Al Ghurair University
College of Business Studies
Principles of Macroeconomics (BSE202)
UAE’s main economic challenges, including domestic issues and its relations with the rest of the world
Gross Domestic Product
In UAE, Economists are usually concerned about inflation thanks to its effects on the Growth Domestic Product (GDP) or the economy of a country at large. The resultant effects of inflation are a product of its effects on other variables in the economy including consumption and investment. Macroeconomic policy makers have had their central objective as the sustenance of low levels of inflation coupled with high and sustained economic growth in UAE. The increased research on inflation usually emanates from the serious implications that it has for income distribution and growth in the economy. Debates, however, have also concentrated on factors that determine the rate of inflation as they have a bearing on its consequent effects. There is demand-pull inflation, which results from an increase in the aggregate demand in the economy. Cost-push inflation, on the other hand, results from supply shocks. This should have strong and positive correlation with the output gap in the economy. However, the relationship existing between inflation and growth depends on the economy. It is possible to have high growth devoid of inflation in cases where the economy’s potential output grows sufficiently to cover up for the increased demand (Samuelson & Nordhaus, 2005). This would also be possible in instances where the actual output of the country is lower than the potential output, and there exists enough spare capacity available to accommodate the demand pressures in UAE. In instances where the actual output equals the potential output, the economy would have no spare capacity as it would be operating on full level of employment. In essence, increased growth would eat at the rising inflation. In case the growth of demand persists and there is no commensurate expansion of the productive capacity, the general price level would be likely to experience rapid growth in the long run without additional output growth. This phase of increased inflation is likely to have severe effects on the economy.
Growth of the economy
Economic development or growth in UAE involves actions that are sustained and concerted by policy makers and the entire community. These actions lead to improved standards of living as well as the economic health within a specified area either in the local, regional or global environment. Economic development can also be termed as the qualitative and quantitative changes that occur within an economy. For economic development to take place there has to be contributions by various factors. Some these factors can lead to economic development if they are appropriately managed (Mohr, 2012). There is a lot of interest in macroeconomics when it comes to these factors of economic development. Macroeconomics deals with performance, behavior, structure and the entire decision making of an economy in general as opposed to looking at individual markets. This encompasses national, regional as well as the global economies. Through microeconomic there is the aggregation of indicators like GDP, price indexes and the rates of unemployment that enable the understanding of the functioning of the entire economy.
The system of government that is found within a country is a major determinant of the economic development that can take place within the country. This is because; most of the industries in a country are under the control of the government in one way or another. There are government agencies that usually maintain the standards of operations within the industries. The government also has the duty to approve of investments that are being made in the country. These investments are what bring about economic development within the country since they will be made in different sectors of the economy. Therefore, it is important for good governments to be in place which will encourage and allow investments in different sectors of the economy .this particularly the sectors that have a potential when it comes to economic development. There are policies that government set that favor businesses such as tax incentives, and encouraging of a business culture which can lead to economic development. Without a good government that allows investment and sets policies that can lead to economic development then a country cannot realize economic development (Wijeya Newspapers Ltd ,2010).
Market economy is an economy where decisions that pertain to investment, production are made on the basis of supply and demand. The market economy is characterized by making decisions pertaining investment as well as the allocation of the producer goods through markets. The market economy is an important factor when it comes to economic development of a country. This is because; there can be creation of market economies that support economic development. This is such as the creation in demand of products from particular sectors of economies which will lead to increase in investment in such sectors and hence economic development in the sectors (Mohr, 2012).
Labor force and unemployment rate
Basic economic principles have played an immense role in guiding economic policies both at the national and state level. This is especially with regard to unemployment and its relationship with inflation. Needless to say, unemployment in UAE has been one of the most fundamental issues in the country. Indeed, it comes up as one of the hottest topics even in the political arena. Scholars have always come up with explanations for the relationship between inflation and unemployment. More often than not, unemployment is associated with the actions of the national government without proper examination on the dynamics within the specific industries. These are the dynamics that are examined in the article “Unemployment and Inflation in the UAE” by Alexander Koscinch.
In July 2011, the national unemployment rate reduced by a meager 0.1% after an additional 117,000 new jobs, taking the rate to 9.1%. Every new vacancy gets at least three applications for employment, with hardworking individuals finding it extremely difficult to retain their jobs as lay-offs increase by the day (Koscinch, 2011). Alexander blames the increased unemployment rate to market failure stating that in instances where business entities are unable to sell their products they are forced to reduce expenditure, lay off workers, as well as reduce production to ensure sustainability (Koscinch, 2011). On the same note, an increase in the wages and salaries results in an increase in the cost of production, which results in an increase in cost of the product. In essence, Alexander underlines the importance of keeping inflation low so as to increase economic growth, noting that the price of products increase when the dollar value is depreciated by the inflation.
While quite a number of brilliant ideas are espoused in the article, it is imperative that the relationships underlined and the solutions put forward are examined. First, Alexander is right on the fact that the price of products goes high in instances where the dollar value is depreciated by inflation. However, questions arise as to whether the solution rests on keeping the inflation low.
The relationship between inflation and unemployment was explained using the Philips curve. This theory underlines the notion that an increase in the number of people who are working would result in an increase in the national output, resulting in an increase in the wages. This means that customers would have more disposable income, in which case there would be an increase in demand for goods and services (Cobham, 2010). Consequently, there would be an increase in the price of goods and services. In essence, the Phillips curve indicated that inflation and unemployment have an inverse relationship where an increase in inflation resulted in a decrease in unemployment and vice versa (Cobham, 2010). It is worth noting that the two fundamental objectives of economic policy makers remains keeping both unemployment and inflation low. This means that policy makers must carry out a tradeoff between the two variables (Cobham, 2010). A large number of policies that are used in lowering unemployment such as those used in recessions come with the risk of increasing the inflation level. Policies aimed at lowering inflation, on the other hand, would potentially increase the rate of unemployment, for example the adjustment of the national interest rate. A reduction in interest rate results in expansion of businesses, causing more employees to be hired and resulting in increased money supply and inflation (Cobham, 2010). In essence, it is imperative that policy makers determine the appropriate inflation rate that would keep unemployment rate at a minimum.
CPI and InflationOne of the effects of inflation on the UAE’s GDP revolves around the investment decisions that individuals make. Economists have lays emphasis on the fact that inflation may result in economic damage through distorting consumption and investment decisions. These distortions result from uncertainty in business and households pertaining to the future course of inflation, as well as from the interaction between inflation and the UAE’s tax code (Samuelson & Nordhaus, 2005). The interaction between inflation and personal income taxes may distort decisions pertaining to the amount of income that an individual would spend on housing. This can be seen especially in owner-occupied housing where the payments of mortgage interest are deductible. Inflation is built on nominal interest rates, in which case even a moderate increase in the price level results in an increase in the deductions. Housing services representing a proportion of the housing investment returns escape taxation (Masimo, 2001). In essence, moderate to high levels of inflation prompt individuals to invest more in housing than they would do in the case of low rates of inflation. This was the case in the 1970s when there was a real estate boom, which was triggered by distortions induced by inflation. High rates of inflation resulted in an increase in the purchase of homes through increased real, after-tax returns on investments pertaining to owner-occupied housing rather than other investments (Mankiw, 2009). Constant interest rates reinforced the demand uptick. The faster increase in the price level of houses relative to the general price level stimulated an increase in purchasing as individuals feared facing higher prices in the future. The distortions were projected in other markets such as forestry and lumbering (Wessels, 2006). Distortions pertaining to the economic activity could also emanate from uncertainty pertaining to the future course of inflation. However, economists have acknowledged that there is a correlation between high inflation and increased variability in price (Masimo, 2001). Such variations pertaining to the prices would result in uncertainty on how profitable investment projects would be in the future. This uncertainty, therefore, results in an increasingly conservative investment decisions compared to how they would be likely to be (Masimo, 2001). This, ultimately, results in reduced levels of investments, as well as economic growth. Considering that the UAE’s Gross Domestic Product (GDP) is the total aggregate output of its entire economy, a reduction in investment would, therefore, result in a reduction in the Gross Domestic Product.
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Massimo, Ca. (2001) “Investment and the Persistence of Price Uncertainty,” Research in economics, Vol. 55,
Mankiw, N. G. (2009). Principles of economics. Mason, UAE: Cengage Learning.
Samuelson, P. A., & Nordhaus, W. D. (2005). Economics. UAE: Tata mcGraw-Hill.
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Koscinch, A (2011). Unemployment and Inflation in the UAE. Examiner.com
Cobham, D. P. (2010). Twenty years of inflation targeting: Lessons learned and future prospects. UAE.