Study Background
Introduction
In economy, inflation is the increase in the price levels of commodities. The level of inflation in a country has both the direct and the indirect influences on the economic development. Positive changes in the economic development entail an improvement in the standards of living of people from that particular region. Inflation often leads to slowed or negative economic development (Financial services report, 2010).
The causes of inflation are divided into two categories: causes from the demand side of the economy and those from the supply side. From the supply side of the economy, the UAE Central Bank has recently extended substantial financial backing to failing banks, intermediaries, and other financial institutions within the country to avoid further extortion of the economy and recapture the public confidence. Another prominent move evident in this context is the manipulation of the capital reserve requirements. In banks, capital reserve means the available securities, which can be lent to other financial institutions for dissemination to the public. In this regard, the UAE Central Bank has tried to regulate its capital reserves to ensure that the money in circulation is enough to normalise the situation. Secondly, there was a need to boost people’s power to purchase. Others include reduced savings, lowered direct taxes, positive change in population growth, and excess of illegal money in the economy. All these are factors that increase the amount of money in circulation in the concerned economy.
Factors that could lead to inflation from the demand side of the economy are those that negatively impact on supply levels. For instance, in some developing economics, a substantial rise in prices occurs when the demand for goods and services surpasses supply, thus causing a critical demand-pull inflation. In the UAE, the same demand-pull inflation affected the entire economy, which was the case that demanded the intervention of the Central Bank. Others include the laws of lessening proceeds, hoarding effects from consumers and traders, and the influences of natural tragedies. All these factors have the effect of increasing the initial price of commodities, consequently resulting in inflation (Hamia, 2011).
The UAE government has instituted different measures to counter the causes of inflation. This has occurred through different governmental bodies, especially those that regulate the exports, imports and the monetary circulations. One such institution is the UAE Central Bank. The UAE Central Bank is charged with the responsibility of controlling the level of inflation through various monetary policies. Evidently, the hands of the UAE Central Bank were tight due to the US dollar peg, and need to follow the U.S. monetary policy of low interest rate (Hamia, 2011). It consistently evaluates the current position of the economy and institutes the relative policies that ensure that the level of pricing for the different commodities remains steady. For instance, in response to the recent financial crisis, the UAE Central Bank has tried to regulate the monetary policies by controlling the credit and monetary conditions in the economy in attempt to utmost employment, steady pricing provisions, and modest long-term interest rates. Evidently, the public usually feel the pinch of financial crisis through these factors. This paper evaluates how the UAE Central Bank sustained steady pricing in order to ensure the economic development of 3.2% experienced in 2010.
Generally, during economic crisis, central banks can assume critical measures to restructure financial markets and restore public confidence. The recent financial challenges have affected the economies of numerous countries. Consequently, the concerned central banks have taken swift moves to help in the matter. The connection between price stability and the economic development of a country is measurable through the exposure to inflation, employment and interest rates, and other economic provisions. The research identifies the mechanisms underlying the changes in the economy of the UAE due to the shift in the level of prices, as discussed later.
The regulation of inflation in the UAE can be attained through diverse avenues. Some of these regulations do not concern the Central Bank but constitute a formidable provision. This study studies how the monetary policies within the mandate of the Central Bank can be utilized to avert inflation. The Central Bank influences the inflation rate in vast ways. It has the mandates to impose laws that help in stabilising the money market values, as discussed. Generally, the UAE has a Central Bank established to monitor the monetary issues and control other financial bodies, such as the commercial banks. As the uppermost monetary controller within a state, the Central Bank has basic influences on the financial service providers through its policies. For example, the UAE Central Bank has the capacity to regulate the commercial banks and other financial service providers to reduce or increase interests chargeable on loans lent.
Basically, the Central Bank is the controller of economic stability and inflation in a given state. Through its direct control of financial service providers in terms of management of lending rates, it defines the amounts of loans to be given, as well as the duration of payback on these loans. It, therefore, acts as an indirect cushion to the consumers or the citizens who are the major dependents on commercial banks. Evidently, a notable current event in the financial crisis is the reduced interbank lending where banks do not trust each other with money in the financial arenas. In such circumstances, central bank serves as the last resort for the borrowing opportunities, which must be critically observed. Precisely, the research evaluates the strategies, monetary or fiscal, that are instituted by the central bank in order to keep the level of inflation at sustainable levels. It also evaluates when and how each of these strategies should be applied.
Statement and purpose of the problem
The role played by the United Arab Emirates’ Central Bank in the sustenance of the price stability in the country is critical. For better comprehension, analysis should be done in reference to the year 2010. The purpose of the study is to create awareness of the possible measures that can be utilised to control the level of inflation in an economy. This can be used as a reference point by other nations with similar economies. Moreover, it offers a good reference point for the country itself in the future years, especially when confronted by such situations as the recent global recession. The study also illustrates how different sectors contribute to the economic development in relation to the price stability of different commodities.
Study Questions and Hypotheses
In order to conclusively respond to the problem stated above, the research seeks to answer the following questions:
What is the maximum inflation rate that may foster economic growth in a country?
The research strives to determine the threshold of inflation in the United Arab Emirates. This is the value of inflation below which the economy of the country can sustain steady economic development. Above this limit, the economy of the country begins deteriorating relative to the prevalent level of inflation. The research supposes that this optimum level is 0%. Inflation targeting exercises tremendous economic policies. Through this process, concerned central banks maintain inflation in a quantitatively acknowledged band. The most distinctive feature of inflation targeting is that in its practice, which means that the central bank must communicate to the general public. Basically, the quantitative monitoring aspect in inflation targeting is important. This is because it entails the regulation of the amounts of money within an economy. As a policy directive, inflation targeting seeks to maintain the level of inflation within tolerable ranges. Agreeably, it is the amount of cash in circulation within an economy that causes the effects of inflation to appear. Therefore, inflation targeting operates to manage the money supply within an economy.
How does the Central Bank influence the country’s inflation rate?
The study focuses on the approaches adopted to control the level of inflation at sustainable levels. It also tries to find out when and how these strategies should be implemented. Specific focus is laid on the strategies employed by the UAE Central Bank in reducing the inflation from 1.5% in 2009 to 0.9% in 2010. The UAE Central Bank, having relatively few tools considering the US dollar peg, can influence monetary policy by imposing laws that help in restoring the money market values. This situation is evident in the Greek’s Central Bank, The Fed, BoE, and other regulatory financial institutions. Additionally, the policy should be sensitive to the operational interest rates. If these interest rates are normal, the entire lending phenomenon normalises. The UAE Central Bank has regulated its operational lending interest rates depending on the financial situation, thus affecting the financial markets considerably.
What relationship exists between price stability and economic development of a country?
The relationship between price stability and economic development of a country can be measured through vulnerability of inflation, employment and interest rates, among other economic provisions. The research identifies the mechanisms behind the changes in the economy of the UAE due to the shift in the level of prices. It examines how a reduction in the price of the commodities will eventually lead to a positive change in the Gross Domestic Product (GDP), and vice versa. Furthermore, it determines how the fiscal or monetary policies advanced by the Central Bank result in decrease or increase in the level of pricing of the various commodities. The pricing of oil and its impact on the economy in 2010 are also evaluated. This is necessitated by the fact that the UAE is one of the biggest exporters of oil to other nations.
What is the influence of the oil and non-oil sector of the UAE economy to the price stability and the long-term economic development of the nation?
The influence of the oil and non-oil sector of the UAE economy to the price stability and the long-term economic development of the nation will be measured through the foreign exchange rates and the US dollar stability on which the foreign markets operate. Although the UAE is known for its huge exportation of oil, there are other sectors that contribute to its annual GDP. The construction and the tourism industries have been considered among the most prominent sectors by the year 2010. The UAE is famous for its extra-ordinary sceneries that attract many tourists from all over the world. The study intends to evaluate these non-oil sectors in their diversity and assess the influence they exercise on price stability. It also determines how these sectors are influenced by the policies adopted by the Central Bank.
Significance of the study
The consumer index indicates that the inflation rate in the year 2010 dropped by 0.7% from a high of 0.16% in the previous year (Indexmundi.com., 2012). This was a result of the aggregate decline particularly in the communications sector which recorded a remarkable change (from 0.2% in 2009 to -0.36% in 2010). The housing sector’s inflation rate dropped from 0.16% in 2009 to -0.12 in the year 2010. In the clothing and foot-wear sector, the inflation rate dropped from 4.77% to -4.96%, thus contributing immensely to the reduction in the overall inflation rate (Indexmundi.com., 2012). The inflation rates experienced from the food and beverages sector served to increase the inflation rates unlike other sectors of the economy.
This study strives to uncover the underlying reasons for decline in inflation rates in some sectors of the economy and increase in the others. By evaluating the roles that the UAE Central Bank has played in the perceived changes, one can determine which sectors have been affected by the policies adopted. For instance, if certain monetary policies led to a decrease in the inflation rates of telecommunication sector, while having caused an increase in the food and beverage industry, such policies should not be used in future when the Central Bank targets a decline in the latter.
Definition of terms
Portfolio Balance refers to the balance of assets held by people.
Real Interest Rate stands for the interest occurred due to the prevailing inflation.
Natural Interest Rate is the market interest rate occurred if the influence of thee monetary actions was withdrawn.
Hyper inflation means a very high rate of inflation, that is two-digit inflation
Demand-pull inflation is a term referred to inflation resulting from an increase in the demand for commodities and subsequent scarcity of the latter
Bond means long-term assets issued by companies to their creditors. They accrue interest at a particular market defined rate.
Limitations of the study
The inflation regulation in the UAE can be attained through different avenues. Some of these may not be instituted by the UAE Central Bank. This study evaluates how the monetary policies, within the mandate of the Central Bank, can be used to avert inflation. The research does not consider other governmental actions that could influence these policies. Moreover, it does not go into details on how the pegging of the Dirham on the US dollar limits the freedom of the Central Bank, affecting its role or regulating the price stability. Other GCC countries, such as Kuwait, have neglected these measures and opted for a basket of currencies instead. However, the research studies the role of the UAE Central Bank, the oil sector, and the non-oil sector in influencing the price levels within an economy.
References
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Financial services report. (2010). Financial Services Industry Report: UAE, 2(1), 9-23.
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Indexmundi.com. (2012). United Arab Emirates Inflation rate (consumer prices). Web.
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