variable	Abbreviation	Source
Inflation, consumer prices (annual%)	CPI	World development indicators database, World BANK 2023
Official exchange rate (LCU per US$)	ER	World development indicators database, World BANK 2023
Broad money (annual%)	M2	World development indicators database, World BANK 2023
Real interest rate (%)	IR	World development indicators database, World BANK 2023
Trade (% of GDP)	Trade	World development indicators database, World BANK 2023

Source: prepared by the researcher based on the mentioned data sources

Research analysis:

 Preliminary tests: Testing for stationarity.

We conducted time series unit root tests before performing the main estimations. The tests are necessary to check whether the variables are stationary or not.

Table 2: unit root test at level

At level
		CPI	ER	IR	M2	Trade
With constant	t-statistic	-2.996	-0.053	-2.936	-3.858	-2.228
	Prob	0.047	0.946	0.053	0.006	0.2014
		Yes	No	No	Yes	No
With constant & trend	t-statistic	-3.017	-2.145	-3.686	-4.122	-2.31
	Prob	0.144	0.501	0.039	0.015	0.4146
		No	No	Yes	Yes	No
Without constant & trend	t-statistic	-1.729	1.364	-2.044	-1.543	-0.8312
	Prob	0.079	0.953	0.041	0.11	0.347
		No	No	Yes	No	No

Source: prepared by the researcher based on EViews 12

We found that most of the time series is not stationary at level as can be seen in the table.

 But We found that all the time series is stationary at first difference as can be seen in the table:

Table 3: unit root test at first difference

At First Difference
		CPI	ER	IR	M2	Trade
With constant	t-statistic	-6.731	-4.009	-5.917	-5.705	-4.186
	Prob	0.0000	0.0045	0.0000	0.0001	0.0029
		Yes	Yes	Yes	Yes	Yes
With constant & trend	t-statistic	-6.634	-4.10	-5.83	-5.70	-4.107
	Prob	0.0000	0.0159	0.0003	0.0004	0.0159
		Yes	Yes	Yes	Yes	Yes
Without constant & trend	t-statistic	-6.8	-3.885	-6.039	-5.818	-4.1695
	Prob	0.0000	0.0004	0.0000	0.0000	0.0002
		Yes	Yes	Yes	Yes	Yes

Source: prepared by the researcher based on EViews 12

Regression Model:

Figure19: ARDL model estimation

Source: Author’s Estimation Result, using EViews 12

Results:

• R-squared (R²): Based on the results of data processing in the table above, the results illustrate that 83.3 percent change in the dependent (CPI) is perfectly explained by the independent variables used in the model while the rest 16.7 percent is explained by other variables not included in the model (error term).
• F Test (the total significance of model): By Looking at the outputs of model we can find that (prob.) equals 0.000001 which is less than the 0.1 (level of significance). Therefore, we reject the null and accept the alternative hypothesis which means that the model has statistical significance (the independent variables have effect on the dependent variable).
• Auto correlation test: According to the results of the model which is (D. W=2.17) which means that does not suffer from the problem of auto correlation.

 Economic evaluation of the model

• CPI_t = β₀ + β₁ CPI_t-1 + β₂ CPI_t-2 + β₃ ΔER_t + β₄ IR_t + Β₅ ΔM2_t +

β₆ ΔM2_t-1 + β₇ Trade_t + ε_t

 CPI_t = -3.342 + β₁377 + β₂ 0.174 + β₃ 1.77 – β₄ 0.236 + β₅ 0.019 +

 β₆ 0.248 + β₇ 0.16 + ε_t

 

Boundary test (test of cointegration of the long-run relationship):

We decide to reject the null hypothesis and accept the alternative hypothesis that there is a cointegration relationship between the variables of the model, as the value of F-statistic = (8.25) is greater than the upper limit (3.49) at the level of significance used 5%, as can be seen in the following figure:

Figure20: Boundary test result

Source: Author’s Estimation Result, using EViews 12

Through the results shown in the table, it is noted that in the long run, the cointegration equation is:

• EC = CPI – (3.9344*D(ER) – 0.5243*IR + 0.5921*D(M2) + 0.3541*TRADE – 7.4303)

Error Correction Coefficient (ECM) Model:

Table 4: Error correction coefficient estimation

Variable	Coefficient	Std. Error	t-Statistic	Prob.
CointEq(-1)*	-0.45	0.057	-7.83	0.00000

 Source: Author’s Estimation Result, using EViews 12

The previous results showed that the error correction coefficient (the speed of adjusting the model towards equilibrium) is significant (the sufficient condition) and has a negative sign (the necessary condition, where the speed of adjusting short-term errors is about 45% per year , and its probability value is (0.00000) less than the level of significance used 5% , which indicates that about 45% of the short-term fluctuations to which the dependent variable (inflation) is exposed in the previous period (1-t) as a result of shocks to which the independent variables are exposed are corrected in the current period (t).

Testing for Multicollinearity:

We used the variance inflation factor to test for the multicollinearity as you can see in the table below the centered VIF for the four variables is less than 10 which proves there is no multicollinearity in the model.

Figure21: VIF test

Source: Author’s Estimation Result, using EViews 12

Auto correlation:

We used the LM test just to be fully assured that there is no autocorrelation in the model so as seen in the table below the probability of f-statistic is 0.7088 which is clearly higher than 5% so we can accept the H₀ which says there is no serial correlation.

Figure22: LM test

Source: Author’s Estimation Result, using EViews 12

Testing for heteroscedasticity:

we used the Breusch-Pagan-Godfrey test to investigate if there is heteroscedasticity. According to the result of the prob. of f-statistic we can accept the H₀ that the probability is not significant as it is more than 5%.

Figure23: heteroscedasticity test

Source: Author’s Estimation Result, using EViews 12

HISTOGRAM – NORMALITY TEST:

To test the extent of the hypothesis that the residuals follow the normal distribution, a Bera-Jarque test was performed on the residues of the model.

Figure24: HISTOGRAM – NORMALITY TEST

Source: Author’s Estimation Result, using EViews 12

From the outputs shown in the previous figure, the probability value of the test is 0.142917, which is greater than the level of significance 5%, and this means that the decision here is to accept the null hypothesis that the residuals follow the normal distribution and reject the alternative hypothesis.

Diagnostic Stability test

To ensure the stability of the model structure, some tests must be carried out, such as the Ramsey RESET Test for the mathematical description of the model, and the (CUSUM) and (CUSUMSQ) tests for structural stability.

It was concluded through the Ramsey RESET Test that the estimated model does not suffer from the problem of mathematical misspecification, as the probability value of t-statistic f- statistic was estimated at 0.5244, which is not significant at the level of 5%, which means that the null hypothesis is accepted. That the model does not suffer from poor mathematical characterization.

Figure25: Ramsey RESET test:

Source: Author’s Estimation Result, using EViews 12

The structural stability of the model is achieved when the graph of the statistics of (CUSUM) and (CUSUMSQ) falls within the critical limits at the assumed level of significance 5%. The coefficients are unstable if the graph of the statistic of the two tests moves outside the limits at the level.

                     Figure25: Diagnostic stability test (CUSUM)

Source: Author’s Estimation Result, using EViews 12

                        Figure26: Diagnostic stability test (CUSUMSQ)

Source: Author’s Estimation Result, using EViews 12

Results:

1. There is a positive relationship between inflation and exchange rate, when the first difference of exchange rate increased by 1 unit, the inflation rate increased by 1.78.
2. There is a negative relationship between inflation and interest rate, when the interest rate increases by 1 unit, the inflation rate decreases by 0.24.
3. When the money supply increases during year by 1 unit, the inflation rate increased by 0.017, due to the positive relationship between them.
4. Relationship between inflation and trade is positive, so the inflation rate increased by 0.16 when trade increased by 1 unit.
5. It turned out that there is a positive relationship in the long run at a significant level of 0.05 between inflation and the exchange rate, as an increase in the difference between the year and the previous year by one unit in the exchange rate leads to an increase in inflation by 3.93.
6. It turned out that there is a negative relationship in the long run at a significant level of 0.1 between inflation and the interest rate, as an increase in the difference between the year and the previous year by one unit in the interest rate leads to an increase in inflation by 0.52.
7. It turned out that there is a positive relationship in the long run at a significant level of 0.05 between inflation and trade, as an increase in the difference between the year and the previous year by one unit in the trade leads to an increase in inflation by 0.35.
8. The exchange rate represents a real measure of the success of countries.
9. The rise in the inflation rate is due to the effect of the Egyptian pound’s depreciation.
10. The exchange rate affects inflation by 20.8%

Recommendations:

Through this research, we recommend the following:

1. Countries must choose an exchange rate system that is compatible with their economic data.
2. Limit the over-vulnerability of the economy to exchange rate fluctuations by increasing the openness of the economy and improving the exporting ability.
3. Activate sufficiently developed channels besides exchange rate to guide monetary policy choices. Therefore, the monetary authorities must intervene in the exchange market to organize and supervise it in order to preserve the monetary balance.
4. Working to raise exports and put pressure on imports.
5. Rationalize and improve the efficiency of public expenditures as a way to stop the ongoing increase in the ratio of expenditure to GDP.
6. The monetary authority must have the ability to influence various tools effectively in the event of a deviation of the inflation rate from its value in the future.
7. The state must work to control inflation through the exchange rate because it affects it by 20.8%.
8. Economists should pay attention to making studies of the relationship between the exchange rate and inflation and other independent variables such as trade, money supply and interest rate.
9. Researchers must give more importance to researching the inflation rate and how to control it through fiscal and monetary policies and others.

Conclusion

After a study that lasted for an academic year, and after listing the study and presenting it in this research project through an analytical method, as well as an econometrics method based on the econometrics study to clarify the effect of the exchange rate on inflation and commodity prices in Egypt, the study was also divided into two chapters. The first chapter dealt with three topics, the first of which addresses inflation, its definition and types, the second of which includes the exchange rate, its definition, systems and policies, and finally the relationship between inflation and some economic variables in Egypt, in addition to an econometric study to clarify the effect of the exchange rate on inflation.  After the end of the study, we concluded that the exchange rate is a picture that reflects the extent of the state’s development or not, and the same thing is about inflation, which is represented in that it is a statistical record that summarizes in an organized manner what is happening in a particular economy, and the liberalization of economic transactions in all its forms and also the increase in the movement of capital led to the occurrence of economic crises.

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Appendix

Figure1:

Figure3: Causality Tests:

Figure2: Akaike Information Criteria:

Figure4: Error Correction Model:

Figure5: LM Test:

Figure6: Heteroskedasticity Test:

Figure7: Ramsey Reset Test: