Tuesday, October 02, 2012

Making sense of the magnitude of the Iranian Rial’s depreciation

The relative value of currencies is determined by a variety of factors, including inflation differential, interest rate differentials, and terms of trade shocks. In the case of the recent exchange rate crisis in Iran, the main cause of the rapid depreciation is the sudden loss of a big chunk of oil revenues as a result of the international sanctions on oil exports from Iran.

This is similar to a terms-of-trade depreciation since a reduction in the quantity of oil exports has a similar impact on the government’s revenue as a reduction in the price of oil. Therefore, to make sense of the magnitude of the Rial’s fall, it is reasonable to use a model that focuses on the movements in the terms of trade and assumes away other factors such as inflation differentials.

Consider an endowment-economy in which the country is endowed with x units of domestic consumption good and y units of exportables. Also, without loss of generality, suppose that each unit of the exportable good can buy one unit of imports that can be used for domestic consumption. Therefore, consumers will have x unit of domestic product and y units of imports for consumption.

Suppose that the consumers’ preferences are given by the following Cobb-Douglas utility function 
$U=x^{\alpha }y^{1-\alpha }$
The relative value of x to y is equal to their relative marginal utility, which is given by e= $\frac{( 1-\alpha)x}{\alpha y}$

Now suppose that at an initial point in time we had $e=e_{0}$ and $y=y_{0}$. Therefore, today’s exchange rate, e, given today’s value of exports, y, can be written as:  e= $\frac{e_{0}y_{0}}{y}$

Oil revenues used to be around 80% of the government’s revenue. If the government loses X% of its oil exports compared to date 0, we have y/y0=1-0.8X.

Therefore, if the rial-dollar fair exchange rate was 15000 rials/dollar before the crisis and if we have lost X% of oil revenue, today’s exchange rate should be e=15000/(1-0.8X)which is the same formula I provided in a previous post.

18 comments:

Mohsen said...

Salaam Mostafa,

I accidentally came across this news story about South Korea begging the U.S. for permission to reprocess its spent nuclear fuel (http://www.nti.org/gsn/article/us-seen-still-unconvinced-south-korean-need-atomic-fuel-reprocessing). I thought it's quite relevant to the discussion we had the other night. I think Prof. Joyner provides a very good description of the whole process:

"There's just a tone to stories like this of the little developing state begging the big powerful developed supplier state to please, sir, allow them to have this technology that they really want, and think would be really beneficial for them. Like little Oliver asking for more gruel from the headmaster. The paternalism is just palpable, and really disturbing to me. The child presents its well-thought-through reasons why they should have the new stuff, and how they’ll be extra careful with it and make sure it doesn't hurt anyone. And then the dad just shoots them down, saying they don't really need it; its just too dangerous for them to have; they can’t be trusted to be responsible with it yet; they're fine without it and should just keep relying on dad for the stuff."
http://armscontrollaw.com/2012/07/26/south-korea-as-oliver-twist/

Mohsen

Mostafa Beshkar said...

Salaam Mohsen!
What I see here is that South Korea has agreed to refrain from certain nuclear activities to ensure the world that their program will not be used for military purposes.

Aside from the rhetoric, please note three things:
1) "South Korea is one of the world's top producers of nuclear energy," as mentioned in the link you provided. So the deal has not prevented Korea from becoming very successful in this industry.

2) Korean people overwhelmingly approve of the US: "South Koreans have one of the most favorable views in the world towards the United States and Americans (ranked within top 4 among the countries in the world). [10][11] Also, according to a Korean gallup poll, South Korea views the U.S. as the most favorable country amongst the countries in the world." (Wikipedia!)
This second point tells me that Korean people are very happy about their relationship with the US, they don't feel disadvantaged and they are a proud nation. Why should we pity Koreans for the Nuclear deal they have with the US?

3) Above all, US's role as a police on the nuclear technologies serves the security interests of south Korea by preventing the spread/use of this weapon in East Asia. It is very wise for Koreans to accept and promote this role for their own security.

Mohsen said...

Salaam Mostafa :)

I don't think any of the points you mention is in disagreement with my comment. The U.S. is indeed an admirable country in many respects. What I'm concerned with is its foreign policy. As far as I understand, it's like Tamerlane's policy :) That is, if you do not resist its supremacy, it will be kind to you, and you can even prosper under its protection. Indeed, if you have a competition in your region and you want to have the upper hand, you’d better curry favor with the U.S. (by agreeing to base some ten thousand U.S. troops, for example) to have an advantage over your rivals. In such a situation, you are likely to have a very positive view of the U.S. (or Tamerlane, for that matter!).

If you challenge the hegemony of the U.S., however, you are likely to be devastated, as the U.S. will be a most cruel enemy (again, like Tamerlane).

Admittedly, this is an oversimplification, because in addition to the U.S., there are other Great Powers. Also, U.S. allies are sovereign to a large extent, at least as far as their internal affairs are concerned. (At the risk of overstretching the Tamerlane analogy: he was also quite liberal in terms of leaving a city’s internal affairs at the hands of its local magnates.)

There is one difference, though. Tamerlane didn’t have powerful media; the U.S. has. So the latter can get away with doing horrible things, because it dominates media discourses around the world. Its immense media machine highlights its successes and positive aspects, downplays its vices, and at the same time magnifies the vices of its enemies. The result is that almost no one in the U.S. remembers any longer the genocidal sanctions against Iraq, no one pays attention to the huge rise in birth defects in Iraq after the invasion (and many similar stories), whereas everyone knows that a Pakistani girl was shot by the Taliban, etc.

At any rate, like any similar situation in human history, there are going to be those who accept U.S. hegemony and those who oppose it. If I were a policy maker, I wouldn’t have made challenging U.S. hegemony my top goal (at least not until my country was economically/technologically comparable to the U.S.—something which will not happen for Iran in the foreseeable future). However, I understand why some people would be motivated to do so. Who knows, probably they are partly influenced by supposedly American ideals such as liberty, independence, revolution, and resistance. Perhaps they've been watching too many Hollywood movies :)

Mohsen said...

Salaam Mostafa :)

I hope you are well! Sorry that I keep coming back; I was reading a piece in Foreign Policy about Japan, and since it was quite relevant to our discussion the other night, I couldn't help sharing it. Specifically, this paragraph toward the end is really interesting:

"Writing Japan's 1947 Peace Constitution and nailing down an asymmetric partnership through the U.S.-Japan security arrangements were two of the smartest moves the United States ever made. A secure Japan with a low military profile has been an effective yet autonomous instrument of American foreign policy goals in East Asia. Japan today is an ideal security partner for nations ranging from India to Australia to the Philippines -- a huge market, a great overseas investor, a major source of development aid, yet for the most part uninterested in great power politics."

It's fascinating how the author openly speaks of the asymmetric US-Japan relationship and that therefore Japan has been a good "instrument" of American policy in East Asia. That's exactly what I was claiming that night, that South Korea and Japan are not independent countries, at least not when it comes to their foreign policy.

Here's the link: http://www.foreignpolicy.com/articles/2012/12/14/five_reasons_the_japanese_elections_matter?page=0,3

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