Economics Model Essay 18

Discuss whether a rise in interest rates in the United States would adversely affect the Singapore economy. [25]

Introduction

Interest rate is the cost of borrowing and the reward for lending. The effects of a rise in interest rates in the United States on the Singapore economy can be discussed in terms of the effects on the balance of payments, national output and hence national income, unemployment and inflation.

Body

A rise in interest rates in the United States may lead to a deterioration in the balance of payments of Singapore. The balance of payments is a record of all the transactions between the residents of the economy and the rest of the world over a period of time and is made up of the current account and the capital and financial account. When interest rates in the United States rise, the incentive to save and the costs of borrowing will increase which will lead to a decrease in consumption expenditure. When households in the United States decrease consumption expenditure, not only will they purchase less domestic goods and services, they will also buy less imports including those produced in Singapore. When this happens, exports in Singapore will fall which will lead to a deterioration in the current account and hence the balance of payments. Furthermore, an increase in the costs of borrowing in the United States will lead to fewer profitable planned investments resulting in a decrease in investment expenditure. When firms in the United States decrease investment expenditure, not only will they invest less in the United States, they will also invest less in other economies including Singapore. When this happens, foreign direct investments in Singapore will fall which will lead to a deterioration in the capital and financial account and hence the balance of payments. When interest rates in the United States rise, interest rates in Singapore will become relatively lower which will lead to a decrease in hot money inflows and an increase in hot money outflows in Singapore resulting in a deterioration in the capital and financial account and hence the balance of payments.

When interest rates in the United States rise, aggregate demand in Singapore may fall which may lead to decrease in national output and hence national income. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. The decrease in hot money inflows and the increase in hot money outflows in Singapore will lead to a decrease in the supply of loanable funds resulting in a rise in interest rates. When interest rates in Singapore rise, consumption expenditure and domestic investment will fall. Coupled with the decrease in exports and foreign direct investment, this will lead to a decrease in aggregate demand which will induce firms to decrease production resulting in a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income.

 

Diagram

 

 

In the above diagram, a decrease in aggregate demand (AD) from AD0 to AD1 leads to a decrease in national output and hence national income (Y) from Y0 to Y1. When firms decrease production in response to a decrease in aggregate demand due to a decrease in consumption expenditure, investment expenditure and exports, they will employ less factor inputs from households and hence will pay them less factor income resulting in a decrease in national income. When national income falls which will lead to a decrease in disposable income, households will further decrease consumption expenditure which will lead to a further decrease in aggregate demand and this will induce firms to further decrease production. When this happens, firms will employ even less factor inputs from households and hence will pay them even less factor income. The further decrease in national income and hence disposable income will induce households to further decrease consumption expenditure resulting in a further decrease in aggregate demand. Therefore, the initial decrease in aggregate demand due to the decrease in consumption expenditure, investment expenditure and exports will lead to further decreases in consumption expenditure and hence further decreases in aggregate demand resulting in a larger decrease in national output and hence national income. This is commonly known as the reverse multiplier effect.

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

The decrease in aggregate demand in Singapore will lead to a fall in the general price level resulting in deflation. A decrease in aggregate demand in Singapore will lead to a surplus of goods and services resulting in a fall in the general price level. Furthermore, when aggregate demand in Singapore falls which will induce firms to decrease production, the decrease in the demand for factor inputs in the economy will lead to a fall in the prices. When this happens, the cost of production in the economy will fall which will induce firms to decrease prices to maintain competitiveness resulting in a fall in the general price level. When the general price level falls, households may expect it to fall further. If this happens, consumption expenditure will fall which will lead to a further decrease in aggregate demand.

A rise in interest rates in the United States may lead to a decrease in aggregate supply in Singapore. Aggregate supply is the total supply of goods and services in the economy over a period of time and is determined by the production capacity and the cost of production in the economy. The decrease in hot money inflows and the increase in hot money outflows in Singapore will lead to a decrease in the demand for Singapore dollars and an increase in the supply resulting in a fall in the exchange rate. When the Singapore dollar depreciates, the prices of imported intermediate goods in domestic currency in Singapore will rise. Therefore, the cost of production in the economy will rise which will lead to a decrease in aggregate supply. A decrease in aggregate supply will lead to a decrease in national output and hence national income resulting in a rise in unemployment. A decrease in aggregate supply will also lead to a shortage of goods and services resulting in a rise in the general price level and hence higher inflation, and if this makes Singapore’s goods and services relatively more expensive than foreign goods and services, net exports will fall which will lead to a deterioration in the current account and hence the balance of payments, assuming the demand for exports is price elastic. In addition to higher indirect imported inflation or imported cost-push inflation, a depreciation of the Singapore dollar will lead to an increase in the prices of imported consumer goods in domestic currency which will lead to a rise in the general price level resulting in higher direct imported inflation.

When interest rates in in the United States rise, aggregate supply in Singapore may rise at a slower rate in the long run. The decrease in investment expenditure in Singapore will lead to a less rapid increase in the production capacity in the economy in the long run, assuming net investment remains positive. Therefore, aggregate supply will rise at a slower rate in the long run. When this happens, assuming aggregate demand is rising which is the normal state of the economy, national output and hence national income will rise at a slower rate which may increase unemployment, and the general price level will rise at a faster rate resulting in higher inflation which may worsen the balance of payments.

A rise in interest rates in the United States may not adversely affect the Singapore economy. When the Singapore dollar depreciates, Singapore’s goods and services will become relatively cheaper than foreign goods and services which will lead to an increase in net exports possibly resulting in an improvement in the current account and hence the balance of payments, assuming the sum of the price elasticities of demand for exports and imports is greater than one. Furthermore, a depreciation of the Singapore dollar will decrease the costs of investments in foreign currency in Singapore which will lead to an increase in foreign direct investments resulting in an improvement in the capital and financial account and hence the balance of payments. An increase in net exports and investment expenditure will also lead to an increase in aggregate demand which will lead to an increase in national output and hence national income resulting in a fall in unemployment. Furthermore, the production capacity in the economy and hence aggregate supply will rise at a faster rate in the long run, assuming net investment is initially positive. When this happens, assuming aggregate demand is rising which is the normal state of the economy, national output and hence national income will rise at a faster rate which may decrease unemployment, and the general price level will rise at a slower rate resulting in lower inflation which may improve the balance of payments.

Evaluation

In the final analysis, whether a rise in interest rates in the United States would adversely affect the Singapore economy depends on several factors. Apart from interest rates, consumption expenditure is also determined by several other factors such as consumer sentiment, the wealth of households, expectations of price changes, the availability of credit and the distribution of income. For example, when households are more optimistic about the economic outlook, they will expect their income to rise and hence increase consumption expenditure. Therefore, if interest rates in the United States rise at a time when consumer sentiment is rising, consumption expenditure may not fall. For example, when the Federal Reserve raised interest rates in December 2015, consumption expenditure increased due to rising consumer sentiment, among other factors. It follows that a rise in interest rates in the United States may not lead to a decrease in exports in Singapore. Similarly, a rise in interest rates in the United States may not lead to a decrease in investment expenditure and hence may not lead to a decrease in foreign direct investments in Singapore. Singapore operates under the managed float exchange rate system whereby the Singapore dollar is pegged to a basket of other currencies within a policy band set by the central bank. Therefore, if the exchange rate in Singapore is near the lower bound of the policy band, a rise in interest rates in the United States may not lead to a fall in the exchange rate in Singapore, at least not significantly, as the Monetary Authority of Singapore (MAS) will intervene in the foreign exchange market by buying domestic currency and selling foreign currency. It follows that a rise in interest rates in the United States may not lead to an increase in net exports and foreign direct investments in Singapore.

The question will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

Click to Read Next Model Essay

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. Economics tutors and teachers who wish to use the materials for teaching may submit a request to Economics Cafe.

economics tuition, back to homepage

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