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 appreciate. If demand for exports is price elastic, the rise in price of exports in foreign currencies will cause the quantity demanded for exports to fall more than proportionately. This results in an appreciation of the domestic currency, causing X and (X-M) to fall. • As C, I and X are components of aggregate demand (AD), AD decreases from AD1 to AD2 in Figure 1 . Assuming that the economy is operating near full employment, a decrease in AD will cause a multiplied decrease in real national income (RNY) through the reverse multiplier process. • As AD decreases, there is an unplanned accumulation of inventories. Firms decrease production to meet t he decreased demand and they do so by decreasing the hiring of FOPs (ie. fall in demand for labour). Given the fall in demand for FOPs (ie. less competition for resources), this leads to less upward pressure on prices of FOPs. Firms pass on the cost savings to consumers, leading to a decrease in general price level from P1 to P2. Demand-pull inflation is alleviated as the economy returns to a state with more spare capacity, reducing inflationary pressures. Figure 1 • [Context]Moreover, due to Singapore’s small domestic economy, its size of consumption and investment expenditure is small. Hence the interest rate policy aimed at decreasing C and I, coupled with a small multiplier, is unlikely to have a significant impact on the AD, RNY and curbing demand-pull inflationary pressures. • This is in contrast with other larger economies like the US, with a large consumption and investment expenditure as a component of AD. Hence the contractionary interest rate policy likely to have a significant impact on the AD, RNY and curbing demand -pull inflationary pressures. • For example, the US Fed has been adopting aggressive interest rate hikes of late (ie. 2022-2023) with consecutive rounds of interest rate increases, due to soaring inflation rates from post-pandemic recovery and hence increases in consumer spending, as wel l as supply chain issues. Body Point 2: How a rise in interest rates would not be able to control inflation in Singapore Given the openness of Singapore’s economy to capital flows, Singapore is an interest rate taker with limited control over its interest rates.

3 • Singapore is an international financial centre, open to capital flows, hence it is very easy for residents to borrow, lend or speculate in foreign assets and for non -residents to speculate in domestic assets as well. • Thus, an attempt by the government to increase interest rate would only result in quick shifts of loanable funds into the country. As there is a huge inflow of short-term capital flow (hot money), assuming short -term investors prefer to save their capital to countries offering higher interest rates, Singapore would face an increase in supply of our loanable funds, decreasing interest rate. This would negate or render the initial rise in interest rates ineffective in controlling inflation. • As Singapore is an interest-rate taker, it limits the ability of the government to use interest rates as an instrument of monetary policy. This explains why Singapore’s monetary policy is centred on the exchange rate rather than interest rates. • Moreover, with large inflows of hot money, the currency appreciates. Such effects and fluctuations on the exchange rate due to changes in interest rate is destabilizing given the export-driven and import-reliant nature of the Singapore’s economy. Conclusion • Unlike other larger and less open economies like the US which uses interest rate centred monetary policy to control inflation, the small and open nature of Singapore’s economy renders the interest rate monetary policy ineffective. Instead, Singapore uses the exchange rate monetary policy to control inflation, especially imported inflation which we are most susceptible to. Mark Scheme Level Knowledge, Understanding, Application, Analysis Marks L3 Full display of AO1, AO2 and AO3 skills: For an answer that shows well -developed explanation of why the rise in interest rate would be used to control inflation in other countries, but not in Singapore. • clear and accurate explanation of the interest rate policy with appropriate ADAS diagram(s) • appropriate examples of Singapore and other countries utilising monetary policy to control inflation rates. 8-10 L2 Uneven display of AO1, AO2 and AO3 skills: For an answer that shows under-developed explanation of why the rise in interest rate would be used to control inflation in other countries, but not in Singapore. • lacks depth of analysis (i.e. , limited effective use of relevant economic analysis or gaps in diagrammatic analysis) • lacks scope in explaining the use of interest rates in controlling inflation in Singapore versus other countries • lacks appropriate examples of Singapore and other countries util