Dollar pegging and curreny basket - Essay Example

As the oil producing countries are getting more capital due to rising oil prices, people have more spending power and the relative commodity prices increase in the domestic economy. Table 1 shows the inflation rates in gulf countries over three different periods: 1980-81 (high inflation), 1986-2003 (low but volatile inflation) and 2006-07 ( current inflation situation). As chart 1 and Table 1 show falling dollar contributes to high oil prices that in turn lead to high inflation. On the other hand when the state of dollar is normal the oil prices remain average and hence the result is low inflation (Garriga and Armesto, “A Falling Dollar Raises Inflation in the Gulf”).

After de-pegging from dollar, new exchange rate was governed by the basket of currencies that helped to stabilize the effect of depreciating dollar on the exchange rate of Kuwaiti Dinar in the world market. Due to this basket of currencies which included a good proportion of Euro allowed checking rising import rates due to depreciation of dollar against Euro. This further helped in controlling inflation which was rising due to increase in imports from European and exports to Asian countries. “Since 1980 the Bahraini dinar and the Qatar riyal have been pegged to US dollar at the rate of 0.

37 per $ and 3.64 per $, respectively. Likewise, since the 1980s the Saudi riyal (1986) and UAE dirham (1981) are fixed at a rate of 3.75 per $ and 3.67 per $, respectively” (Hebous “On the Monetary Union of the Gulf States”). The exchange rate of a currency is determined by the “purchasing power parity”. For eg. If 10 gms of 24 carat gold can be bought with 1 USD and same amount of gold can be purchased with 4 Qatar riyal then 1$ equals to 4 Qatar riyal. This is how the exchange rate of every currency is determined in the world market (Saville “How are currency exchange rates determined”).

“The value of a currency is usually determined by the demand for and supply of that currency.” For