RI H1 Economics Lecture Notes 8 Monetary Policy and Exchange Rate Policy

2019 Y6 H1 Economics Macroeconomics 59 RAFFLES INSTITUTION YEAR 6 H1 ECONOMICS 2019 Outline of Contents 1. Introduction – Monetary policy around the world 2. Definition of monetary policy 2.1 Types of Monetary Policy 3. Monetary Policy and Its Effectiveness 3.1 Using Expansionary Monetary Policy in a Recession and to reduce Cyclical Unemployment 3.2 Using Contractionary Monetary Policy to reduce Demand Pull Inflation 4. Exchange Rate Determination 4.1 Definition of Exchange Rate 4.2 Determination of Exchange Rate 4.3 Determination of Exchange Rate in a Freely Floating Exchange Rate System 4.4 Foreign Exchange Market Intervention by the Central Bank 5. Exchange Rate Policy and its Effectiveness 5.1 Devaluation of currency 5.2 Revaluation of currency 6. Monetary Policy in Singapore 6.1 Reasons for choice of Exchange Rate instead of Interest Rate 6.2 Conduct of Monetary Policy in Singapore 6.3 Limitations of Monetary Policy Centred on Exchange Rates 6.4 Monetary Policy does not work alone Appendix: Appendix1: Why is Singapore different – Neither fixed nor floating ER References Abel, Andrew B., & Bernanke, Ben S., Macroeconomics, 8th Edition, Addison-Wesley Lispey, et al., Economics, 9th Edition, Harper Collins Slavin, Stephen L., Macroeconomics, 11th Edition, McGraw-Hill Sloman, J., Economics, 8th Edition, Hertfordshire: Prentice Hall Singapore Department of Statistics www.singstat.gov.sg Monetary Authority of Singapore www.mas.gov.sg The Federal Reserve http://www.federalreserve.gov/ The Bank of England http://www.bankofengland.co.uk/monetarypolicy/ Lecture Objectives: - Explain how the AD/AS approach may be used to analyse the way monetary policies (interest rate and exchange rate) can affect the levels of employment, rate of inflation, economic growth and the balance of payments position. - Evaluate the effectiveness of these policies to address the economic aims in a country. - Have a good knowledge of recent economic trends and developments, with a focus on the Singapore economy. MACROECONOMIC POLICIES MONETARY POLICY & EXCHANGE RATE POLICY @dream

2019 Y6 H1 Economics Macroeconomics 60 1 Introduction - Monetary Policy around the world The financial news is always full of reports about interest rates. Below are some examples of such reports. From the above examples, it is evident that interest rate is an important variable in the economy as it has implications on the macroeconomic goals of the government. As such, interest rate has been employed by governments all over the world to influence t he performance of their economies. 2 Definition of Monetary Policy Monetary policy (MP) refers to a Central Bank’s actions to influence the availability and cost of money and credit, so as to achieve macroeconomic goals of sustained rate of economic growth, low inflation, full employment and favourable balance of payments. The Central Bank can do this either through influencing the interest rate or the money supply in the economy. In large economies like the United States, where consumption and investment expenditure make up a large part of aggregate demand, interest rate or money supply is used as a tool of monetary policy. This is conventional MP. However, in small and open economies like Singapore, where the value of its total trade is close to 4 times its GDP value, the Central Bank may choose to anchor its monetary policy to the exchange rate. This is also known as Exchange Rate Policy. The Monetary Authority of Singapore manages the value of the Singapore dollar within a desired range in relation to a basket of foreign currencies1. This will be explained in Section 4 under The Exchange Rate Policy. 1 Adopting the managed float system, the Singapore dollar is allowed to fluctuate within an undisclosed band against a trade-weighted basket of currencies of Singapore’s major trading partners. “Bank of England maintains Bank Rate at 0.5% and the size of the Asset Purchase Programme at £375 billion. The MPC voted unanimously to maintain Bank Rate at 0.5%. The Committee also voted unanimously to maintain the stock of purchased assets financed by the issuance of central bank reserves at £375 billion.……” (Bank of England 04 February 2016) “Japan’s investment industry is seeking protection from negative interest rates as the central bank’s policy comes into effect this week and threatens a $100bn slab of savings.” (http://www.ft.com/cms/s/0/38c1d806-d2d6-11e5-8887-98e7feb46f27.html#ixzz4091mlk1g) The Federal Reserve decided to hold steady and not raise US interest rates for at least another two months at its latest meeting, arguing that near-term risks to the US economy have diminished. This is the fifth time that the Fed has decided against raising interest rates since December, when it raised interest rates for the first time in almost a decade. Federal interest rates remain unchanged at 0.25% to 0.5%. (https://www.theguardian.com/business/2015/dec/16/federal-reserve-us-interest-rate-rise-fed-funds-janet-yellen) The Central Bank is the principal monetary authority of a nation, which performs several key functions, including issuing currency and regulating the supply of credit in the economy. Refer to Appendix 1 for the functions of the central bank. Central Banks around the world: US - Federal Reserve Bank (Fed), UK - Bank of England, Japan - Bank of Japan, Singapore – Monetary Authority of Singapore Note: There are 2 possible tools of Monetary Policy: 1. Interest-rate 2. Exchange rate @dream

2019 Y6 H1 Economics Macroeconomics 61 2.1 Types of Monetary Policy Depending on the circumstances facing each economy, the Central Bank can choose to adopt either:  An Expansionary Monetary Policy (Cheap or Loose Monetary Policy) The Central Bank increases money supply or lowers interest rate to make credit more easily available and borrowing cheaper.  A Contractionary Monetary Policy (Restrictive or Tight Monetary Policy) The central bank reduces money supply or increases interest rate to limit the availability of credit and make borrowing more costly. 3 Monetary Policy and its Effectiveness Recall that in a 4-sector economy, AD = C + I + G + (X-M). Interest rate changes will affect consumption spending by households and firms’ investment on capital goods and inventories, as well as net exports by the foreign sector. These components of AD will then have an impact on the level of national output, employment, general price levels and the balance of payments. 3.1 Using Expansionary Monetary Policy in a Recession and to reduce Cyclical Unemployment Expansionary monetary policy seeks to boost the rate of economic growth and reduce cyclical unemployment. i. How It Works Internal Effects: A lower interest rate makes it cheaper to borrow. Households are more likely to borrow to purchase big-ticket items or consumer durables such as cars, furniture and household appliances. Consumption spending rises as a result. For firms, there will be more projects which will now be profitable due to the lower cost of borrowed funds used to finance these projects. As long as the expected profits from the project are greater than the lowered interest rate, firms will increase investment in plants and machines as well as inventories. External Effects: The fall in domestic interest rates may make it lower than that of other countries. People are likely to place their funds in other countries with higher rates to enjoy the higher interest returns. This induces a rapid outflow of ‘hot money’ from the country. As the domestic currency is given up in exchange for foreign currency, its supply rises in the foreign exchange market. Ceteris paribus, the result is a fall in its exchange rate