This document discusses functional finance approaches for countries with fixed exchange rates. It notes that countries with fixed exchange rates have limited policy flexibility compared to those with flexible rates. However, countries with foreign exchange reserves above the minimum required for maintaining their peg have greater ability to pursue deficit spending and meet goals like full employment. The example of Saudi Arabia is provided, as a major oil exporter that has seen rising reserves in recent decades, allowing greater fiscal policy space to support economic and social objectives.

1. FUNCTIONAL FINANCE
FOR FIXED EXCHANGE
RATE ECONOMIES
SHAMA AZAD
University of Missouri-Kansas City
Binzagr Institute for Sustainable Prosperity

2. FIXED EXCHANGE RATE
REGIMES
 Countries on a fixed exchange rate must ensure that they have
sufficient reserves in order to deficit spend.
 The outstanding units of currency must be backed by foreign
exchange reserves.
 Interest rates in such countries cannot be set independently.
 Factors that determine the rate at which governments borrow
money include the market’s assessment of the country’s
creditworthiness and the country’s requirements to maintain its
peg.

3. TWO OPTIONS FOR GOVERNMENT
SPENDING
 SPENDING BY ISSUING CURRENCY
The risk here is that the outstanding units of currency must be
converted on demand to the reserve currency unit.
 SPENDING BY BORROWING
The bank reserves are preserved and the government is less likely to
default on its conversion requirements, but the interest rate for
borrowing is set by the market.
Market forces determine the ‘indifference’ levels in
choosing between the two financing options. This is
different from flexible exchange rate economies where
the interest rate is set by the Central Bank.

4. PURSUING POLICIES IN COUNTRIES
WITH FIXED EXCHANGE RATES
 Countries on pegged exchange rates have relatively limited
policy space.
 These countries are only able to issue currency in accordance
with the amounts of foreign exchange reserves they hold and
their legal conversion requirements.
 They do not have a ‘free hand’ in undertaking government
spending to meet policy goals such as full employment, price
stability and other economic welfare goals.

5. COUNTRIES THAT HOLD SUFFICIENT
RESERVES
What if a nation on a fixed exchange rate system has ample
reserves?
 Such countries are more likely to be able to maintain their
exchange rate peg.
 They also run a lower risk of defaulting on their legally binding
conversion requirements.
 If their reserve levels are greater than those required for
maintaining their peg, they have a greater ability to spend
through issuing currency.

6. IMPLICATIONS FOR MEETING POLICY
GOALS
 Countries with more than sufficient currency reserves have
more fiscal policy space.
 They have a greater degree of freedom to undertake government
spending by running deficits.
 They have more independence in pursuing goals such as full
employment and economic welfare programs, such as JG
schemes, investment in infrastructure, education programs, etc.

7. IMPLICATIONS FOR INTEREST RATES
 Markets will also view countries that have greater than required
foreign exchange reserves differently.
 Interest rates are likely to be lower for such countries as their
risk of default is perceived to be lower.
 This could also mean that they are in a better position to
undertake government spending through borrowing.

8. EXAMPLE: Saudi Arabia
 The country’s currency has been pegged to the US dollar at a
rate of 3.7500 since 1986.
 Major exporter of oil in the world market.
 Oil revenues are the greatest source of foreign exchange
reserves, making up 87% of total revenues between 2003 to
2011.
 Oil revenues have seen a general upward trend since 2003.
 Levels of foreign exchange reserves have also been on a steady
incline since 2003.

9. RISING FOREIGN EXCHANGE
RESERVES IN SAUDI ARABIA
1,400,000
1,200,000
1,000,000
800,000
600,000
400,000
200,000
0
Oil Revenues (Million Riyals)
Oil Revenues (Million
Riyals)
Saudi Arabian Foreign Exchange
800,000,000,000
700,000,000,000
600,000,000,000
500,000,000,000
400,000,000,000
300,000,000,000
200,000,000,000
100,000,000,000
0
Reserves (Current US$)
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Saudi Arabian Foreign
Exchange Reserves
(Current US$)
Source (TOP): SAMA 44th,
45th & 49th Annual Reports.
2008, 2009, 2013.
Source (LEFT): World Bank Data on
Total Reserves in Saudi Arabia
(including gold, current US$).
http://data.worldbank.org/indicator/FI.
RES.TOTL.CD

10. MEETING POLICY GOALS
With rising foreign exchange reserves, the country has a greater
ability to increase their level of deficit spending.
 Large foreign exchange reserves provide the country with more
independence and greater fiscal policy space.
 Can address multiple economic and social issues with a greater
ability to deficit spend.

11. APPLICATION OF
FUNCTIONAL FINANCE
 Can we apply the laws of functional finance to a country such
as Saudi Arabia?
 If private spending is insufficient, public spending can fill the
gaps.
 With more flexibility in the country’s ability to run deficits, the
government in to ensure price stability.

12. DAILY AVERAGE OIL PRODUCTION
(MIILLION BARREL)
10
9.5
9
8.5
8
7.5
7
2004 2005 2006 2007 2008 2009 2010 2011 2012
Daily Avg Oil Production (Million Barrel)
Source (TOP): SAMA 44th, 45th &
49th Annual Reports. 2008, 2009,
2013.

13. PREPARING FOR THE FUTURE
 Daily average oil production per barrel has not fallen below 8
million in the last decade.
 Proven reserves of crude oil stand at 265.9 billion barrels.
 Proven reserves of natural gas are 290.8 trillion standard cubic
feet.
With these levels, the country is expected to be a major exporter
of oil and gas for several decades to come.