Monetary Theory and Inflation in the UAE - Research Paper Example

Macro & Micro economics November, Monetary Theory Money: The world is full of people running various businesses, organizations and even governments that deal with money all through different structured levels. They all have different interpretations in the event that money is in their pockets; wealth, power and contentment in nature among others. Money is any substance that serves as a store of value, meaning that people can save it and use it later smoothing their purchases over time; a unit of account providing a common base for prices; or medium of exchange which people can use to purchase and vend from one another (Asmundson and Oner imf.org). Its value differs in different regions and parts of the world when compared. However, it is a common accepted and standard means of exchange by people within a boundary; that is why an individual from outside a nation will find himself with either few or more money after currency change in a foreign land that does not share similar currency. According to Leyshon and Thrift, there exist several forms of money, “namely; pre-modern money; commodity money; money of account; state money and virtue money” (3). Money exists as paper (certified currency notes), metallic coins, made of kinds of metals and credit money which is easily convertible and highly appreciated through cheques. In the past, a variety of commodities ranging from iron, gold, copper, silver, shells and animals served as a medium of exchange in various locations and times. The history of money can be traced back from the act of exchange; however, barter trade was not able to handle the complexity of life dealings and so had to be replaced with a common medium. Money must be easy to transport and identify, durable, difficult to duplicate, divisible and widely accepted (“the measure of money,” boj.org). Money supply in the economy: This is simply the amount of money circulating in an economy. Several methods have been put across to measure money supply in an economy. However, the measures differ from nation to nation, in time and the intention. According to Dwivedi, “(i) money supply is a stock variable and measure of money supply refers to the stock of money at of point in time; (ii) by measure of money supply is meant the measure of stock of money available to the public as a means of payments and store of value and (iii) the term ‘public’ means all economic units including household, firms and institution” (212) excluding some areas like commercial and main central banks where money is in circulation. To quantify money, various policy makers and economists use M0, M1, M2 and M3 methods. “M1includes money in circulation, checkable deposits and traveler’s checks while M2 adds savings deposits, time deposits held in depository information and money market mutual funds share on top of M1”( Gwartney, Stroup, Sobel, and Macpherson 266). M0 is the monetary base from which other measures build on while M3 is a broader measure including items that would be termed to be close substitutes for money. Money value is affected by its supply in the market; when its supply is limited comparing with its demand, its value is high at the time, but when unlimited in circulation, it looses its value; that is, one uses a lot of it to buy few items. Money supply is a very central issue in any nation; in most countries, it is handled by the government through central banks and treasury, other involved groups are credit unions and depository institutions among others with regard to a nation. Money supply in an economy will always affect interest rates; with increase in supply, the GDP increases too in the short run while price level in the long run, otherwise they both decrease in the same manner respectively. Money supply is important to GDP calculation and its increase bids bond prices up as it slows down the interest rate to affect investments which in turn influences total output in an economy. Suppose money supply generates faster than real output, inflation tends to occurs; hence, as much as developing economies need a growing money supply to pay for the increase in aggregate output, they need to be careful to avoid entering into such a situation. Referring to Beenhakker, money supply is expressed as MV=PQ; where M, V, P and Q means money supply, money velocity, price level and real output level respectively(103). Inflation in the UAE: United Arab Emirates is one of the leading influential oil producing countries. Its main revenue is generated from oil trading since it’s the main resource in the nation. The global economic financial crisis between 2007 and 2008 that began in the U.S and Europe did not spare UAE economy. Following the economy’s relation with the western nations (mostly the US and Europeans) through trading, the foreign nations decline in purchasing power resulted to sharp drop in oil prices. In UAE, as a member of the GCC countries, inflation rates appear to be positively associated with petroleum prices where high oil prices lead to increased spending higher liquidity and increased domestic demand which contribute to even higher inflation (MacDonald  and Al Faris 19). The pattern of inflation between 1980 and 2008 indicates that UAE faced a double inflation rate in the last period, when compared to the 1980 to 2000 period. For the last three decades, UAE mean inflation criteria in 1980 to 1990 was 3.66, from 1990 to 2000 it ranged 3. 65 while in 2000 to 2008 it hiked to 6.22 (MacDonald and Al Faris 19). Besides the global financial crisis, the correction of the Dubai property market also contributed to inflation level in the country. As from 2008, major sectors’ prices continue to decrease at different ranges leading to a recovery in the economy (International Monetary Fund 5) (see fig. 1). Fig. 1. CPI inflation, 2009-12; International Monetary Fund. “United Arab Emirates; Staff Report for the 2012 Article IV Consultation”; Imf.org; 27April 2012; Web; 3 November 2012. The causes of inflation as of 2009 was associated with restricted access in the housing market, and increased population growth, connected to the weakened foreign currency, profuse liquidity, a surge in the entire government spending and high global food prices during the time. Judging from its impact, increase in public spending and decline in revenues resulted in a depreciation of the consolidated fiscal position from a surplus of 21% in GDP in 2008, to balance in 2009(Carlos 64). Following the inflation, the government has focused on restructuring the economy to boost investment, improve business climate and emergence of a more vibrant private sector (“United Arab Emirates,” heritage.org). The economy seems to be regaining its stability in the general open trade system. Inflation in Abu Dhabi which is the leading high oil producer in UAE dropped from 14.9 % in 2008, 0.8 % in 2009 and 3.1 % in 2010 (“Abu Dhabi’s Economic,” adced.ae). Interest rates in the UAE: All over the world interest rates would help determine the economy savings. Its changes affect investment either limiting profits, or expanding it for economic gain. In the UAE, the law stipulates that interest rates on loan be determined on loan agreement made between the parties involved, failure to which common interest rates in the market provided it does not exceed twelve percent would determine the rate (Baamir 178). Economic need and changes have made a shift of perception from the legislation view based on Sharia facilitating interest in commercial loans, and later in ordinary practices of money-making activities. The economy is well connected to the US dollar through the oil exports which causes serous implications especially in the event of changing oil prices connected to the monetary policy of the US. Real rates of interest have been affected by the existence of low nominal interest rates, following the dollar currency fixation and the increased capital mobility, together with the high inflation. After the US macroeconomic policy, UAE nominal interest rates has kept close track to the US rates, resulting to real rates of interest becoming increasingly negative, even with the Emirates high inflation and after pegging to the US dollar combined with perfect capital mobility(MacDonald and Al Faris 100). For a long time the UAE struggle has been associated with the lack of independent monetary policy, problem arising from exponential capital mobility and fixed exchange rates. The Central Bank in UAE discontinued matching interest rate cuts by the US Federal Reserve which effectively led to rising of the relative cost of funds. However, this act of unexpected shift in foreign investment left its relative small economy exposed to market and economic risk. “The Central Bank has lowered its interest rate on repurchase of certificates of deposit from 5% in Q4 of 2007 to 2.25% in Q1 of 2008 in line with several cuts by the US Federal Reserve” then to 2% by Q3 of 2008, 1.5% by Q4 and a constant 1% down in 2010 (Hasan 18). (See table 1). Table 1: Interest rates in UAE at 3 months inter-bank and repurchase rate between 2008 and 2nd Quarter of 2010 Source: UAE Economic outlook 2010, globalinv.net, September 2010, Web, table 9. a. Note: The central bank continues to lessen interest rates in certificates of deposit repurchase from 2008 to a constant value from 2009. Commercial banking: this is the concept by which financial institutions are concerned with getting deposits and lending monetary services to businesses at an aggregate level whose aim is to earn profit. According to Jain T., Khanna, Grover, and Jain D., commercial banking entails primary functions that involve accepting of deposit and loans advancement (317). Concentrating on deposits in the bank, customers can choose from a variety of accounts at their convenience. Using fixed deposits accounts, cash is deposited for a fixed period while in Demand deposit accounts, the customer has the right to store and withdraw money the number of times he wishes. For recurring accounts, precise amount is stored, each month for a particular period with strict observation of expiry date for withdrawal purposes. Also, the saving accounts meant to promote small business and individual savings through imposed restrictions by the bank on the amount an individual can withdraw. Recently, commercial banks have introduced portable, home safe saving accounts that are kept at the depositor’s residence though the key is held in the bank. Not all the amount of money collected is kept in the bank, but partial quantity is issued as loans in the economy on approved security. Loans advancement by commercial banks includes over-drafts, loans and advances and cash credits. According to Beckwith, from a socialist point of view, commercial banks put idle money and capital to work and increase the supply of money hence benefiting the society(61- 62). The bank main liability are the deposits made the customers while the bank hold reserves at the fed the same manner customers would make deposits in the bank. Loans and bonds as bank’s assets are the ones that earn interest for the commercial banks. The required reserve ratio is the fraction of reserve at the fed (commercial banks bank) that is similar to people deposits in the commercial bank. The relation between deposits and reserves are indicated by the following formulas; Reserve = (reserve ratio)*deposit and deposits = (1/reserve ratio) * deposits (Taylor 239). Interlinking of global economies: Countries’ and region’s economies are connected to the general global economy through many channels. There is no single economy that can survive alone, without having to interact with other markets exposure and risks. As the economies in counties develop, they are increasingly connected by material suppliers and the markets, manufacturing capacity, networked infrastructure and logistical systems (“The interlinked global,” wdlc.net). The state of the connection begins from a closer perspective, within a region that would then interlink with other regions normally referred to as regional alliances. Else, individual countries would engage with foreign nations at a grassroots level. There exist many economic groupings in the world all trying to strengthen their financial viability in both local and international level; ECOWAS in Africa, MENA in North African and Middle East oil producing countries, NAFTA in North America, EFTA in Europe, OECD and G-8 amongst. The interlink becomes strong everyday as the alliances in economic integrations are supported by customs union, free trade agreement, economic union and common market. Through the free trade agreements, countries within a region can participate fully in trading engaging in other markets outside its borders without having to pay taxes. Tariffs elimination in imports and exports enable businesses to adjust to dealing with goods and services that they have a comparative advantage. Custom Unions and common markets operate in a similar manner where tariffs between two countries are eliminated but imposed on any other non member country and regions. Common market however, embraces unrestricted movement of factors of production controlled by market conditions within the involved member states. Economic union, which serves at the highest in integration, aims to standardize fiscal and monetary policy within the members’ nations. The interlinking global economies come with benefits and weaknesses; with the pegging of foreign currencies and intense global investment (especially by powerful nations), any shock like inflation in their economies will relay back to the dependent economies, but in the same manner, the strength of powerful economies linking them assist to dissolve any pressure exerted in the economy. An example is how the strength of the US economy reduced the risk of recession within US and later in Europe in the event of economic melt down of the far East in 1998 (Groucutt, Leadley, and Forsyth 40). Current European crisis: Europe is experiencing a debt crisis that stretches all along from 2008, after the US financial crisis that shook the global economy. The struggle to clear the debt accumulated over the years continues in some European countries that have been affected by the slow down in global economy growth, exposing the unsustainable fiscal policies of European countries just like it is doing around the globe. Portugal, Spain, Italy and Greece are amongst the countries that have not managed to generate enough economic growth to be able to pay back bondholders the guarantee they meant to; hence have been called to embrace strict austerity measure (Alessi cfr.org). Current European debt is attributed to governments’ spending in the last decade supported by the artificial low interest rates on premiums provided by the European central bank (ECB). Greece appeared in the limelight first, than other nations after been detected that it had substantial usage and consumption of resources, combined with high wages and government benefits after a period of adoption of the Euro; though it was 1st bailed out with a total of $163 billion loan, and later $178 billion, with a hope that the country would implement strict spending cuts and tax hikes, there exist doubts that the bail out will restore Greece back to its former fiscal stability; hence, the IMF has called on Greece's official creditors (including Germany and the ECB) to bear losses on their holdings of Greek debt ( Alessi cfr.org). Following the housing bubble collapse in 2008, the bank default crisis encouraged Ireland’s debt crisis while Portugal’s reliance on foreign debt, as expressed by the current account deficit made it vulnerably prone to the crisis. Both the two countries have received bail outs of $112 billion in 2010 (Ireland) and $116 billion in 2011 (Portugal) through the EU-IMF rescue package as they struggle to implement EU-IMF-mandated budget cuts and privatization plans (Alessi cfr.org). Spain and Italy are also on the verge of crisis where a rescue program is not an option for Italy that holds public debt of over $2.5 trillion. The entire situation has put forth uncertainty on the future of the euro and feasibility of (EMU) European Economic and Monetary Union which led to the formation of the fiscal union as a step to reformation giving the European Union a right to control state budgetary policy of European nations that accepted the agreement. Current Economic condition of Japan: Early 2011, Japan was hit by a catastrophic earthquake that led to its output contraction by 0.5 percent, slow import growth at 1.9 percent and GDP reduced by 0.5 Percent at the end of the year (“Trade growth to slow,” wto.org). As the nation tried to recover from the natural disaster, Thailand’s flooding hindered the structure of supply chain, considering that Thailand is a key supplier of manufactured inputs. Japan economy is currently at the state of reconstruction where the government is taking enough measures in controlling public spending to generally support economic pick- up growth in by the end of the year. According to the OECD, “The government plans to spend a total of around 19 trillion Yen (about 4% of GDP) over five years for reconstruction…..Three packages and the FY 2012 budget containing a total of around 18 trillion Yen of reconstruction spending have been approved” (71). Employment is expected to change positively from 2011perfomance as individual and businesses stretch out for recovery. The government however, has to plan for budget deficit that would follow in the process of slicing other ministries for reconstruction purposes. The deficit is projected to rise to 10 percent this year and the next, which will consequently push the economy to a gross public debt of over 220 percent of GDP risking its stability (OECD 72). Financial institutions amongst the Bank of Japan have been working close with the government in Japan’s economy recovery. The policy interest rates have been reviewed and the bank has kept it almost at zero value and at the same time announcing its aim as one percent annual change in CPI to stabilize price and as a way to end deflation. The affected relation between China and Japan after the territorial dispute over Senkaku islands has impacted negatively on Japans auto market, which may lead to the industry not achieving its target by the end of the year.   Work cited “Abu Dhabi’s Economic Performance in the Last 10 Years: Chart book (2001-2010).” Adced.ae. July 2012. Web. 3 November, 2012.   Alessi, Christopher. “The Eurozone in Crisis.” Cfr.org. 23 July, 2012. Web. 4 November 2012. Asmundson, Irena, and Ceyda Oner. “What is money?” imf.org. September 2012. Web. 3 November, 2012. Baamir, Abdulrahman Y. Shari'a Law in Commercial and Banking Arbitration: Law and Practice in Saudi Arabia. Fanham Surrey: Ashgate Publishing Limited, 2010. Print. Beckwith, Burnham P. The Economic Theory of a Socialist Economy. New York: Stanford University Press, 1949. Print. Beenhakker, Henri L. The Global Economy and International Financing. Westport: Greenwood Publishing Group, 2001. Print. Carlos, Di Tata Juan. Staff CountryReports. 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