TMJC 2022 A Level H2 EQ5

2022 A Level H2 Economics Suggested Answers to Paper 2 EQ5 © TAMPINES MERIDIAN JUNIOR COLLEGE Essay 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) Suggested Answer Introduction • [recognise that interest rate is a tool of monetary policy (MP) and define MP] Interest rate is one of the main tools of monetary policy used by large economies such as US, UK, the Eurozone and Japan. Monetary policy is the manipulation of monetary variables such as money supply, interest rate and the exchange rate to influence aggregate demand to achieve macroeconomic objectives such as economic growth, price stability, full employment and a favourable BOT. • [note the difference between choice of MP between other countries and SG] However, the choice of instrument depends on the nature of the economy. Development #1: Explain why a rise in interest rates is used as a macroeconomic policy tool to control inflation in some countries like the US • For many large countries such as the US / UK which depends on domestic demand such as domestic consumption and investment to drive growth, it is relatively easier to implement contractionary monetary policy (raising interest rates) as compared to a contractionary fiscal policy to address the problem of demand-pull inflation due to overheating. This is because it is relatively easier to adjust interest rates than to approve of changes in government spending and taxation, the latter is often facing more resistance from the public especially when the government is trying to cut back on public spending and increase taxes. • Interest rates represent the cost of borrowing as well as the returns to savings, which the Central Bank aims to control to regulate the level of borrowing and hence AD in the economy. For example, the Central Bank (Federal Reserve) can deliberately raise interest rates to prevent overheating of the economy and achieve price stability. When interest rate increases, households will decrease consumption for two reasons: - The returns on saving money has risen or the opportunity cost of spending has increased. Hence, households will be incentivised to save rather than spend. - The cost of borrowing money for expensive purchases (such as houses and cars) has risen. Hence, households would not be attracted to borrow money to fund these purchases.

2022 A Level H2 Economics Suggested Answers to Paper 2 EQ5 © TAMPINES MERIDIAN JUNIOR COLLEGE A rise in interest rates also implies a rise in the cost of borrowing for firms to finance their investment spending. As such, projects with lower expected returns will now appear unprofitable. Hence, firms will be less willing to invest, resulting in a decrease in the volume of investment, which in turn decreases investment expenditure. With a decrease in C and I, this will lead to a decrease in AD, ceteris paribus. The fall in income from the initial fall in AD causes a fall in income-induced consumption resulting in a further decrease in AD. As one’s reduction in spending reduces income of another there will be multiple decreases in AD until a new equilibrium is rea ched whereby real output decreases by a multiplied amount from Y1 to Y2 and GPL decreases to P2 as seen as in the figure, thus reducing inflationary pressure due to overheating of the economy. Development #2: Explain w hy interest rates is not used as a macroeconomic policy tool to control inflation in SG Explain why SG does not use interest rates [any 1 point] • Changing interest rates result in instability in exchange rates If SG were to vary its interest rate, this would cause a significant impact on the exchange rate. This is because hot money, which is short term capital in search of higher returns and monetary stability, would flow out of a SG if its interest rates were to be lowered. This increases the supply of SGD in the foreign exchange market whic h would cause the exchange rate to depreciate. A depreciation of the exchange rate brings about an increase in the price of imports in domestic currency, worsening imported inflation as unit COP persistently increases given that Singapore relies heavily on imported raw materials. • SG is a price taker for interest rates → difficult to target interest rates As SG is a financial centre, it has open capital markets which makes it difficult to target interest rates. If the MAS were to raise interest rates, a significant amount of hot money would enter SG. This would increase the supply of loanable funds which would reduce interest rates. Thus, it would be difficult to vary the interest rates away from that of foreign interest rates as any change would be thwarted by the inflow or outflow of hot money in the economy. • Demand for investment is interest rate inelastic in SG The interest rate inelasticity for the demand for investment makes interest policy less effective. Even if SG were able to change its interest rates, the extent of the impact on AD would be small as the MEI tends to be interest rate inelastic. This means that a fall

2022 A Level H2 Economics Suggested Answers to Paper 2 EQ5 © TAMPINES MERIDIAN JUNIOR COLLEGE in interest rates would mean that the cost of borrowing is lower, and thus previously unprofitable investment project may now be profitable. The volume of investment thus increases, leading to greater investment expenditure. However, since MEI is interest inelastic as majority of investment in SG is due to FDI and foreign firms may not borrow locally, this leads to a less than proportionate rise in the volume of investment. Thus, investment expenditure would increase to a small extent only. Therefore, impacts on AD would not be significant. Explain why exchange rate is chosen by SG as its main tool of monetary policy to control inflation Singapore is a small and open economy and its characteristics are the underlying reasons for its choice of tool of monetary policy. - Small: Limited natural resources, small domestic demand - Open: Dependent on imported raw materials, external demand is relatively larger Exchange rate policy is able to curb imported inflation and demand-pull inflation Imported inflation is one of the main sources of cost-push inflation in SG. As a resource poor country, SG is very dependent on imported factors of production e.g. oil and other raw materials. If import prices were to rise, it would significantly affect th e cost of production of domestic firms, raising the GPL to a large extent which is a concern to the government as it affects both export competitiveness and the cost of living. In such a case, MAS can strengthen (revalue) the currency to reduce the price o f imports (measured in domestic currency), thus reducing cost of production for firms, and thus the GPL as well. In comparison, interest rate policy is unable to directly address imported inflation. Moreover, as an open economy, trade is an important engine of growth for SG and thus a policy such as exchange rate policy that can influence X and AD, would be more effective in controlling demand -pull inflation. Revaluing the SGD would raise export prices (in foreign currency) and lower import price (in SGD). Assuming PEDx>0, demand for SG exports would fall as SG exports are relatively more expensive resulting in a fall in X. In addition, as price of imports falls in terms o