Question

Critically analyze what is the relationship between a UAE’s monetary and fiscal policy and its exchange rate? demonstrate the main costs that UAE faces when they adopted the pegged exchange rate to dollar? What are the general conditions under which a fixed exchange rate makes sense for a country?

Answer 1

UAE & Pegged Exchange Rate

UAE’s fixed exchange rate ties it currency to US dollars for an amount which is fixed over the fluctuations of the dollar. Even the system increase the confidence of investors over the currency helping them to adopt strategies and plans for investment avoiding the concern about fluctuation of the value of currency, the fixed exchange rate system does not help the central bank to adopt monetary policies in order to manage the growth of the economy. The system prevents the efficiency of the central bank to manage an under or overvalued domestic currency. Varying interest rate through monetary policies cannot stimulate economic growth since the currency is pegged to a foreign currency. Fixed exchange rate system leads to no effect of monetary policies.

The government running under a fixed exchange rate manages the growth of economy through its fiscal policies. Incentives and production subsidies, tax exceptions can all leads to a growth of economy. Since exchange rate is fixed, the growth cannot be encouraged through the scope of fluctuations in the value of foreign currency. Depending only on fiscal policies, the strain of government to manage the economy is higher than that of one in the floating exchange rate system. An inefficient fiscal policy can lead to fail in the growth of economy since it is not able to be managed by monetary policies.

The cost UAE face on adopting a fixed exchange rate system are the requirement of large foreign currency reserves to manage a crisis, inability to take advantage on the appreciation and depreciation of value of the foreign currencies, stable level of inflation which do not have much to contribute the growth etc. Through fixed exchange rate, UAE cannot take advantage on the appreciation of foreign currency to increase the level of exports and attaining growth in production. Central bank in order to maintain fixed value on exchange rate, they have to suffer the costs of varying exchange rate to keep the economy not affected from the fluctuation of value of currency.