EJC Econs N2022 H2 EQ5

1 2022 A-Level P2 Question 5 A low rate of inflation is a key macroeconomic policy objective for most governments. During the first quarter of 2020, interest rates in most countries throughout the world fell to very low levels. (a) Explain why a rise in interest rates is used as a macroeconomic policy tool to control inflation in some countries but not in Singapore. [10] (b) Discuss whether a change in interest rates in other countries is likely to have a significant impact on Singapore’s domestic and external economy. [15] Part (a) - Question Analysis Approach Command Word Explain Question Type Policies Start point Rise in interest rates as contractionary monetary policy tool End Point Control inflation Content and Context Content Mechanism of interest rate centred monetary policy and its limitations Context Singapore and other countries which adopt interest rate centred monetary policy Introduction • Amid a rise in inflation rate in countries all round the world owing to a culmination of factors including post -Covid economic recovery, supply chain issues and high energy prices, implementing a rise in interest rate would be able to control inflationary pressures. • [Tools of monetary policy] Monetary policy is a demand-management policy that works through the tools of interest rate; or exchange rate to influence aggregate demand (AD), and eventually affect real national income/output, employment and general price level. • [Criteria why economies choose a certain tool] Though it is appropriate for some countries, it is not appropriate in Singapore’s context given our small and open nature of the economy, hence the choice of instrument depends on the nature of the economy. Body Point 1 : How a rise in interest rates (ie. contractionary monetary policy) would be able to control demand-pull inflation in other countries, like the US. • Raising interest rates would increase the cost of borrowing for households and they would be less likely to borrow to finance big ticket consumer items such as housing and cars. It would also increase the returns on savings (or opportunity cost of spending increased), incentivizing households to save than spend. Taken together, an increase in interest rate would decrease consumption expenditure (C). • A rise in interest rate will als o mean that the cost of borrowing for firms to finance their investment spending has increased. Hence it would make previously profitable projects appear unprofitable. Firms would now be less willing to borrow to finance its investment, decreasing investment expenditure.

2 • A rise in interest rates also results in short term capital inflow as the rate of return increases. In the foreign exchange market, there will be an increase in demand for the domestic currency, which thus causes the domestic currency to appre