RVHS H1 ECONS P1 Essay Q4 Soln

2017 RVHS Prelims II (Y6 H1 8819) a) Explain the factors that will affect the externa l value of Singapore dollar. [10] b) Discuss whether exchange rate policy is the best policy to achieve price stability in Singapore. [15] ________________________________________________________________________ a) Explain the factors that will affect the externa l value of Singapore dollar. [10] Introduction The external value of Singapore dollar (SGD) (also referred to as the exchange rate of SGD) is the amount of foreign currency that can be exchanged for SGD. The external value of SGD is determined by the demand and supply of SGD. Body One of the factors affecting the external value of Singapore dollar is the amount of goods and services internationally traded. For example, with an increase in income and a change in taste and preferences towards goods and services from Korea like overseas trip to Korea, that will lead to an increase in supply of S GD from S 0 to S 1 in exchange for Korean Won as shown in Figure 1. At the same time, an increase in demand for Singapore exports like an increase in demand for electrical machinery from Korea will lead to an increase in demand for SGD from D 0 to D 1 as shown in Figure 1. As seen, it is the intersect ion of demand and supply of SGD that determines the extern al value of SGD. As the increase in demand is more than the increase in supply of SGD i n this case, SGD appreciates from E 0 to E 1. Another factor affecting the external value of Sing apore dollar is the amount of capital flows into and out of Singapore. As Singapore does not determine her own interest rate and is an interest rate taker, interest rate in Sin gapore is likely to increase with US interest rates on the upward trend. Comparing to countries where interest rates is lower e.g. Japan, this will lead to hot money inflows into Singapore. This will lead to an increase in demand for SGD and will cause SGD to appreciate. Another factor is the type of exchange rate regime in Singapore. Singapore adopts a managed float exchange rate regime and the characte ristics of Singapore exchange rate are basket, band and crawl. MAS conducts direct int erventions in the foreign exchange market to maintain the exchange rate within an undi sclosed policy band. For example, if D0 D1 S0 S1 Quantity of SGD KRW / SGD 0 Figure 1: Determination of the external value of SGD Q0 Q1 E0 E1

the exchange rate falls below the lower support lim it, MAS will then intervene by buying SGD using its foreign reserves, this will increase the demand for SGD in the foreign exchange market so that SGD falls within the band again. Illustrated above are some factors that will affect the demand and supply of SGD and thus, the external value of SGD. Knowledge, Understanding, Application & Analysis L3 Developed explanation, with examples, on three fact ors that will affect the external value of SGD. [Developed explanation includes examples given in t he context of Singapore and just one diagram explaining how the e xternal value of SGD is determined by the demand and supply of SGD.] 8-10 L2 Undeveloped explanation on three factors that will affect the external value of SGD, with no examples given in the context of Singapore. OR Developed explanation, with examples, on two factor s that will affect the external value of SGD. 4-7 L1 Smattering of valid points; Undeveloped explanation on factors that will affect the external value of a currency, with no re ference made in the context of Singapore. 1-3

b) Discuss whether exchange rate policy is the best policy to achieve price stability in Singapore. [15] Introduction Price stability refers to the situation whereby the general price level of goods and services in an economy either change very slowly or do not c hange at all. Exchange rate policy is important to achieve price stability in Singapore. Thesis: Exchange rate is the best policy to achieve price stability in Singapore Given that Singapore has to import virtually everyt hing, Singapore usually adopts a gradual appreciating stance relative to a basket of currencies. By allowing the SGD to appreciate, imports into Singapore will now be rela tively cheaper in terms of SGD, which means that we will now need to pay less SGD for the same amount of imports. This will in turn help to maintain costs of production low for f irms who rely on imported inputs and subsequently keep the price of end-products / finis hed goods competitive. This helps to prevent the fuelling of cost-push inflation and als o help to maintain Singapore’s export competitiveness given the high import content for t he exports. Moreover, in times of demand-pull inflation caused by external factors, k eeping a stronger exchange rate is also helpful as it increases the prices of exports in terms of foreign currency and moderates the external demand for our goods and services. Since t he Marshall-Lerner condition is satisfied in Singapore, net exports will fall, whic h triggers a fall in aggregate demand (AD) and thus, helps to curb demand-pull inflation. More importantly, using the exchange rates is more of a necessity than a choice in Singapore’s context. This is because, our openness to capital flows implies that any attempts to change interest rates to tackle inflati on will be negated by hot money inflows/ outflows, thus rendering the traditional tools of monetary policy ineffective. Anti-Thesis: Exchange rate is NOT the best policy to achieve price stability in Singapore Nonetheless, in the short term, the Marshall-Lerner condition might not be satisfied. This is because it may take some time before importers can really ‘benefit’ from the stronger SGD. For example, if importers have previously signed lo ng-term contracts to import a certain quantity of goods at a fixed price in Singapore dol lars, this implies that the import expenditure to be paid (in terms of SGD) is likely to remain constant even though it could have dropped given that SGD is now stronger. Another limitation of having a strong SGD is that S ingapore’s exports will now become more expensive in terms of foreign currency (i.e. l ess competitive compared to other countries’ exports). Even though, this loss in expo rt competitiveness due to the strong SGD will be mitigated by the lower cost of producti on because of cheaper imported raw materials to some extent, net exports might fall by too much if SGD appreciates by a large extent. The fall in net exports will lead to a fall in AD and a multiple fall in national income (NY). This will have an adverse impact on Singapore ’s economic growth if we are not experiencing demand-pull inflation. With a fall in national income, unemployment will a lso increase subsequently.

In addition, exchange rate policy will not really h elp to tackle inflation if it arises due to internal sources. For example, if there is an incre ase in domestic wages arising from government policies like an increase in foreign wor ker levy which results in cost-push inflation, then exchange rate policy will not be ab le to help. In addition, exchange rate policy will also not help if there is demand-pull i nflation which arises due to an increase in domestic consumption and investment because of an optimistic economic outlook. One other policy to achieve price stability in Singapore: As exchange rate policy will not really help to tac kle inflation that arises due to internal sources, other policies are needed. One alternative policy will be supply-side policies. Supply-side policies aim to increase long-run aggre gate supply so as to mitigate the effects of inflation. Examples of supply-side polic ies include lowering personal income and corporate income tax rates. Lowering personal incom e tax will attract foreign talent, prev