The UAE Central Bank: Role in Maintaining Price Stability

Subject: Economics
Pages: 15
Words: 4112
Reading time:
15 min
Study level: College

Inflation denotes a period of consistent increases in the price level of a country’s commodities, that results in the devaluation of its currency in the international markets. The level of inflation in a country has both direct and indirect influences on the economic development of that country. Positive changes in economic development imply an improvement in the standards of living of the people from that particular region. Inflation often leads to slowed or negative economic development (Financial services report, 2010).

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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 demand side of the economy, there are different factors that can contribute to the rise in the prices of commodities. First is the injection of more money into the economy that consequently shifts the demand for different commodities. Secondly, increased inflow of foreign currency into the country also boosts people’s power to purchase. Others include reduced savings, reduced 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 supply side of the economy are those that negatively impact on supply levels. For instance, scarcity of the factors of production increases the cost of production and subsequently alters the market price. Others include the laws of lessening proceeds, hoarding effects from the consumers and the 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 institutes different measures to counter the causes of inflation. This is effected through the different governmental bodies especially those that regulate the exports, imports and the monetary circulations such as the banks. One such institution is the Central Bank. The central bank is charged with the responsibility of controlling the level of inflation through various monetary and fiscal policies (Hamia, 2011). It consistently evaluates the current position of the economy and institutes the relative policies that ensure the level of pricing for the different commodities remains steady. This paper evaluates how the U.A.E Central Bank sustained steady pricing in order to ensure the economic development of 3.2% experienced in 2010.

Statement and purpose of the problem

The problem statement of the research is the role played by the United Arab Emirates’ Central Bank in the sustenance of the price stability in the country. For better comprehension, analysis is done with reference to the year 2010. The purpose of the study is to create awareness of the possible measures that can be utilized in containing the level of inflation in an economy. This can be sued as a reference point by other nations with relatively similar economies. Moreover, it offers a good reference point for the country itself in the future years to come, especially when confronted by situations such as the recent global recession. The study also hopes to illustrate 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 above, the research seeks to answer the following questions:

What is the maximum inflation that fosters economic growth in a country?

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The research hopes to determine the threshold of inflation in 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 to deteriorate relative to the prevalent level of inflation. The research supposes that this optimum level is 0%.

How does the Central bank influence the country’s inflation rate?

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 the strategies should be applied. Specific focus is laid on the strategies employed by the Central bank in reducing the inflation from 1.5% in 2009 to 0.9% in 2010.

What relationship exists between price stability and the economic development of a country?

The research identifies the mechanisms underlying the changes in the economy of a 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 a decrease or increase in the level of pricing of the various commodities. The pricing of oil and how it impacted the economy in 2010 is also evaluated. This is necessitated by the fact that U.A.E is one of the massive 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?

Although, UAE is known for its huge exportation of oil, there are other sectors that contribute to its annual GDP. Among the prominent sectors by the year 2010 include the construction and the tourism industry. UAE is famous for its extra-ordinary structures that attract many tourists form the West. 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.

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Significance of the study

The consumer index indicates that the inflation rate in the year 2010 had dropped by 0.7% from a high of 0.16% in the previous year. This was as a result of the aggregate decline particularly in the communications sector which recorded a remarkable changed from 0.2% in the previous year 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 clothes and foot sector, the inflation rate dropped from 4.77% to negative 4.96% thus contributing immensely to the reduction in the overall inflation rate. The inflation rates experienced from the food and beverages sector served to increase the inflation rates unlike other sectors of the economy.

This research is meant to uncover the underlying reasons for the decline in inflation rates for some of the sectors of the economy and an increase in others. By evaluating the roles that Central Bank played in the perceived changes, one can determine which sectors are affected by the policies adopted. For instance, if certain monetary policies led to a decrease in the inflation rates of Commutations group but caused an increase on the food and beverage sector, such policies should not be used when the Central Bank targets a decline in the latter in future. Secondly, in determining the maximum level of inflation that can sustain development, the research hopes to offer insight to other GCC countries that have relatively similar economies.

Definition of terms

  • Portfolio balance: this refers to the balance of assets that people hold
  • Real interest rate: interest due to the prevailing inflation
  • Natural interest rate: the market interest rate if the influence of thee monetary actions was with drawn
  • Hyper inflation: very high rate of inflation, that is, two-digit inflation
  • Demand-pull inflation: inflation resulting from an increase in the demand for commodities and s subsequent scarcity of the commodity
  • Bond: are long-term assets that issued by companies to their creditors. They accrue interest at a particular market defined rate.

Limitations of the study

The regulation of inflation in UAE can be attained through different avenues. Some of these may not be instituted by the Central Bank. This study concerns itself with how the monetary policies those are within the mandate of Central Bank. It ignores other governmental actions that could influence these policies. Moreover, it does not go into details of how, the pegging of the Dirham on the US dollar limits the freedom of the Central Bank in effecting its role or regulating the price stability. Other GCC countries such as Kuwait have neglected such measures and opted for a basket of currencies instead. However, the research covers the role of Central bank, the oil sector and the non-oil sector in influencing the price levels conclusively.

Literature review

The central bank of the UAE has several options that it can employ to counter the effects of inflation in the country. However, these measures are dependent on the nature of inflation and how it has resulted. Therefore, prior to any analysis on the corrective measures it adopts, a brief understanding of the mechanism of inflation and how it arises would be vital

Inflation can be termed as the alteration in the level of the absolute pricing of a commodity. For some commodities the price of the price will experience significant increases while in others the price change may be relative. For instance on UAE, the price of electronics in the year 2010 decreased considerably while that of the food and beverages increased. This results in the discrepancies experienced in the inflation rates indicated earlier on. Besides the absolute price of a commodity, there is its real price. This refers to a commodities price when viewed in relation to the price of other commodities. Whenever the real price of a commodity increase, then its absolute price is bound to change significantly relative to the overall price level.

In answering the question of the most effective inflation rate to sustain economic development, one can consider the costs that are associated with inflation and the benefits that could result. Form the perspective of the UAE citizens, businessmen and the government representatives, inflation should be the number one priority in trying to achieve economic recovery for any nation. In fact, it is perceived as more significant than cutting down the level of unemployment of eradicating poverty.

The effects of inflation can be severe especially at heightened levels. Hyper inflation can actually be destructive the economy of any nation. However, the social costs associated with inflation are an exaggeration by the financial institutions whose businesses operation thrives well in low inflation situations. Studies conducted indicate that at low inflation is actually beneficial to an economy. It can be essential in fueling the economy. For instance, if the level of prices change is matched by an equivalent change in the income of the citizens, the inflation level may perceive as inconsequential (Hancock, 2010).

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In practical situations however, it is impossible that the level of price changes will correspond to the income changes. The wages may match inflation and in other instances exceed it or the prices changes in the prices of the different commodities may vary considerably. In order to shield themselves from the effects of inflation, individualism UAE index their salaries on the price levels. To achieve this, there are social programs that offer adjustments to the cost of living for the different individuals.

In the inflation incidences, there are losers and winners. For instance, the largest beneficiaries are the money borrowers. The fact that a large section of the debt is eroded by the effects of inflation serves their interest appropriately. Therefore, the government being a large debtor, often has little to lose from the inflation. However, other participants of the economy are bound to suffer significant loses. For example, people with fixed incomes that are dependent on the performance of the dollar; workers who cannot negotiate for a better pay that matches the level of inflation; lenders who institute fixed rate on their interests are some of the people gravely affected by the level of inflation. These are the people whom the UAE’s central bank seeks to protect as they are vital for the development of the economy (Karkouti, 2009).

According to views by different economists high rates of inflation, particularly hyper-inflation, can result in significant strain on individuals and businesses or even the siphoning of the country’s capital. However, there is no conclusive evidence that indicates that single digit inflation can result in hampering the economic progress of an economy (Alkholifey & Alreshan, n.d.). In fact, there seem to exist a link between the economic growth and small rate of inflation (less than 10%). For instance, despite UAE’s inflation of 0.9% in 2010, it still managed to register a growth rate of 3.2%. The argument advanced for this is not that single-digit inflation directly increases the economic growth rate, but modest inflation rates of 0.5% to 2% gives the sellers a margin to decrease their prices whenever it is deemed appropriate. This happens without effecting changes on the supposed price of the dollar. Relative price adjustments are vital for any budding economy and such modest inflation creates such an environment. Therefore, when the Central bank of the UAE institutes its monetary policies, it does so regulate the inflation level to this beneficial level.

Though different countries may experience same inflation rates, the cause of the inflation may differ from country to country. In UAE, the central Bank strives rectify inflation due to different aspects. First is the kind of inflation that relates to an increased spending. This is termed as demand-pull inflation. If the banks lower their lending rates and there is more up take of loans, then consumers and businesses are bound to have plenty of money to spend. This increase may not match of the availability of goods in the economy and could result in scarcity of products. Individuals and businesses will be competing to buy the goods since they all have the money. For the Central Bank to check this kind of inflation it institutes policies that counter the increased demand. This can entail the introduction of higher lending rates by the banks. However, the alternative of stimulating the supply levels could demand lower rates. Therefore, it must strike a balance between the two for policies to be efficient.

The second cause could be increased labor costs. Whenever the salaries in the economy are increasing at a faster rate than the level of productivity, the increase production cost is transferred to the consumer of the product. However, this is subject to the reigning competitive forces. The remedy that can be institute by the Central bank to curb to this is advancement of policies that promote unemployment. The central bank is not responsible for other alternative measures such as the introduction of price controls or the regulation of imports.

Another form of inflation can be triggered by the appetite of companies to realize higher profits. If businesses realize they can achieve increase the price levels without altering the demand for their commodities they can easily do so. An increase in the raw materials critical for production in the economy such as oil products could also trigger inflation. However, UAE is an exporter of oil and can hardly experience this form of inflation. Lastly, if inflation is left unchecked for a while, it can become self-propelling. Different economic players can fuel the inflation to greater levels while attempting to cushion themselves. For instance, companies can pass over the increased production costs of employees may demand a raise in their salaries to match the increased prices of different commodities.

The Central Bank may be the chief regulator of the inflation levels in the UAE but it is not the only regulators. However, the monetary policies it institutes have a direct or indirect effect on the policies advanced by other government agencies such as that in charge of the taxes. The mechanism of altering the price level has various intrinsic aspects. However, policies instituted could take up to two years before their effect is felt in the economy itself.

The aspect of how the Central bank counters inflation revolves around the demand for money in the economy and regulation of portfolio balance. It entails the increasing or reducing the demand as may be deemed appropriate. In a collection of bonds and capital, money can be viewed as an asset. For any investor to be content with the nature of their portfolio, the returns they realize must relate directly to the assets they have invested. Bonds and capital are used to yield liquidity services such as and consequently determine the amount of money available for circulation.

The UAE Central Bank ensures the prices are steady by instituting measures such as

  1. Restriction on the money supply
  2. Monitoring the credit levels through the banks
  3. Placing financial ceilings on the banks and other finance drivers in the economy
  4. Controlling the fiscal policies and the amounts available for spending.

The above measures are best exercised by an independent Central Bank. Luckily the UAE Central Bank does not suffer from political interferences and hence institutes the relevant policies solely. So the important question is how the Central Bank comes up with the most appropriate interest rate that ensures there is portfolio balance for the county’s citizens while avoiding the excessive supply of money that consequently fuels the level of inflation. Two conditions are mandatory for the realization of this goal. First, it sets a credible inflation target. This target must be set relative to the general expectation of the public. For instance, public expectations of a future inflation should be countered by a reduction in its interest rate targets. However, it is crucial to note that the interest rate target does not match the actual interest rate. Secondly, the Central Bank factors in the effect of the set interest rate in the pricing mechanism of the economy

Key to the pricing mechanism is the real interest rate. The shifts in this interest rate bring about the scarcity of products in the markets and the increase in consumer needs. Fishers’ connection between the real interest rate and that of the level of consumption is well depicted by the equation below. rr represents the real interest rate and p represents people’ time preference for present spending over future spending

rr= {(1+ p)(c2/c1)}-1

If all the monetary alterations were to be withdrawn, the prevailing interest rate is referred to as the natural rate. The goal of Central Bank is to vary its interest rate goal so that it relates closely to the natural rate.

Often when UAE experiences a high inflation which the Central bank wishes to reduce, it uses a short-term interest on the credit facilities awarded by the financial institutions. To get the actual figure it modifies the above formula with the current and expected future price of the level as per the public.

Rt = {(1+ rRt)Pt+1* /Pt}-1

By altering this formula and making the future price level the subject, the Central Bank is in a position to use its make assume the direction of its inflation target, that is:

Pt= {(1+ rrNt)/ (1 + rTt)}P*t+1

Alterations in the natural rate (rrNt) must be matched by the relative changes in the Central Bank’s interest rate targets.

Through the above formulas, the Central Bank manages to arrive at the best interest rate that counters the prevailing level of inflation. In the year 2010, the interest rate adopted by the Central bank and imposed on the banks was favorable. This is depicted by the fact that loans increased level of loan uptake by the banks by 1.3%.

The next issue is how the interest rate arrived at is used in effecting the price stability. The Central bank acts as the Bank of all other Banks in UAE. Therefore, it has the mandate to regulate the operations of these banks through the interest rates. High inflation, as explained above, could result from the increase in the demand due to availability of liquid cash. Usually, once this occurs, the Central bank immediately, works out the appropriate rate depending on its target inflation rate; it imposes the rate on the commercial banks (Al Khater, 2012).. Banks are profit making organizations and they therefore apply the Central Bank rate as their base rate. All loans they lend out are then given at an interest rate that includes this base rate and their supposed profit margin. If the Central bank rate is high, the final interest rate on the loans will be relatively high for the borrower. They will be required to pay very high interest rates that do not match the returns on their potential investments. They will therefore shy away from taking loans and this has the effect of reducing the amount of money in circulation. A reduction in the case available for spending reduces the product demand and consequently brings down the price levels. This is referred to as deflation. In 201, the Central bank increased the lending the minimum lending rate to 1% from a previous 0.5% and this led to the decline in the inflation between 2009 and 2010

Other measures that are utilized by the central banks in order to trigger the same effects include the increase in the level of deposits by the banks. The Central Bank issues a policy, in which the financial institutions are required to keep a certain level of deposits with it. The banks are forced to dig deeper into their coffers in order to meet these targets. Consequently, the amounts of funds available for lending are reduced and this limits the amount money available to the public.

Though the Central bank of UAE has the above power, its powers are limited by the fact that the country’s currency, Dirham, is pegged on the dollar. This is referred to as dollarization. The central bank of UAE uses this measure in order to ensure stability of its local currency and reduce the levels of risk. This has the effect of attracting foreign invests since they are confident in the performance of the currency. However, the disadvantage of the approach is that its results in the transferring the economic shocks of the US to the UAE economy. For instance, the global crisis of 2008 affected UAE due to this strategy. For an economy that attracts a large number of investors, the benefits are much more than the consequent restrictions on the Central Bank (Middle East Central Bank Governors, 2011).

UAE is a large exporter of oil to other nations. Many of the industries in the economy depend on the oil for production to be realized. Whenever the prices of oil increase, this can result in inflation. Increase in the price of oil raises the cost of production. Companies pass these costs to the consumers by increasing the prices of the commodities. The non-oil sectors in UAE that apply this strategy include the tourism and the construction sector. In the year 2010, the oil prices increased internationally. This could have caused the inflation in food and beverages sector that increased the inflation. However other sectors such as communication that experienced a decline in the level of pricing offset the increase to result in the perceived 0.9%.

UAE is considered as one of the high income countries in the world, particularly due to its oil production levels and upcoming tourism sector. It has managed to sustain reasonable annual inflation rates of between 0.5% – 2%, that is considered as the optimum level that greases the wheels of the economy. Consequently it had continued to experience an annual growth rate of above 3.2% per annum, which is commendable. However, this has been achieved through the contribution of the Central Bank. The Central bank checks the inflation level mostly by changing the interest rates as me be deemed appropriate. In order to pick the most appropriate interest rate it uses the Fisher formula. This formula factors in the current price of the commodities, the expected future price of the commodities as per the public and the, the natural rate and its inflation target. The figure obtained is then passed to the banks in order to controls the level of money supply in the economy. The effective rates of the banks on the loans then dictate amount of cash available in circulation. Reduction in the amount available for spending causes the perceived decline in the price levels. In case the money in circulation goes below particular levels, then the Central bank can institute alternative procedures that increase the money supply. This way the Central Bank keeps the prices in UAE stable. However, pegging its currency on the U.S Dollar sometimes often results in complication in instituting the relevant policies.

The availability of oil in UAE helps shield the economy from inflation due to increased cost of raw materials. Other sectors can therefore exert little influence on the level of prices through transfer of costs. The interplay of these factors makes UAE the tourist destination for many tourists and sustains its economic development.

References

Al Khater, R. K. (2012). The Monetary Union of the Gulf Cooperation Council and Structural Changes in the Global Economy: Aspirations, Challenges, and Long-term Strategic Benefits. Web.

Alkholifey, A, & Alreshan, A. (n.d.). GCC Monetary Union. Web.

Financial services report. (2010). Financial Services Industry Report: UAE, 2(1), 9-23.

Hamia, M. (2011). Measuring and modeling core inflation for three GCC countries: Kuwait, Oman, and the UAE. Journal Of International Finance & Economics, 11(2), 1-30.

Hancock, M. (2010). Central bank to tighten lending criteria under new rules. MEED: Middle East Economic Digest, 54(41), 19.

Karkouti, M. (2009). Dubai — getting by with a little help from its friends. Middle East, (400), 54-55.

Middle East Central Bank Governors. (2011). MEED: Middle East Economic Digest, 55(27), 38.