The model to estimate is a long run co-integration model, based on the model by Al-Mulali and Che (2011) with the real exchange rate as the dependent variable, expressed in the form:

ERit = i + 1iOPit + 2iCAit + 3iGDPPCit + 4iFDIit + it; (1)

Where;

ER = Real Exchange Rates

OP = Real Oil Prices

CA = Real Current Account balance

GDPPC = Real GDP Per Capita

FDI = Real Foreign Direct Investment inflows

i takes 6 values for the six respective countries of the GCC.

Real exchange rates are constructed using domestic and foreign price levels. They are calculated using the following equation:

RER= Nominal ER * (Domestic price levels/Foreign price levels)

The nominal exchange rate is the price of domestic currency in terms of the foreign currency (USD), i.e. the number of foreign currency units required for one unit of the domestic currency. The real exchange rate is hence the nominal exchange rate adjusted for the relative price ratio. The domestic GDP deflator is used to account for domestic price levels, while the US GDP deflator is used a proxy for foreign price levels.

The coefficients 1i to 4i are the long run coefficients to be estimated, while it is a residual term. The significance of this long run co-integration model confirms the associated variables have a long run co-integration relationship with the real exchange rates.

Based on this theoretical model, a rise in the real exchange rate or an appreciation of the GCC currency is expected to result from either a rise in oil prices, a positive current account balance, an increase in GDP per capita, or positive FDI flows (FDI inflows).

As mentioned earlier, with fixed exchange rates the impact of these variables on the real exchange rate is explained through their impact on the relative prices. Higher oil prices are forecast to appreciate the dollar-pegged GCC currencies because they generate a higher flow of oil revenues into these economies, which induce higher government expenditures. This in turn stimulates a high and rapid growth of liquidity, which creates inflation in these economies. Domestic prices of goods and services would be higher than their foreign counterparts. With a fixed nominal exchange rate, this means the real exchange rate of the GCC currency must appreciate.

The current account indicates whether a country is a net borrower or a net lender. An increase in oil exports, driven both by an increase in their prices and quantities produced, will increase export revenues and cause a sudden rise in liquidity in these economies. This in turn raises domestic prices causing inflation and appreciates the real exchange rates of the GCC currencies, and once more domestic goods and services would be more expensive relative to foreign goods and services.

Moreover, the higher GDP per capita reflects high oil revenues that led to increased government expenditures and investments, and hence higher GDP. An increase in the level of expenditures and investment by the government tends to lead to higher inflation and a real appreciation of the GCC currencies relative to the dollar. Higher GDP per capita may also induce retailers to import more goods and services into the economy, hence contributing to the overall increase in domestic prices.

Finally, the model suggests a positive relationship between FDI inflows and the value of the currency. FDI inflows represent the capital supplied by a foreign direct investor to an enterprise residing in the economy. The higher these investment flows, the more international reserves accumulated at these countries' central banks and the higher is the growth of money. Excessive money supply growth would therefore put upward pressure on domestic prices and hence induce inflation and appreciate the real exchange rate.

Q1. Based on the information given above discuss the main variables that significantly affect the exchange rate in the GCC. ( all details mentioned above )