Behavior of Monetary Aggregates, Inflation, and Output in the UAE - Example

Central Banks and Monetary Policy Name: Institution: Date: Introduction Central banks are government institutions in control of monetary policy. Thus, central banks play an important role in monitoring the performance of financial markets. The main objective of central banks is to ensure price stability because fluctuation in prices makes the information that economic planners obtain from the existing price system so hard to interpret. It is also difficult to plan for the future economic development of a country within an inflationary environment. The objectives of monetary policy are to realize stable economic growth, high employment, ensure sustainable stability in financial market, interest rates, prices and exchange rates. As a result, central banks work hard to defend their monetary systems against the unexpected financial conditions (Piffe 2011). A brief discussion of the five objectives of central banks Price stability proves to be the central monetary policy objective. For instance, a stable domestic purchasing of a country’s currency dominates the legal objective in price stability. Price stability provides a dual role in the contemporary central banking where it acts as an end and means of the monetary policy. Since it is of the mandated objectives of Fed, price stability exists as the ultimate goal of policy. Basically, central banks ensure price stability because it preserves the integrity as well as purchasing of a nation’s money. This implies that stable prices are an indicator that individuals are holding money for transactions without necessarily worrying about inflation to affect their money balances. Furthermore, stable prices makes people to rely more on the dollar to determine the value at the time of making long-term contracts, plans, lending or borrowing (Bordo & Wheelock, 2008). Central banks have for a long period of time had a powerful interest in the financial stability. This is because financial instability has been considered a big threat to crucial macroeconomic objectives of the central bank such as achieving sustainable output growth as well as price stability. As a result, a number of central banks are always empowered and required to lender the last resort service within the financial crises. This implies that monetary policy is increasingly implemented through the activities in financial markets. Therefore, transmission of such policies to existing economy essentially depends on effective functioning of the main financial institutions and the associated markets (Padoa‐Schioppa 2002). Monitoring the interest rate is yet another objective of the central bank where the public trust of commercial banks is ensured in a country’s economy. Therefore, central banks set the most appropriate interest rates expected of the commercial banks to operate at in relation to their financial service provision to the clients. This means that when the central bank sets a low interest rate, it encourages economic growth of a country since large sum of the money can be loaned to commercial for investments which in turn charges low interest rates to domestic clients. As a result, the public trust banks to transact with them more freely. An increase within the supply of money in a country lowers the interest rates, and thus minimizes the costs incurred in operating a business. Guarantee exchange rate stability where central banks oversee as well as manages the accounts of commercial banks. Central banks determine the currency giver, and thus place a value of its own currency as a way to monitor the exchange rates with those of other countries (Piffe, 2011). To ensure real economic growth is also a key objective that central banks pursue by investing a country’s capital to improve its economy. The central banks funds projects that contributes to economic growth and development of a country, for instance, supporting the establishment of social amenities and infrastructure development, through the provision of advisory services to the government on areas to invest so as to ensure stable growth of the economy. Central banks also promotes a stable real economic growth by regulating and ensuring that taxes are collected to support economic development of a country. The balance sheet of the central bank and how the following are determined Central bank balance sheet is crucial in the development and pursuit of policies in respond to the financial crises. Since central banks are large institutions they have acquired a wide range of the financial assets which enables them to focus more on the major macroeconomic as well as the financial stability objectives. This implies that a comparable increase within the domestic liabilities is also achieved which have entirely contributed to an unprecedented expansion of the central bank balance sheet worldwide. However, the current size of the balance sheet involves a broad range of policy risks that surpass the increased exposure of the central bank balance sheet to the market developments. Such risks include financial instabilities, conflicts with the government debt controllers, inflation as well as distortions within the financial markets. Therefore, assessing the risks related to balance sheet is important to the creation of appropriate exit strategies based on the current financial policies (Vasco & Woodford 2011). a) The monetary base The monetary base is the sum of currency within circulation and the reserve balances or deposits kept in banks as well as other depository institutions at their respective accounts in the Federal Reserves. M1 is considered as the sum of currency kept by the public inclusive of the transaction deposits in public institutions, for instance, commercial banks, loan associations, savings and the credit unions. On the other hand, M2 includes M1 and the savings deposits, retail money acquired from the market mutual support shares and the small-denomination of time deposits. The monetary base comprises of the most liquid forms a country’s payment in terms of currency within circulation and the bank deposits. Through the monetary policy control, the size of monetary base can be changed. For example, use of the open market operations, central banks may decide to either by or sell bonds in return to the currency. This causes either an increase or decrease in the money supply, and thus affecting the monetary base. However, other tools that could be used in the implementation of monetary base include, the reserve requirement and changes in the interest rates. b) The money supply Money supply is coins and currency at the hands of the public which is controlled by central or the Federal Reserve (Fed), a case with the U.S and deposits in the accounts which are controlled through the interaction of households, firms that take loans and banks in charge of money creation. Central banks in distinctive countries control the supply of money, commonly referred to as M1:M2 which can be increased either if there is an increase in coins or currencies circulation or reviewing the account balances to increase demand deposits. c) What is the role of banks in the money supply process? The profitability of banks is that they are in pursuit to achieve high profits, and thus their decisions are increasingly guided by their profit motif. However, the discretion of banks over the money supply shows that the decisions made by banks affect the supply of money in the sense that if bankers decide to raise the value charged on demand deposits. Automatically, the money supply of a country will increase as well, while if the bankers increase their excess reserve holdings the supply of money will decrease as illustrated by the money multiplier diagram below. Increased exposure to runs which causes potential conflicts between banks’ profits and safety, the banks become tempted to increase the demand deposits which means that if depositors claim for cash the banks may not be in a position to meet the needs. Therefore, banks play a key role within the money supply process (Mishkin, 2000). d) How the central banks control the money supply? The tools of monetary control Through the monetary policy control, the central banks determine the size of monetary base depending on the needs in the financial market. For example, use of the open market operations, central banks may decide to either by or sell bonds in return to the currency. This causes either an increase or decrease in the money supply, and thus affecting the monetary base. However, other tools that could be used in the implementation of monetary base include, the reserve requirement and changes in the interest rates. Central banks use three major instruments in their attempt to control the money supply. Discount policy which is implemented through the changing discount rates used by the central banks to control money growth in the country. This means that an increase in the discount loans equally increases the monetary base which in turn expands the money supply. However, a fall in the discount loans increases the monetary base which leads to a shrinkage in the money supply. Therefore, discount rate policy signals the key intentions of the central banks concerning the future monetary policy. Increased discount rates, suggests the slowdown expansion within the economy. Central banks may use the discount policy to successfully accomplish its role as the lender of last resort. The reserve requirements also affect the supply of money through the causing change in the money supply multiplier. Furthermore, open markets purchases or sales may expand or lower the monetary base. When the central banks use of the open market operations, it may decide to either by or sell bonds in return to the currency. This causes either an increase or decrease in the money supply, and thus affecting the monetary base. The three controls do not directly affect the economic activity of a country, but rather their impacts are exhibited on the financial markets. It is quite clear that central banks affect the state of money supply, the level of interest rates, credit availabilities as well as security prices (Mayes & Jan, 2007). The relationship between the money supply and price The link between money and prices stem from the relationship with the quantitative theory of money. For example, there is a direct and long-term association between price inflation and the money supply growth, particularly in situations of rapid increase of money within the economy. The measuring of money supply can be classified base on the spectrum between the narrow and broad monetary aggregates. An increase in the money supply equally leads to increase in the prices, a situation known as quantity theory of money which is measured in terms of velocity of circulation. This is the average number of incidences in which a dollar of money can be annually used to pay money for GDP. The measures used to determine the money supply reflect the different levels of liquidity that various forms of money have. There is interlinking between the money supply and inflation because a higher quantity of money often devalues the demand for money. The relationship between the money supply and inflation occurs when a market experiences higher prices due to an increase in the supply of money. For example, a consumer may refuse to buy a product for which its prices were initially affected by inflation as it is perceived that the buying power the currency used was eroded (Oosterloo et.al, 2007). The link between price stability and the other goals of the central bank Price stability is directly linked to other objectives of the central bank in the sense that when it is not legally stated may appear to be too general in nature. Therefore, price stability must be considered as a key objective within the legislation particularly those concerned with the implementation of monetary policies to ensure that there is a legally dominant objective. This helps to avoid relying on the general definition of a currency value (Bordo & Wheelock, 2008). Studies indicate that potential conflicts occur in situations where various monetary policy actions have been motivated through different objectives. For example, multiple objectives concerning the price stability as well as real economic variables can pose potential conflicts. Additionally, using floating exchange rate systems implies that both domestic price stability and the exchange rate stability justify the need for adjustments of interest rates in either direction. Such potential conflicts points out issues related to the interpretation of the legal objectives in various countries that specify price and currency stabilities as their monetary policy objectives. In other countries, the recognition of interdependence between macroeconomic performance and the financial stability has made the central banks charters to reflect more on the concern for macro objectives of satisfactory economic performance and the financial stability (Leijonhufvud, 2007). Discussion of the behavior of monetary aggregates, inflation and output in the UAE The UAE Annual Monetary Growth 2000-2011 table 1-attached, shows that UAE has experienced a stable relationship regarding its monetary base and monetary aggregates, M1 and M2. The period between 2000 and 2011 of monetary performance, the UAE has been a radical increase in the monetary aggregates, particularly from the years 2005 to 2011. From the table, it is quite clear that M1 and M2 are the key indicators of economic development in the UAE as they act as the monetary multipliers. On the other hand, G1 and G2 provide the view that the level of prices relatively stable due to the UAE Central Bank’s capability to control the supply of money which in turn determines the price levels. It can be argued that an increase in money supply leads to high levels of inflation. This clearly shows that the UAE government is committed to improving the scope and operation of its financial market. This is based on the presumption that underlies financial depending as a requirement for sustained economic growth. Financial deepening within the UAE has over time mitigated the economic growth instability on long-term horizon. The UAE government inflicts minimal restrictions in their financial institutions transaction, particularly in the aspects of money transfers and repatriation of profits. Therefore, the financial sector of UAE is identified through several desirable features such as comparatively low levels of non-payment risk, a high level of economic openness as well as market liberalization. Table2 shows that the UAE from the year 1995 to 2010 had a consistent raise in prices due to improved economic performance as reflected in the GDP Index where 2003-2010 recorded a sharp increase in prices. However, stable increase GDP Index was experienced in 2005 despite a few Implicit Price Deflations. Therefore, the Central Bank of UAE is committed to the measures that control inflation such as regulation of Dirham supply which leads to stable monetary performance, particularly in 2005. Review of the performance of UAE central bank. Comment about interest rate and exchange rate stability in the UAE As noted in table 1 and 2 of the UAE Annual Monetary Growth 2000-2011, a stable relation in the monetary base and monetary aggregate provides the implication interest rates and exchange rates are relatively low since the central bank is keen on the money supply. This promote investments because people can acquire loans from banks, whereas banks from central banks at an affordable rates. The 2000-2011 financial performance of the UAE shows that the central banks are committed to its Pegged Dirham supply control measures. The UAE’s policy on pegging the country’s dirham in constant relationship with the US dollar indicates that UAE is committed to the issues of interest rate and exchange rate stability. Generally, the UAE as well as most of the Gulf economies have fixed their domestic currencies based on the performance of the US dollar. However, the increased uncertainties that affect the dollar pose an issue of global concern on whether if the UAE should re-peg it dirham to the rest of world currencies or float it and pursue the other monetary objectives. It has been argued that a strong dirham do not have to be an objective policy in itself Although the positive features of a stronger currency involve the lower imported inflation yet in the UAE, the rate of inflation is lower compared to other nations because of its fixed exchange rate (Tarek 2011). Based on the second option of floating the dirham against the rest of other currencies in the world, suggests that the UAE Central Bank will be forced to set and pursue a unique inflation-targeting system as the best alternative to the currency peg. This is because targeting a specific inflation rate enables the central banks to make expectations for their private sectors to forecast on the rate of inflation that may affect their future performance. Most market participants rely this to make informed decisions, a clear indication that stable rate of inflation increases the confidence among consumers as well as investors (Bleaney & Francisco, 2005). Since the UAE is an open economy, inflation volatility is often imported which exceedingly make the role of the central bank difficult. In regard to the contemporary monetary regime, the Central Bank of UAE has managed to trade the rate of inflation stability in association with the exchange rate stability. It is important to note that stability in inflation rate would be significant to the UAE residents, while economic activity would be negatively affected. Today, the UAE acquires more benefits from massive direct investment, and thus setting its dirham a float will make investment returns harder to measure. This will in turn remove the perception that investors are not affected by domestic currency risks. Therefore, UAE Central Bank through its efforts to increase consumer confidence will be forced to decrease money supply so as support the value of its dirham. This is expected to generate more interest rates which lower the levels of UAE’s domestic investment, creating negative consequences for its economic growth. Based on the above analysis, the UAE Central Bank has declined to float its dirham, but rather decided to maintain its current position of pegged monetary policy. Research indicates that is de-pegging the dirham from the US dollar has been ruled out. Various sources within the UAE Central Bank declined that the dirham would be de-pegged at the current economy in relation to Kuwait’s de-pegging decision (Bleaney & Francisco 2005). The interest rates in the UAE have been tracking those of US dollar due to dirham’s pegging. Kuwait has taken a great step to link its currency to a basket which enables the central bank to increase interest rates. This monetary policy is important in preventing the region from the issue of being priced out, a policy that may not be optional for UAE, Bahrain and Qatar to implement. Today, exchange houses and banks within the UAE are rejecting the large dollar exposures as they price in a likelihood of revaluation. Conclusion In regard to the above discussion about the functions, objectives of central banks on the regulation money supply and assuring stable economic development, it can conclude that central banks play an important role in monitoring the performance of financial markets. The key objectives of central banks in their efforts to implement monetary policy are to realize stable economic growth, high employment, ensure sustainable stability in financial market, interest rates, prices and exchange rates. The UAE’s policy on pegging its dirham in constant relationship with the US dollar is total commitment to the issues of interest rate and exchange rate stability. Price stability is the main monetary policy objective, and thus must be considered as a key objective within the legislation concerned with the implementation of monetary policies to ensure that there is a legally dominant objective. References Bleaney, M.F. & Francisco, M., (2005). Exchange rate regimes and inflation: only hard peg make a difference, Canadian Journal of Economics 38, 1453-71. Bordo, M & Wheelock, D. (2008). Price Stability and Financial Stability: The Historical Record, Federal Reserve Bank of St. Louis Review, Sept./Oct. pp. 41-62. Leijonhufvud, A. (2007). Monetary and Financial Stability, Policy Insight No. 14, Center for Economic Policy Research. Mayes, D & Jan, T. (2007). Open Market Operations and Financial Markets. New York: Routledge. Mishkin, F. (2000). Financial Stability and the Macro-economy, Central Bank of Iceland Working Paper No. 9. Oosterloo, S. et.al. (2007). Financial Stability Reviews: A first empirical analysis, Journal of Financial Stability, March, pp. 337‐355. Padoa‐Schioppa, T. (2002). Central Banks and Financial Stability: Exploring a Land in Between, paper presented at the Second ECB Central Banking Conference, Frankfurt am Main. Piffe, M. (2011). International Monetary Policy: Central banking: goals. London School of Economics. Tarek, C. (2011). Should the UAE keep the dirham tied to the dollar? Retrieved May 14, 2012 from, Vasco, C & Woodford, M. (2011). The Central-Bank Balance Sheet as an Instrument of Monetary Policy, Journal of Monetary Economics 58(1), 54-79. Table1 Table2 Read More