Economics Lecture Notes – Chapter 10

INTEREST RATE AND EXHANGE RATE will be covered in the sixth and seventh weeks of term 1 in economics tuition.

Students can refer to Economics – A Singapore Perspective for the diagrams. The book is available in the major bookstores in Singapore.

1          INTRODUCTION

Interest rate and exchange rate are two economic variables which influence a large number of other economic variables such as national output and hence national income, unemployment, inflation and the balance of payments. In some economies such as the United States, the central bank chooses to control interest rates to manage the economy. However, in some economies such as Singapore, the central bank chooses to control exchange rates to manage the economy. The difference in the choice of policy instrument to manage the economy is largely due to the difference in the sizes and hence the composition of the economies. Therefore, it is important to have a good understanding of interest rate and exchange rate before proceeding further. This chapter provides an exposition of interest rate and exchange rate.

2          INTEREST RATE

2.1       The Money Market

Interest rate is the cost of borrowing and the reward for lending. Interest rates are determined in two markets: the money market and the loanable funds market.

Interest rates are determined in the money market. The demand for money is the amount of money that people are able and willing to obtain at each interest rate over a period of time, ceteris paribus. The supply of money is the amount of money that the central bank is able and willing to provide at each interest rate over a period of time, ceteris paribus.

In the above diagram, given the demand for money (DM) and the supply of money (SM), the interest rate is r0.

The Demand for Money

The demand for money consists of three components: the transactions demand for money, the precautionary demand for money and the speculative demand for money. The transactions demand for money is the amount of money people demand to carry out normal day-to-day transactions owing to the time lag between the receipt of factor incomes and the payment of expenditure outlays. The precautionary demand for money is the amount of money people demand over and above their expected transactions needs owing to the existence of uncertainty. Some expenditure outlays such as medical bills are unpredictable and rational people will therefore demand an amount of money over and above their expected transactions needs to deal with such contingencies. The transactions demand for money and the precautionary demand for money depend directly on the level of national income. The speculative demand for money is the amount of money people demand for speculative financial transactions if market conditions appear favourable. The speculative demand for money is inversely related to the interest rate.

The Supply of Money

There are two approaches to measuring the supply of money: the institutions-based approach and the monetary characteristics of instruments approach. By the institutions-based approach, only monetary liabilities of selected deposit-taking institutions make up the money supply. By the monetary characteristics of instruments approach, instruments that exhibit money-like characteristics are included in the money supply. The institutions that issue the instruments are not the defining characteristics of the money supply by this approach. In Singapore, the institutions-based approach is adopted.

Institutions-based Approach

Narrow money, also known as M1, measures the immediate purchasing power of money in the economy. This definition of money looks at money primarily as a medium of exchange and consists of currency in active circulation and demand deposits with banks. Currency in circulation refers to currency held by the public, at the central bank and in banks’ vaults. Currency in active circulation refers to currency held by the public and excludes currency held at the central bank and in banks’ vaults.

M1 = Currency in Active Circulation + Demand Deposits with Banks

Quasi-money, also known as near money, refers to highly liquid assets that can easily be converted into cash. It includes savings deposits, fixed deposits and negotiable certificates of deposit. Quasi-money does not serve as a medium of exchange and hence is not included in M1. Adding quasi-money with banks to M1 yields M2.

M2 = M1 + Quasi-money with Banks

Broad money, also known as M3, measures the potential purchasing power of money in the economy. This definition of money looks at money primarily as a store of value and consists of M2 and net deposits with non-bank financial institutions. Net deposits with non-bank financial institutions refer to deposits with non-bank financial institutions minus these institutions’ deposits with banks.

M3 = M2 + Net Deposits with Non-bank Financial Institutions

When economists talk about the money supply, they are referring to broad money (M3). The measure of broad money (M3) explained above may seem complicated to some. In essence, the money supply which refers to broad money (M3), consists of currency in active circulation and deposits. As the money supply is determined by the central bank based on economic conditions, it is perfectly interest inelastic which gives rise to a vertical supply curve.

Application of the Determination of Interest Rates in the Money Market

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 national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment. Monetary policy will be explained in greater detail in Chapter 12. 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. This will also be explained in greater detail in Chapter 12.

Note:   There are more complex models which explain why higher interest rates will lead to a higher supply of money. However, such models do not significantly change the results of economic analyses and hence are not required in the examination.

The Principal Economics Tutor will discuss the money market in greater detail in the economics tuition class.

2.2       The Loanable Funds Market

Interest rates are determined in the loanable funds market. The demand for loanable funds is the amount of loans that people are able and willing to obtain at each interest rate over a period of time, ceteris paribus. The supply of loanable funds is the amount of loans that people are able and willing to provide at each interest rate over a period of time, ceteris paribus.

In the above diagram, given the demand for loanable funds (DLF) and the supply of loanable funds (SLF), the interest rate is r0.

The Demand for Loanable Funds

The demand for loanable funds is inversely related to interest rates. The higher the interest rates, the lower the demand for loanable funds. The demand for loanable funds consists of the borrowings of households, firms and the government. Households borrow to consume at the expense of higher future consumption. A rise in interest rates will mean that a larger amount of future consumption will be forgone for any given amount of borrowings. Therefore, the higher the interest rates, the lower the demand for loanable funds by households. Firms borrow to invest. A rise in interest rates will lead to higher costs of borrowing and hence fewer profitable planned investments. Therefore, the higher the interest rates, the lower the demand for loanable funds by firms. The government borrows to finance a budget deficit which is done through issuing securities (i.e. bonds and bills). In some economies, despite a budget surplus, the government borrows to develop the bond market to enable the central bank to more effectively conduct monetary policy.

The Supply of Loanable Funds

The supply of loanable funds is directly related to interest rates. The higher the interest rates, the higher the supply of loanable funds. The supply of loanable funds consists of the savings of households and firms. Households save to increase their future consumption. A rise in interest rates will mean that a larger amount of future consumption will be made available for any given amount of savings. Therefore, the higher the interest rates, the higher the supply of loanable funds by households. Firms save when they retain a part of the profits that they make. However, this does not depend so much on interest rates. Rather, firms make decisions regarding retained profits based on factors such as the economic outlook and investment opportunities.

Singapore has a high supply of loanable funds due to the high savings rate and the high hot money inflows. The savings rate in Singapore is high due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. The hot money inflows in Singapore are high due to the stability of the Singapore dollar and market expectations of an appreciation of the Singapore dollar. This will be explained in greater detail in Chapter 12.

Application of the Determination of Interest Rates in the Loanable Funds Market

Interest rates in developing economies are typically higher than those in developed economies. Households in developing economies are generally poor and hence have little money for saving after spending the bulk of their incomes on necessities. Therefore, banks in developing economies have little money to lend which leads to a low supply of loanable funds resulting in high interest rates. High interest rates lead to high costs of borrowing resulting in a small number of profitable planned investments and hence low investment expenditure. As investment expenditure is low, the production capacity in the economy increases at a slow rate which leads to low economic growth. This explains why many developing economies are trapped in poverty.

The crowding-out effect is the effect of an increase in government expenditure on goods and services resulting in a decrease in private expenditure. An increase in government expenditure on goods and services due to expansionary fiscal policy is likely to lead to a budget deficit. Fiscal policy will be explained in greater detail in Chapter 12. If the government runs a budget deficit, it will borrow by issuing securities (i.e. bonds and bills) to finance the deficit, assuming it does not have sufficient reserves. When this happens, the demand for loanable funds will rise which will lead to a rise in interest rates. Higher interest rates will increase the incentive to save and the costs of borrowing and this will lead to a decrease in consumption expenditure. Furthermore, an increase in the costs of borrowing will lead to fewer profitable planned investments resulting in a decrease in investment expenditure. A decrease in consumption expenditure and investment expenditure will lead to a decrease in aggregate demand. Therefore, the increase in government expenditure on goods and services may not lead to a significant increase in aggregate demand. Therefore, the crowding-out effect is a limitation of expansionary fiscal policy.

Note:   Loanable funds can be defined as funds available for loan in the form of bank loans or funds available for loan in general. In this book, the second definition is used. In everyday English, the loanable funds market is more commonly known as the capital market.

The Principal Economics Tutor will discuss the loanable funds market in greater detail in the economics tuition class.

3          EXCHANGE RATE

3.1       The Floating/Flexible Exchange Rate System

The exchange rate of a currency is the rate at which the currency can be exchanged for another currency. It is also defined as the price of the currency in terms of another currency. For example, the exchange rate of the Singapore dollar against the Malaysian ringgit is about RM2.50/S$ which means that 2.5 Malaysian ringgits are required to exchange for or purchase 1 Singapore dollar.

Under the floating exchange rate system, or the flexible exchange rate system, the exchange rate of a currency is determined by the market forces of demand and supply, with no central bank intervention in the foreign exchange market. The demand for a currency is the quantity of the currency that people are able and willing to buy at each exchange rate over a period of time, ceteris paribus. The supply of a currency is the quantity of the currency that people are able and willing to sell at each exchange rate over a period of time, ceteris paribus. Most of the large economies in the world operate under the floating exchange rate system. An example is the United States.

Under the floating exchange rate system, an increase in the demand for a currency will lead to a rise in the exchange rate (i.e. an appreciation of the currency).

In the above diagram, an increase in the demand for a currency (DDC) from DDC0 to DDC1 leads to a rise in the exchange rate (E) from E0 to E1. The converse is also true.

Under the floating exchange rate system, an increase in the supply of a currency will lead to a fall in the exchange rate (i.e. a depreciation of the currency).

In the above diagram, an increase in the supply of a currency (SDC) from SDC0 to SDC1 leads to a fall in the exchange rate (E) from E0 to E1. The converse is also true.

Under the floating exchange rate system, an increase in exports or a decrease in imports will lead to a rise in the exchange rate and vice versa. An increase in exports will lead to an increase in the demand for domestic currency which will result in a rise in the exchange rate. A decrease in imports will lead to a decrease in the supply of domestic currency which will result in a rise in the exchange rate. Exports may rise and imports may fall due to several reasons. When domestic inflation is lower than foreign inflation, domestic goods and services will become relatively cheaper than foreign goods and services. When this happens, exports will rise and imports will fall. For example, inflation in Singapore is generally lower than that in other economies which has led to an increase in export competitiveness in Singapore resulting in an increase in exports and a decrease in imports. Exports may also rise due to an increase in foreign income and imports may also fall due to a decrease in domestic income. For example, the increase in foreign income has led to an increase in exports in Singapore over the last few decades.

Under the floating exchange rate system, an increase in hot money inflows or a decrease in hot money outflows will lead to a rise in the exchange rate and vice versa. An increase in hot money inflows (HMIs) will lead to an increase in the demand for domestic currency which will result in a rise in the exchange rate. A decrease in hot money outflows (HMOs) will lead to a decrease in the supply of domestic currency which will result in a rise in the exchange rate. HMIs may rise and HMOs may fall due to several reasons. A rise in domestic interest rates or a fall in foreign interest rates will lead to an increase in HMIs and a decrease in HMOs. For example, when the central bank of Russia raised interest rates from 10.5 per cent to 17 per cent in December 2014 to defend the weakening ruble which was under severe downward pressure, HMIs increased and HMOs decreased. HMIs may also rise and HMOs may also fall due to expectations of an appreciation of domestic currency. For example, expectations of a rise in interest rates and hence the exchange rate in the United States in June 2015 as the Federal Reserve planned to end its quantitative easing programme led to an increase in HMIs and a decrease in HMOs earlier in the year.

Under the floating exchange rate system, an increase in inward foreign direct investments or a decrease in outward foreign direct investments will lead to a rise in the exchange rate and vice versa. An increase in inward foreign direct investments (FDIs) will lead to an increase in the demand for domestic currency which will result in a rise in the exchange rate. A decrease in outward FDIs will lead to a decrease in the supply of domestic currency which will result in a rise in the exchange rate. Inward FDIs may rise and outward FDIs may fall due to several reasons. When the government reduces corporate income tax, expected after-tax returns on planned investments will rise. When this happens, inward FDIs will rise and outward FDIs will fall. For example, the decrease in the corporate income tax rate in Singapore from 40 per cent in 1986 to 17 per cent currently has led to an increase in inward FDIs and a decrease in outward FDIs. Inward FDIs may also rise and outward FDIs may also fall due to other factors such as an increase in business sentiment. For example, the global economic recovery in 2010 from the 2008-2009 Global Financial Crisis led to an increase in business sentiment in Singapore resulting in an increase in inward FDIs.

Advantages of the Floating Exchange Rate System

Automatic Correction of a Balance of Payments Disequilibrium

Under the floating exchange rate system, any balance of payments disequilibrium will be automatically corrected through an adjustment of the exchange rate. If the balance of payments is in deficit, which means that money outflows exceed money inflows, the supply of domestic currency will exceed the demand which will lead to a downward pressure on the exchange rate. Under the floating exchange rate system, domestic currency will depreciate. When this happens, domestic goods and services will become relatively cheaper than foreign goods and services which will lead to an increase in net exports. Assuming the sum of the price elasticities of demand for exports and imports is greater than one, an increase in net exports will improve the current account and hence correct the balance of payments deficit. Similarly, if the balance of payments is in surplus, which means that money inflows exceed money outflows, the demand for domestic currency will exceed the supply which will lead to an upward pressure on the exchange rate. Under the floating exchange rate system, domestic currency will appreciate. When this happens, domestic goods and services will become relatively more expensive than foreign goods and services which will lead to a decrease in net exports. Assuming the sum of the price elasticities of demand for exports and imports is greater than one, a decrease in net exports will worsen the current account and hence correct the balance of payments surplus. The balance of payments will be explained in greater detail in Chapter 11.

No Need to hold a Large Amount of Foreign Exchange Reserves

Under the floating exchange rate system, the central bank does not need to hold a large amount of foreign exchange reserves as it does not need to intervene in the foreign exchange market. Holding a large amount of foreign reserves incurs a high opportunity cost as they can be put to productive uses to develop the economy.

Independent Monetary Policy

The central bank can pursue an independent monetary policy under the floating exchange rate system. According to the Impossible Trinity or the Open-Economy Trilemma, an economy cannot have simultaneously a fixed exchange rate, free capital mobility and an independent monetary policy. For example, if the central bank increases the money supply to lower interest rates, hot money inflows will decrease and hot money outflows will increase. When this happens, the demand for domestic currency will fall and the supply will rise which will cause the exchange rate to fall. To bring the exchange rate back to the initial level, there are two measures that the central bank can use. First, it can reverse the monetary policy which will render it ineffective. Second, it can intervene in the foreign exchange market to prevent domestic currency from depreciating by buying domestic currency and selling foreign currency but this will also cause the money supply to fall back. However, under the floating exchange rate system, the central bank will not intervene in the foreign exchange market. Therefore, the money supply will not fall back. The Impossible Trinity will be explained in greater detail in Chapter 12.

Dampening Effect on Inflation and Unemployment

The floating exchange rate system creates a dampening effect on inflation and unemployment. When the external economic environment is strong, inflation will rise due to an increase in exports and a rise in the prices of imports. Under the floating exchange rate system, domestic currency will appreciate due to an increase in the demand which will decrease export competitiveness and hence reduce the rise in inflation. Conversely, when the external economic environment is very weak, unemployment will rise due to a decrease in exports. Under the floating exchange rate system, domestic currency will depreciate due to a decrease in the demand which will increase export competitiveness and hence reduce the rise in unemployment.

Disadvantages of the Floating Exchange Rate System

Uncertainty

The floating exchange rate system creates uncertainty for international trade and foreign direct investment. Under the floating exchange rate system, international trade and foreign direct investment are more risky as profits are affected by movements in the exchange rate. For example, foreign investors in the economy may experience a substantial fall in their profit margins due to a substantial depreciation of domestic currency against their home currencies. Such uncertainty discourages long-term export and import contractual agreements and long-term foreign direct investments.

Speculation

Speculation is an inherent part of the floating exchange rate system which will further increase uncertainty and hence further discourage long-term export and import contractual agreements and long-term foreign direct investments, and this is particularly true if there is a high level of speculative activity in the foreign exchange market.

Note:   The exchange rate is generally less stable under the floating exchange rate system than under the fixed or the managed float exchange rate system. Nevertheless, the floating exchange rate system is adopted in most of the large economies in the world due to the Impossible Trinity, which is also known as the Open-Economy Trilemma. The Impossible Trinity will be explained in greater detail in Chapter 12.

The Principal Economics Tutor will discuss the floating exchange rate system in greater detail in the economics tuition class.

3.2       The Fixed Exchange Rate System

Under the fixed exchange rate system, the exchange rate of a currency is fixed whereby the currency is pegged to another currency at a particular rate, with central bank intervention in the foreign exchange market. The fixed exchange rate system is or has been used in only a few economies. An example is China where the yuan was pegged to the U.S. dollar at 8.28 yuan to one U.S. dollar from 1994 to 2005.

Under the floating exchange rate system, an increase in the demand for a currency will lead to a rise in the exchange rate. However, under the fixed exchange rate system, the central bank will intervene in the foreign exchange market by selling domestic currency and buying foreign currency to keep the exchange rate constant.

In the above diagram, an increase in the demand for a currency (DDC) from DDC0 to DDC1 followed by an increase in the supply (SDC) from SDC0 to SDC1 leaves the exchange rate (E) constant at E0.

Under the floating exchange rate system, an increase in the supply of a currency will lead to a fall in the exchange rate. However, under the fixed exchange rate system, the central bank will intervene in the foreign exchange market by buying domestic currency and selling foreign currency to keep the exchange rate constant.

In the above diagram, an increase in the supply of a currency (SDC) from SDC0 to SDC1 followed by an increase in the demand (DDC) from DDC0 to DDC1 leaves the exchange rate (E) constant at E0.

Advantages of the Fixed Exchange Rate System

Certainty

The fixed exchange rate system creates certainty for international trade and foreign direct investment. Under the fixed exchange rate system, international trade and foreign direct investment are less risky as profits are not affected by movements in the exchange rate. For example, foreign investors in the economy will not experience a substantial fall in their profit margins due to a substantial depreciation of domestic currency against their home currencies. Such certainty encourages long-term export and import contractual agreements and long-term foreign direct investments.

No Speculation

Although speculation is an inherent part of the floating exchange rate system which will further increase uncertainty and hence further discourage long-term export and import contractual agreements and long-term foreign direct investments, this is not true for the fixed exchange rate system.

Disadvantages of the Fixed Exchange Rate System

No Automatic Correction of a Balance of Payments Disequilibrium

Under the fixed exchange rate system, any balance of payments disequilibrium will not be automatically corrected through an adjustment of the exchange rate. If the balance of payments is in deficit, which means that money outflows exceed money inflows, the supply of domestic currency will exceed the demand which will lead to a downward pressure on the exchange rate. Under the fixed exchange rate system, the central bank will intervene in the foreign exchange market to eliminate the downward pressure on the exchange rate. In other words, the central bank will buy domestic currency and sell foreign currency in the foreign exchange market to prevent domestic currency from depreciating. Therefore, net exports will not rise and hence the balance of payments will remain in deficit. Similarly, if the balance of payments is in surplus, which means that money inflows exceed money outflows, the demand for domestic currency will exceed the supply which will lead to an upward pressure on the exchange rate. Under the fixed exchange rate system, the central bank will intervene in the foreign exchange market to eliminate the upward pressure on the exchange rate. In other words, the central bank will sell domestic currency and buy foreign currency in the foreign exchange market to prevent domestic currency from appreciating. Therefore, net exports will not fall and hence the balance of payments will remain in surplus. The balance of payments will be explained in greater in Chapter 11.

Need to hold a Large Amount of Foreign Exchange Reserves

Under the fixed exchange rate system, the central bank needs to hold a large amount of foreign exchange reserves as it needs to intervene in the foreign exchange market to maintain the fixed exchange rate. Holding a large amount of foreign reserves incurs a high opportunity cost as they can be put to productive uses to develop the economy.

No Independent Monetary Policy

The central bank cannot pursue an independent monetary policy under the fixed exchange rate system. According to the Impossible Trinity or the Open-Economy Trilemma, an economy cannot have simultaneously a fixed exchange rate, free capital mobility and an independent monetary policy. For example, if the central bank increases the money supply to lower interest rates, hot money inflows will decrease and hot money outflows will increase. When this happens, the demand for domestic currency will fall and the supply will rise which will cause the exchange rate to fall. To bring the exchange rate back to the initial level, there are two measures that the central bank can use. First, it can reverse the monetary policy which will render it ineffective. Second, it can intervene in the foreign exchange market to prevent domestic currency from depreciating by buying domestic currency and selling foreign currency but this will also cause the money supply to fall back. The Impossible Trinity will be explained in greater detail in Chapter 12.

No Dampening Effect on Inflation and Unemployment

The fixed exchange rate system does not create a dampening effect on inflation and unemployment. When the external economic environment is strong, inflation will rise due to an increase in exports and a rise in the prices of imports. Under the floating exchange rate system, domestic currency will appreciate due to an increase in the demand which will decrease export competitiveness and hence reduce the rise in inflation. Conversely, when the external economic environment is very weak, unemployment will rise due to a decrease in exports. Under the floating exchange rate system, domestic currency will depreciate due to a decrease in the demand which will increase export competitiveness and hence reduce the rise in unemployment. However, as the exchange rate does not change under the fixed exchange rate system, this dampening effect on inflation and unemployment will not happen.

Note:   Under the fixed exchange rate system, the central bank may re-peg domestic currency to another currency at a different level, depending on the economic conditions. If the central bank re-pegs domestic currency to another currency at a lower level, a devaluation is said to have occurred. If the central bank re-pegs domestic currency to another currency at a higher level, a revaluation is said to have occurred. 

Students should not confuse depreciation with devaluation and appreciation with revaluation. A depreciation of a currency refers to a decrease in the exchange rate under the floating exchange rate system but a devaluation of a currency refers to a decrease in the exchange rate under the fixed exchange rate system. Similarly, while an appreciation of a currency refers to an increase in the exchange rate under the floating exchange rate system, a revaluation of a currency refers to an increase in the exchange rate under the fixed exchange rate system.

The Principal Economics Tutor will discuss the fixed exchange rate system in greater detail in the economics tuition class.

3.3       The Managed Float Exchange Rate System

Under the managed float exchange rate system, the exchange rate of a currency is fixed within a range whereby the currency is pegged to another currency or a basket of other currencies within a policy band set by the central bank. As long as the exchange rate of the currency falls within the policy band, the central bank will not intervene in the foreign exchange market, unless there are wide fluctuations. Most of the small economies in the world operate under the managed float exchange rate system. An example is Singapore.

Suppose that the demand for a currency under the managed float exchange system increases. If the increase is small, although the exchange rate will rise, if it still falls within the policy band, the central bank will not intervene in the foreign exchange market. However, if the increase is large, the exchange rate will breach the upper bound of the policy band. If this happens, the central bank will intervene in the foreign exchange market by selling domestic currency and buying foreign currency to bring the exchange rate back into the policy band.

In the above diagram, an increase in the demand for a currency (DDC) from DDC0 to DDC1 will lead to a rise in the exchange rate (E) from E0 to E1. As E1 lies within the policy band, the central bank will not intervene in the foreign exchange market. However, a larger increase in the demand for the currency from DDC0 to DDC2 will lead to a larger rise in the exchange rate from E0 to E2’, assuming no central bank intervention in the foreign exchange market. As E2’ lies above the policy band, the central bank will intervene in the foreign exchange market by selling domestic currency and buying foreign currency to prevent the exchange rate from rising above the policy band. In this case, the supply of domestic currency will increase from SDC0 to SDC1 and the exchange will rise from E0 to E2 instead of E2’.

Singapore operates under the managed float exchange rate system due to the small and open nature of the economy. As a small and open economy, the exports and imports of Singapore are high relative to the national income. Therefore, the Monetary Authority of Singapore (MAS) holds the view that the exchange rate is the most effective policy instrument for achieving low inflation in Singapore. Furthermore, due to Singapore’s diverse trade links, the MAS manages the exchange rate of the Singapore dollar against a trade-weighted basket of currencies of Singapore’s major trading partners and competitors within an undisclosed policy band. The trade-weighted exchange rate of the Singapore dollar, or the nominal effective exchange rate of the Singapore dollar (S$NEER), is a trade-weighted average of the bilateral exchange rates between the Singapore dollar and the currencies of Singapore’s major trading partners and competitors. The various currencies are given different weights depending on the extent of Singapore’s trade dependence with that particular economy. The composition of the basket is revised periodically to take into account changes in Singapore’s trade patterns. Exchange rate policy in Singapore, which the MAS calls monetary policy, is reviewed on a semi-annual basis to provide recommendations on the slope and width of the exchange rate policy band consistent with economic fundamentals and market conditions, thereby ensuring non-inflationary sustained economic growth over the medium term. The MAS publishes a semi-annual Monetary Policy Statement (MPS) in April and October which explains its assessment of Singapore’s economic and inflationary conditions and outlook, and sets out its monetary policy stance, or more precisely, its exchange rate policy stance, for the following six months. Exchange rate policy will be explained in greater detail in Chapter 12.

Advantages and Disadvantages of the Managed Float Exchange Rate System

The managed float exchange rate system is similar to the fixed exchange rate system in that the exchange rate is fixed, although within a policy band rather than at a specific level. Therefore, the advantages and disadvantages of the managed float exchange rate system are the same as those of the fixed exchange rate system. However, the managed float exchange rate system is better than the fixed exchange rate system in two ways, which explains why the former is more commonly used than the latter. First, the exchange rate policy band under the managed float exchange rate system provides some flexibility for the exchange rate system to accommodate short-term fluctuations in the exchange rate. Second, the exchange rate policy band under the managed float exchange rate system provides some buffer in the estimation of the equilibrium exchange rate, which cannot be known precisely.

Note:   Under the managed float exchange rate system, the central bank may on occasions, for tactical reasons, intervene before the exchange rate policy band is breached or allow the exchange rate to breach the policy band before intervening.

The Principal Economics Tutor will discuss the managed float exchange rate system in greater detail in the economics tuition class.

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