EJC Econs N2023 H2 EQ4 - students

1 Suggested answer for 2023 A-Level Paper 2 Question 4 The exchange rate is a key policy tool in managing the economy of Singapore. (a) Explain how an appreciation of the exchange rate might affect aggregate demand and aggregate supply in an economy. [10] (b) Discuss whether management of the exchange rate is the most appropriate way of controlling inflation in Singapore. [15] Part (a) - Question Analysis Approach Command Word Explain how Question Type Cause and effect Start point Appreciation of the exchange rate End Point Changes in AD and AS Content and Context Content • Components of AD=C+I+G+(X-M) • COP affecting SRAS • Technology, quantity and quality of resources affecting LRAS Context None Introduction An appreciation of the exchange rate occurs when the value of a country's currency increases relative to other currencies. This has significant implications for both aggregate demand (AD) and aggregate supply (AS) in an economy. R1: Appreciation of exchange rate will lead to an overall fall in AD • When the exchange rate appreciates, the prices of domestically produced goods and services increase for foreign buyers. Consequently, exports become more expensive and less price competitive, while imports become cheaper as foreign goods and services are now relatively less expensive. • For instance, the gradual modest appreciation of the Singapore dollar (SGD) made Singaporean goods and services more expensive for foreign buyers. As a result, exports became less price competitive. Assuming demand is relatively price elastic for Singapore’s exports (|PEDx|>1), f or example, Singapore’s electronics exports, such as headphones produced by Creative Technology, will experience a more than proportionate fall in quantity demanded as there are many other headphones substitutes available from other countries, resulting in lower export revenue for Singapore. • Meanwhile, the stronger Singapore dollar made imports cheaper. As Singapore lacks natural resources, our demand for imported raw materials will likely be less than 1 (|PEDm|<1),

2 suggesting a less than proportionate increase in the quantity demanded for imported foreign goods and services, reducing Singapore’s import expenditure. • Assuming Marshall-Lerner conditions hold, summation of |PEDx and PEDm|>1, appreciation of SGC will most likely lead to worsening of our balance of trade position. If the balance of trade becomes a deficit, it might eventually contribute to a fall in our net exports, ceteris paribus. • Since net exports (export revenue minus import expenditure) are a component of aggregate demand, a decrease in export revenue combined with an increase in import expenditure will reduce net exports (X-M). This reduction will lead to a decrease in AD. The formula for AD is AD = C + I + G + (X - M), where C is consumption, I is investment, G is government spending, X is export revenue, and M is import expenditure. A fall in (X - M), ceteris paribus, will lead to reduction in AD from AD0 to AD1 as shown on Figure 1 below. Figure 2: Appreciation leading to a decrease in AD R2: Appreciation of exchange rate will lead to an increase in SRAS • An appreciated currency makes imported raw materials, intermediate goods, and capital goods cheaper. This can reduce production costs for businesses that rely on imports, increasing short -run aggregate supply in the domestic country. For example, when the Singapore dollar (SGD) appreciates, most companies in Singapore that import raw materials and intermediate goods, such as electronics firms like Venture Corporation and pharmaceutical companies like Singapore Biotech, see a reduction in their costs. This l eads to an increase in short-run aggregate supply (SRAS) from SRAS0 to SRAS1, as illustrated in Figure 2 below.

3 Figure 2: Appreciation leading to an increase in SRAS Conclusion An appreciation of the exchange rate can reduce aggregate demand through lower net exports while potentially increasing aggregate supply due to cheaper imported inputs. The overall impact on the economy depends on the relative magnitude of these changes and the state of economy. 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 how appreciation of exchange rate will affect AD and AS, supported with relevant examples. 8-10 L2 Uneven display of AO1, AO2 and AO3 skills: • For an answer that shows under -developed explanation lacks depth of analysis (i.e. , limited effective use of relevant economic analysis • l acks scope (i.e only explain either AD or AS) • lacks relevant examples 5-7 L1 Limited display of AO1 and AO2 skills: • listing of points, unexplained statements, or descriptive response • many conceptual errors • irrelevant response • smattering of points 1-4

4 Part (b) - Question Analysis Approach Command Word Discuss whether Question Type Policies Start point Appreciation and SS-side policies End Point Controlling demand-pull and cost-push inflation Content and Context Content ADAS Analysis Context Singapore Introduction Singapore is a small, open economy highly dependent on international trade, with the Monetary Authority of Singapore (MAS) using exchange rate policy as a key tool to manage economic stability. R1: Appropriate for SG to adopt Gradual Modest Appreciation to control demand-pull inflation and cost-push inflation • In 2015, the MAS maintained a modest appreciation policy for the Singapore dollar to manage inflation. A notable example is our services sector such as food, beverages and retail, which constitute 70% of Singapore GDP. The slightly more expensive services will cause a more than proportionate fall in quantity demanded to foreigners and a decrease in Singapore’s export revenue (X). Assuming Marshall-Lerner Condition holds where the summation of |PEDx and PEDm| is >1 as explained in (a), appreciation will decrease SG’s net exports (X - M), shifting AD to the left from AD 0 to AD1 to AD2. This shift significantly reduced inflationary pressures from P 0 to P1 to P2, especially given Singapore is most likely operating near full employment at E0, as shown in Figure 3 below. Figure 3: Appreciation to reduce demand-pull inflation in Singapore As explained in (a), a gradual modest appreciation also helps keep imported resources competitively priced, leading to lower unit costs of production across most sectors in Singapore. One of the most critical imports for Singapore is oil and petroleum products.

5 As an island nation with limited natural resources, Singapore is highly dependent on these imports to fuel its industries, transportation, and households. The lower domestic price of imported fuel will reduce unit production costs and translates to higher profitability for firms in Singapore; which will increase short-run aggregate supply (SRAS 0 to SRAS1) across all price levels in the economy , resulting in a decrease in the general price level from P 0 to P1, as shown in Figure 2 above, effectively cushioning against cost-push inflation caused by external oil supply shocks. Intermediate EV#1: conflict of macroeconomic aim  negative actual growth and higher demand-deficient unemployment • However, persistent currency appreciation can harm export competitiveness, leading to slower economic growth and higher unemployment in export -oriented industries, especially given that services constitute 70% of Singapore's GDP. If the fall in