2012 Essay Question 5

Question

During 2009 the Bank of England engaged in what is known as ‘quantitative easing’ by pumping more than £200 billion into the economy. Records low levels of interest rates have also been maintained within the UK economy. Quantitative easing and low interest rates were also adopted by the US.

(a) Explain why exchange rates rather than interest rates are the preferred choice as the instrument of monetary policy in Singapore. [10]
(b) Discuss the likely impact on the Singapore economy of quantitative easing and low interest rates in the US and the UK. [15]

Answer

(a) The question consists of two parts: why Singapore does not use interest rate-centred monetary policy and why it uses exchange rate-centred monetary policy.

For the first part of the question, students should explain how interest rate-centered monetary policy works and why it is not used in Singapore.

To increase economic growth or decrease unemployment, the central bank can increase the money supply by conducting an open market purchase. When the money supply increases, the amount of reserves in the banking system will rise. When this happens, interbank rates will fall which will lead to a fall in the level of interest rates in the economy. For example, the Federal Reserve increased the money supply to lower the federal funds rate from 5.25 per cent in October 2007 to 0-0.25 per cent in December 2008 to boost the faltering U.S. economy. Lower interest rates will decrease the incentive to save and the costs of borrowing and this will lead to an increase in consumption expenditure. Furthermore, a decrease in the costs of borrowing will lead to more profitable planned investments resulting in an increase in investment expenditure. An increase in consumption expenditure and investment expenditure will lead to an increase in aggregate demand which will induce firms to increase production resulting in an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. An increase in aggregate demand will induce firms to increase production resulting in an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

Monetary policy is not used in Singapore due to four reasons: the choice of a managed float exchange rate, the role of an interest rate-taker, the small consumption expenditure and investment expenditure on domestic goods and services relative to the domestic exports and the low interest elasticity of consumption and investment. Due to the examination time constraint, students need not explain all the four reasons why interest rate-centred monetary policy is not used in Singapore. Instead, they only need to explain any of the two reasons, one of which should be the role of an interest rate-taker as it is the most important reason why interest rate-centred monetary policy is not used in Singapore. However, it is good practice to state all the four reasons.

As a small and open economy, Singapore is an interest rate-taker in the sense that it cannot change the money supply to influence interest rates. For example, if the MAS increases the money supply to lower interest rates, hot money inflows will decrease and hot money outflows will increase which will lead to a decrease in the money supply. Due to the small and open nature of the Singapore economy, the effect of the changes in hot money flows on the money supply will be substantial. Therefore, the decrease in the money supply will lead to a rise in interest rates back to the initial level. In addition to the inability to control interest rates, monetary policy is not used in Singapore due to the low interest elasticity of consumption and investment. Consumption and investment are interest inelastic in Singapore. A change in interest rates in Singapore is unlikely to lead to a significant change in consumption due to the culture of thrift, and it is unlikely to lead to a significant change in investment as most of the investments are made by foreign firms with foreign sources of funds.

For the second part of the question, students should explain why it is important for Singapore to control the exchange rate and how the exchange rate-centred monetary policy is used for this purpose. Students should explain exchange rate-centred monetary policy rather than exchange rate policy. This is not to say that exchange rate policy is not used in Singapore. Rather, the explanation of the use of exchange rate-centred monetary policy is more appropriate here as this is what the question is asking.

As domestic exports account for a large proportion of aggregate demand, a sharp fall in the exchange rate which will lead to a large increase in exports is likely to lead to high demand-pull inflation. Furthermore, Singapore has a high level of imports. Therefore, a sharp rise in the exchange rate which will lead to a large increase in the prices of imports in domestic currency is likely to lead to high imported inflation.

Although interest rate-centred monetary policy is not used in Singapore, monetary policy is used to ensure adequate liquidity in the banking system to meet banks’ demand for reserves. This is to maintain the exchange rate of the Singapore dollar in the policy band and is known as the exchange rate-centred monetary policy. For example, when the Singapore government deposits its budget surplus or the CPF board deposits its net proceeds with the MAS, the money supply in Singapore will fall which will lead to a rise in interbank rates resulting in a rise in the level of interest rates in the economy. Higher interest rates in Singapore will lead to an increase in hot money inflows and a decrease in hot money outflows which will result in a rise in the exchange rate of the Singapore dollar causing it to breach the policy band. To maintain the exchange rate of the Singapore dollar in the policy band, the MAS will increase and hence restore the money supply.

Conclusion

The conclusion can simply be a summary or recommendation as there are no evaluation marks.

Answer

(b) The question should be answered with the TAS approach. In the thesis, students should discuss the positive effects of a fall in interest rates in the US and the UK on the Singapore economy. In the anti-thesis, they should discuss the negative effects.

When interest rates in the US and the UK fall, consumption expenditure will rise. When this happens, imports in the US and the UK will increase which will lead to an increase in exports in Singapore. Therefore, the current account of Singapore will improve which will lead to an improvement in the balance of payments. When interest rates in the US and the UK fall, investment expenditure will rise. When this happens, outward FDIs in the US and the UK will increase which will lead to an increase in inward FDIs in Singapore. Therefore, the capital and financial account of Singapore will improve which will lead to an improvement in the balance of payments.

The increase in exports and investment expenditure in Singapore will lead to an increase in aggregate demand resulting in an increase in national output and hence national income.

Students should explain the multiplier effect.

An Example
When exports and investment expenditure rise which will lead to an increase in aggregate demand, firms will employ more factor inputs from households to increase production and hence will pay households more factor income. When households’ income rises, they will increase consumption expenditure. Due to the increase in consumption expenditure and hence aggregate demand, firms will employ even more factor inputs from households to further increase production and hence will pay households even more factor income. When this happens, households’ income will rise further which will induce them to further increase consumption expenditure. Therefore, the initial increase in aggregate demand due to the increase in exports and investment expenditure will lead to increases in consumption expenditure and hence further increases in aggregate demand resulting in a larger increase in national output and hence national income and this is commonly known as the multiplier effect.

The increase in national output due to the increase in aggregate demand in Singapore will lead to a rise in the demand for labour resulting in a fall in unemployment.

When interest rates in the US and the UK fall, interest rates in Singapore will become relatively higher. When this happens, Singapore will experience an increase in hot money inflows and a decrease in hot money outflows and hence the demand for Singapore dollars will rise and the supply of Singapore dollars will fall resulting in a rise in the exchange rate. When the Singapore dollar appreciates, the prices of imported intermediate goods in domestic currency in Singapore will fall which will lead to a fall in the cost of production. When this happens, aggregate supply in Singapore will rise which will lead to an increase in national output and hence national income resulting in a fall in unemployment. Assuming aggregate demand is rising which is the normal state of the economy, an increase in aggregate supply will also lead to a surplus of goods and services resulting in a slower rise in the general price level and hence lower inflation, and if this makes Singapore’s goods and services relatively cheaper than foreign goods and services, net exports will rise which will lead to an improvement in the current account and hence the balance of payments. In addition to lower indirect imported inflation or imported cost-push inflation, an appreciation of the Singapore dollar will lead to a smaller increase in the prices of imported consumer goods in domestic currency which will lead to a smaller rise in the general price level resulting in lower direct imported inflation.

An increase in investment expenditure in Singapore will lead to a faster increase in the production capacity and hence aggregate supply in the long run resulting in higher economic growth which may reduce unemployment, and lower inflation which may improve the balance of payments.

A rise in the exchange rate in Singapore will make Singapore’s goods and services relatively more expensive than foreign goods and services. When this happens, net exports in Singapore will fall which will worsen the current account and hence the balance of payments, assuming the sum of the price elasticities of demand and supply is greater than one. Further, the costs of investments in foreign currency in Singapore will rise. When this happens, FDIs in Singapore will fall which will worsen the capital and financial account and hence the balance of payments.

A fall in net exports and investment expenditure in Singapore will lead to a fall in aggregate demand resulting in a fall in national output and hence national income, a rise in unemployment and a fall in the general price level resulting in deflation. Students should explain why a deflation is undesirable for the economy.

A fall in investment expenditure in Singapore will lead to a slower increase in the production capacity and hence aggregate supply in the long run. When this happens, Singapore will experience a fall in economic growth which will lead to a rise in unemployment, and a rise in inflation which may worsen the balance of payments.

Evaluation

The effect of quantitative easing and low interest rates in the US and the UK on the Singapore economy is indeterminate.

Reason 1: A fall in interest rates in the US and the UK may not lead to an increase in consumption expenditure and investment expenditure if consumer sentiment and business sentiment are weakening.

Reason 2: The exchange rate in Singapore may not rise as it may be near the upper bound of the policy band.

A more elaborate answer to 2012 Essay Question 5 will be provided in the economics tuition class.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. If you are an economics tutor or teacher who wishes to use the materials for teaching, you may submit a request to Economics Cafe.

Economics Tuition Singapore @ Economics Cafe
Principal Economics Tutor: Mr. Edmund Quek