First of all, pegged exchange rate means a fixed exchange rate to stabilize the value of currency. The reason behind countries to peg the US currency is due to the international trade, most of the trade was trade in US dollar. Moreover, it could control its nations inflation. In UAE, if for example the demand for this country shift leftward due to a decrease in foreign demand of UAE’s export. In order to shift backward towards right, UAE requires to lower its expensive to exports. Demand-pull inflation.
Figure 1. UAE government intervene currency.
UAE government could use several methods to decrease supply to make the lower equilibrium back to original point of exchange rate. Such like, limits in imports. By adopt the tariffs or quota to reduce the supply. In addition, contractionary policies also work to shift the supply curve, contractionary fiscal policy or monetary policy, government spending decrease and increase in interest rate by central bank. Reduce in government spending makes the business produce less (Less subsidy). Increase interest rate encourage business to borrow less. Thus, lower the quantity output, S1 to S2. Where for monetary policy, with changing in money supply and tax, it is more likely to prevail over the monetary policy. This is because fiscal policy would make people save more in terms of contractionary.
The advantages for peg with USD are first, creating stability value of currency. For those country with weak economies are strongly recommend pegging. The reason behind this is because a sudden exchange rate of fluctuation will affect and harm the economic. Therefore, it is needed to peg with strong country’s currency. But, UAE are ranked as one of the most developed countries in the world, therefore, their goals would not a stabilize the economic, instead, they are aiming for promotes the foreign investment in the country. With the greater currency stability, investor is likely to invest as there are no exchange rate fluctuation and therefore no risk to invest.
Nevertheless, the disadvantages are that obviously it is needed to constantly maintain foreign currency reserves. The central bank needs the ensure that there is enough money to trading for their currency. Otherwise they would sufficient while trading. It is a huge problem as more currency lead to higher inflation. So, this could be concluded that when central bank could not provide the currency for trade, the pound will be depreciated, and huge inflation would cause in the country.
In conclusion. The monetary is definitely surpass the monetary policy in terms of contractionary, fiscal makes people save more when interest rate increase. Business confidence decrease (Borrow less) and reduce output. Considering the limitation of currency in central bank. If interest rate rise, people might expect the interest rate still rising and eventually stop spending and start saving. Which causing the economic growth slowing down (C+I+G+ Net export).