University of Hull Macroeconomic Impacts of Exchange Rate Misalignments in Libya being a thesis submitted in partial fulfilment of the requirement of the degree of Doctor of Philosophy In the University of Hull By Abdulhamid Ben-Naser August 2019 Acknowledgement To begin, I thank God Almighty, for giving opportunity and ability to complete this thesis. I am deeply grateful to my parents for their support and continuous prayer during the course of this thesis, my family sisters for their patient and sacrifices throughout the completion of this thesis. I am also grateful to my sponsor, the Libyan Higher Education Ministry. My sincere thanks to my supervisor Dr Keshab Bhattarai for his effective guidance, valuable advice, useful comments, and support throughout the research and the preparations of the thesis. i Publication Part of the first empirical chapter was published as: “Estimating Equilibrium Real Exchange Rate and Misalignment in An Oil- Exporting Country: Libya’s Experience”. The Journal of Developing Areas pp.249-267. (https://doi.org/10.1353/jda.2018.0063) ii Abstract This study attempted to shed light on misalignments of real exchange rate in the Libyan economy. This is the first study that focuses on estimating the real exchange rate misalignments for the Libyan currency in my knowledge. The study took into account the most important characteristics of the Libyan economy, which depends almost entirely on public oil sector. This sector plays a significant role in the stability of inflation and value of the national currency. Oil shocks have had an evident impacts on monetary stability due to the fragility of the economy. This study found obvious proof of great and severe misalignments, in the form of over or undervaluation states of local currency which usually lasted for a long time. The large misalignment in the real exchange rate continuously for a long time in this way misses the opportunity for an appropriate economic climate in order to encourage foreign investment and non-oil exports. Libya as an oil exporting economy tried for many years to improve the external trade sector to increase the non-oil exports, reduce imports and substituting some of them by local products. The main target of that is to maintain the foreign exchange resources for investment projects. Oil crisis had made the economy to suffer from sharp structural imbalances, which has been difficult to overcome. The study also focused on the impacts of misalignments on economic performance. The main outcome of this part is that, increase in overvaluation states cause negative effects on economic indicators such as a decrease in non-oil GDP and non-oil exports, an increase black market premium and inflation rates. It is also noticed that, overvaluation episodes accompany with unstable economic situations, particularly in recent years. It was also noted that the overvaluation had negative linkage with endogenous variables in the traditional Keynesian model such as real private consumption, real total taxes, real interest rate, real imports, and real gross domestic income. On the other hand, undervaluation states brought many positive aspects to the economy. The New Keynesian DSGE model, with so-called three-equation model for three associations between output gap, inflation and interest rate rule, was estimated with the same time series data as for the evaluation of macro impacts. This model iii discovered that inflation rates relies on GDP gap in the Libyan economy by the slope of the New Keynesian Philips Curve. It also showed that, significant positive association between current inflation deviations to expected future inflation deviations. The parameter for the degree to which the central bank responds to movements in inflation was at a very low level compared with the literature. The DSGE model also predicts expected inflation to fall after the recovery in oil production that started at the end of 2017. This in turn will lower the real exchange rate appreciation and then will shrink overvaluation episodes moving the actual real exchange rate towards the equilibrium path gradually. Main contribution of thesis lies in measurement of misalignments for Libya, assessing the impacts of such misalignments on the Libyan economy and proposing a simple new Keynesian DSGE model to be suitable for analysing inflation and misalignment in Libya. iv List of Contents Acknowledgement ................................................................................................................ i Publication ........................................................................................................................... ii Abstract ............................................................................................................................... iii List of Contents ................................................................................................................... iv List of tables ..................................................................................................................... viii List of figures ........................................................................................................................x List of abbreviations .......................................................................................................... xii Chapter 1 Background of the Study ......................................................................................1 1.1 Introduction .....................................................................................................................1 1.2 Statement of the research problem ..................................................................................5 1.3 Significance of the study .................................................................................................6 1.4 Aims of the study ............................................................................................................7 1.5 Methodology ...................................................................................................................8 Chapter 2 the Libyan Economy: An Overview .....................................................................9 2.1 Introduction .....................................................................................................................9 2.2 Demography of Libya ...................................................................................................10 2.3 Developments of the Libyan currency ..........................................................................10 2.4 Foreign Exchange Market .............................................................................................12 2.4.1 Demand and supply of foreign exchange ...................................................................13 2.4.2 Equilibrium foreign exchange ....................................................................................14 2.5 The Libyan exchange rate regime ...............................................................................17 2.6 The main indicators in the Libyan economy .................................................................20 2.6.1 Oil exports and non-oil exports ..................................................................................20 2.6.2 Balance of payments ..................................................................................................22 2.6.3 Black market premium in the Libyan economy: ........................................................26 2.6.4 General expenditure and taxes ...................................................................................27 2.6.5 Oil revenue and non-oil revenue ................................................................................29 2.6.6 Money supply and interest rates .................................................................................30 2.7 Exports trading partners ................................................................................................30 2.8 Imports trading partners ................................................................................................32 2.9 Devaluation of national currency ..................................................................................32 2.10 Conclusion ..................................................................................................................35 Chapter 3 Measurement of Equilibrium Real Exchange Rate and Misalignments .............37 3.1 Introduction ...................................................................................................................37 3.2 Literature Review ..........................................................................................................40 3.3 Measurement of real exchange rate ..............................................................................47 v 3.4 Methodology and data ...................................................................................................57 3.5 Estimating Results: .......................................................................................................63 3.6 The gap between actual real exchange rate and its equilibrium path ............................67 3.7 Markov – switching regime and real exchange rate misalignments .............................72 3.8 Markov – switching regime and real exchange rate movements ..................................75 3.9 Conclusion ....................................................................................................................78