2022 SH2 H2 Prelim EQ4 (Suggested answer)

4 The Bank of Korea slashed its benchmark interest rate to a record low of 0.75 per centin an emergency move following similar actions by the Federal Reserve and othercentral banks to combat economic damage from the coronavirus outbreak. Source: The Straits Times, 16 March 2020(a) Explain the factors that affect Singapore’s choice of exchange ratepolicyasitsmainpolicy to achieve internal stability in the economy.[10](b) Discuss whether a fall in world interest rates would have a positive impact on theSingapore’s economy. [15] Part (a)Introduction● State that internal stability in an economy refers to the achievement of macroeconomic goalsincluding price stability, low unemployment and economic growth.● ThefactorsthataffectSingapore’schoiceofexchangeratepolicyisdependentontheexport-orientedandimport reliant natureof Singapore’s economy as well as thelimitations of other macroeconomicpolicies leading to the choice of exchange rate policy instead as the main policy. Body● For a small and open economy such as Singapore, it is an economy that is export-ledandimportreliant and thus the root cause of its macroeconomic problems are related to trade. 1. Import-reliant Nature of Singapore Economy● Given that Singapore has limited resources and thus is import-reliant, a root cause of inflationaryconcerns in the economy is high imported cost of production.● Given that imported cost of production is a root causeof achievingpricestability inSingapore, theuseofappreciatingexchangeratewill beabletoeffectivelyachieveasuccessful economyintermsofprice stability.● Withanappreciationof exchangerate, priceof importedinput will becheaper indomesticcurrency.This helps toreducedimportedcostofproductioninSingapore,thuscausinganincreaseinhershortrun aggregate supply (SRAS).

Figure 1:Impact of Appreciation of Exchange rate on Import Price-Push Inflation2. Export-Oriented Nature of Singapore Economy● Given that Singapore is a small and open economy andthus export-led, aroot causeof economicrecessionandthus loweconomic growthis duetodepressednetexportrevenue.Thus,depreciatingexchange rate policy can help to address this.● Withadepreciationof exchangerate, priceof exports arecheaper inforeigncurrenciesandpriceofimports are more expensive in domestic currency. Given that Marshall Lerner condition, which is|PEDX + PEDM| > 1, will hold in Singapore context, adepreciationof exchangeratewill causeanincrease in net export revenue in Singapore.● The increase in net export revenue thus leads to an increaseinaggregatedemand(AD) andthusmorethanproportionateincreaseinnational incomeviathemultiplierprocess.Thus,actual economicgrowth is effectively achieved. 3. Limitation of Monetary Policy in Singapore● Duetopolicy trilemma, Singaporehastochoosetwobetweenthethreeoptions,namelyopencapitalflow, control of exchange rate or control of interest rate.● GiventhelimitationofmonetarypolicyinSingapore,exchangeratepolicyratherthanmonetarypolicyis chosen instead as the macroeconomic policy to achieve its macroeconomic goals. Singapore as an i/r taker● Monetary policy is limited in its effectiveness in Singapore’s economy. Given the small and opennature of Singapore’s economy, Singapore is unable to effectively manipulate its interest rate.● IfSingaporeweretoincreaseitsinterestraterelativetoglobal interestrates,forexamplefromr1tor0infigure2, thenshort termcapital will flowintotheeconomytogainfromtheinterestratedifferential.This short termcapital inflow will thus increase Singapore’s internal liquidity, and thus increaseitsmoney supply. This will leadtoafall ininterest rateagain. Thus, Singaporeis effectively aninterestrate taker. Conclusion● The factors that led Singapore to choose exchange rate policy as its main policy is due to itsexport-led, import-reliant nature of its economy.● In addition, Singapore being an interest-rate taker also limits significantly the use of monetary policy.

Part (b)Introduction● Statethat afall inworldinterest rates canhavepositiveandnegativeeffectsonSingapore’sinternaland external stability.● The fall in world interest rates would affect the economies of Singapore’s tradingpartners andthiswould in turn affect Singapore internal stability given the small and open nature of Singapore’seconomy via impact on its net export revenue.● Inaddition, givenSingaporeisaninterestratetakerduetothesmall andopennatureofitseconomy,the fall in domestic interest rates would also affect Singapore’s internal stability. Body1. Thesis: Positive Impact on Singapore’s economy due to fall in world interest rates a) Explain how a fall in world interest rates might affect the economies of Singapore’s major tradingpartners and in turn affect Singapore’s export revenue and its external stability (Balance of Payment).● A fall in interest rates in economies of Singapore’s major trading partners would lower the cost ofborrowing for households and firms in the economies. Households would increase consumptionexpenditure (C) and firms would increase investment expenditure (I). GivenAD=C+I+G+(X-M), thefall ininterest rates wouldincreaseADwhichinturnwouldleadtoactual growthandhighernationalincome.● Giventhehighernational incomeofSingapore’smajortradingpartners,therewouldbeanincreaseinSingapore’s export revenue (X).● Theincreaseinnet export revenuewouldleadtoanincreaseincredit items incurrent account andthus lead to an overall improvement in Singapore’s Balance of Payment position. b) GiventhatSingaporeisaninterestratetaker,explainhowafall indomesticinterestrateswouldaffectSingapore’s aggregate demand (AD) and might positively affect Singapore’s internal stability(Economic Growth and Low Cyclical Unemployment).● Given that Singapore is an interest rate taker (as explained in part a), domestic interest rates inSingapore would fall as well.● Therefore, CandI inSingaporewouldalsoincrease(as explainedearlier) as costofborrowingfallswith lowered domestic interest rates. CoupledwiththeincreaseinXexplainedearlier (whichhas asignificant effect on Singapore’s AD because X takes up a large proportion of Singapore’s AD),Singapore’s AD might increases significantly.● The increase in AD would lead to an improvement in economic growth and fall in cyclicalunemployment.

Figure 1:AD-AS (Actual growth in Singapore) c) Positive Impact on Singapore’s internal stability (Potential Economic Growth) due to increase in LRAS● Theincreaseininvestmentexpenditurewouldalsosuggest,forexample,anincreaseintheacquiringof capital assets that wouldincreaseSingapore’s ability toproducemoregoods andservices inthefuture. Therefore, Singapore’s productive capacity would increase thus increasing Singapore’s fullemployment level of output leading to an increase in Singapore’s long run aggregate supply (LRAS).● Hence, the fall in interest rates would increase Singapore’s potential growth. Coupled with theincrease in actual growth, Singapore can enjoy sustained economic growth which is non-inflationary. ● Overall, the fall in interest rates can positively affect Singapore’s internal and external stability. 2. Anti-thesis: Negative Impact on Singapore’s economy due to fall in world interest rates a) Explain how the increase in aggregate demand (AD) might negatively affect Singapore’s internalstability (Price Stability).● However, the increase in AD due to lower interest rates may compromise on price stability. IfSingapore is operatingnear full employment level of output at theupwardslopingportionof AScurvewherethereisalackof/limitedsparecapacity,thefall ininterestratemightleadtodemandpull inflation in Singapore. b) Explain how the increase in prices of imported inputs in other countries might negatively affectSingapore’s internal stability (Import Price-Push Inflation).● Tradingpartners inSingaporemayalsosimilarlysufferfromdemand-pull inflationduetoincreasein AD brought about the fall in world interest rates.● Given that Singapore has limited resources and is