Economics Model Essay 19

(a)   Explain why Singapore chooses to use the exchange rate rather than interest rates as the policy instrument of its monetary policy. [10]

Introduction

Monetary policy is a demand-side policy that is used to control the money supply and interest rates to influence aggregate demand.

Monetary policy can be used to increase economic growth, decrease unemployment and reduce inflation. 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. To increase economic growth or decrease unemployment in an economy where interbank rates are lower than the bank rate and hence banks borrow from each other, such as the United States and Japan, 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 September 2007 to 0-0.25 per cent in December 2008 to boost the economy. To increase economic growth or decrease unemployment in an economy where the bank rate is lower than interbank rates and hence banks borrow from the central bank, such as the United Kingdom and the euro area, the central bank can lower the bank rate to decrease the level of interest rates in the economy. For example, the Bank of England decreased the base rate from 5.75 per cent in December 2007 to 0.5 per cent in March 2009 to boost the 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.

 

Diagram

 

 

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to an increase in national output and hence national income (Y) from Y0 to Y1. Furthermore, due to the multiplier effect, the initial increase in aggregate demand due to the increase in consumption expenditure and investment expenditure will lead to a larger increase in national output and hence 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. To reduce inflation, the central bank can implement the reverse of expansionary monetary policy which is contractionary monetary policy.

Monetary policy is not used to control interest rates in Singapore, which is sometimes called interest rate-centred monetary policy, due to the choice of a managed float exchange rate, the fact that Singapore is an interest rate-taker, the higher dependence on external demand and the low interest elasticity of consumption and investment. For example, as a small and open economy, Singapore is an interest rate-taker in the sense that it is unable to change the money supply to influence interest rates which are determined by foreign 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. Furthermore, consumption and investment are interest inelastic in Singapore. A change in interest rates in Singapore is likely to lead to a small change in consumption due to the culture of thrift, and it is likely to lead to a small change in investment as a large proportion of it is foreign direct investment which is made by foreign firms with foreign sources of funds.

Although monetary policy is not used to control interest rates in Singapore, it is used to control the exchange rate which is called exchange rate-centred monetary policy in Singapore. Exchange rate-centred monetary policy in Singapore, which is more commonly called exchange rate policy, is an important macroeconomic policy 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 MAS holds the view that the exchange rate is the most effective policy instrument for achieving sustained non-inflationary economic growth in Singapore. Singapore operates under the managed float exchange rate system whereby 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. For example, in the face of high external price pressures, even when the external demand is weak, the MAS will revalue the Singapore dollar by raising the exchange rate policy band and simultaneously buying domestic currency and selling foreign currency in the foreign exchange market to reduce inflation. A rise in the exchange rate will reduce the increase in the prices of imports in domestic currency resulting in lower imported inflation. For example, the MAS revalued the Singapore dollar in April 2008 to reduce inflation in the face of a rapid rise in the prices of imported oil and food.

In conclusion, although interest rate-centred monetary policy is not used in Singapore, exchange rate-centred monetary policy which is more commonly called exchange rate policy, is used.

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