MJC H2 ECONS EQ4

2018 JC2 H2 Prelim Essay Q4 Discuss the extent to which trade-offs in macroeconomic objectives will arise when the Singapore government allows its currency to appreciate. [25] Suggested Answer: Introduction: The use of exchange rates is a significant tool to help Singapore achieve her economic goals. Through exchange rate policy, the Si ngapore government is able to control its inflation, which in turn will make her exports competitive and attract FDIs. Development 1: Explain the intended outcome of an appreciation of the SGD i.e. explain how appreciation works to lower inflation rate in SG In SG, a modest and gradual appreciation is used by the Monetary Authority of Singapore (MAS) to mitigate against imported inflation. Th is is important as Singapore has a high marginal propensity to import and a modest appreciation would thus place emphasis on the addressing of imported inflation first. To deal with rising prices from the global commodity markets, a stronger SGD will reduce the cost of imported raw materials that is expressed in terms of local currency, thus possibly offsetting the rise in price of these raw materials in foreign currency. This lowers the unit cost of production significantly and increases supply of goods and services. If many individual market supply curves increase, then SRAS increases from AS1 to AS2 as shown in Figure 1, causing GPL to fall, thus tackling the problem of imported cost-push inflation. In addition, the appreciation also causes imported final goods and services to be cheaper in terms of SGD, and also increases competitive pressure for domestic firms to keep prices low. These overall aim to lower domestic inflation rates in SG. The appreciation of the SGD can also help to curb demand-pull inflation. With an appreciation of the SGD, price of exports in foreign currency rises and price of imports in domestic currency (SGD) falls. Assuming PEDx>0 in SG’s case, there will be a fall in demand for exports, and hence export revenue measured in SGD. At the same time, since PEDm<1 for SG, the fall in prices lead to a less than proportionate increase in quantity demanded for imports, causing a fall in import expenditure. If the Marshall-Lerner condition holds, wher e (PEDx+PEDm)>1, this will decrease net Figure 1 Figure 2

export revenue (X-M) and aggregate demand (A D), ceteris paribus. Marshall-Lerner condition holds for Singapore because the demand for Singapore’s export is price elastic (i.e. PEDx>1) due to the wide availability of substitutes for Singapore’s exports. While this further helps to manage inflat ion through a lowering of the AD and hence GPL (lowering demand-pull inflation), it also in turn leads to lower real output. However, the appreciation of the SGD wi ll mean that export competitiveness is compromised. This is because Singapore’s exports, being expressed in SGD, will now require more foreign currency to be exchanged for them given the stronger SGD. Development 2: Explain the trade-offs (a t least 2) that occur as a result of appreciating the SGD Show that while an appreciation of the SGD can lower cost-push and demand- pull inflation, it may worsen BOP, cause negative growth and increase demand- deficient unemployment in SG While the main intent of the appreciation of SGD is to address imported inflation, it can also address demand-pull inflation, as ex plained above. While the appreciation may successfully reduce inflation rates in Singapore, there are potential trade-offs with the government’s macroeconomic objectives. Firstly, the appreciation of SGD may worsen Singapore’s balance of trade and hence balance of payments. With higher prices of exports measured in foreign currency and lower import prices measured in domestic currency, assuming the M-L condition holds, as explained earlier, (X-M) falls. Assumi ng the trade balance were in equilibrium, where (X-M) = 0, a fall in (X-M) would lead to a deficit in the trade balance and hence BOP, ceteris paribus. This causes a trade-off with the goal of a healthy BOP, should the deficit in the BOP be large and persistent. Secondly, while the fall in (X-M) and hence AD leads to a lowering of demand-pull inflation, assuming the economy is producing with s pare capacity, the fall in AD thus leads to a fall in real output, causing negative economic growth. As a resu lt, firms are likely to decrease the derived demand for labour. Aggregate demand for labour (ADL) decreases, and assuming that there are sticky wages at W1 due to contractual agreements, there is in creased demand-deficient unemployment of L DLS. The appreciation of the SGD to achieve low and stable in flation thus causes a trade- off with the other goals of high a nd sustained growth as well as low unemployment. Figure 3

Development 3: Explain the factors that influence the extent to which trade-offs will occur [Linking to the question] The extent that trade-offs occur depends on the extent to which the X and (X-M) falls, and this is in tu rn affected by a few factors, which will be explained in the next part. Note: Students should explain and evaluate about 2-3 factors Factor #1: Reliance of the economy on imported inputs Even though the appreciation leads to higher export prices, which threatens SG’s export competitiveness, when the SGD is allowed to appreciate, imported factor inputs become cheaper in SGD. With cheaper imported factor inputs, the cost of production falls and this translates into cheaper prices of final goods. As a result, the effect of the appreciation on export prices in foreign currency may be partially offset by the cheaper prices of final goods produced. Export pric es due to the appreciation may not rise as significantly, bringing about a smaller fall in demand for exports and export revenue. [Link to question] In light of this, there is a smaller extent to which trade-offs with the other macroeconomic goals will occur when an appreciation is used to lower GPL. EV (consider the nature of SG’s economy): Given that SG is resource scarce and therefore reliant on im ported inputs in the production of goods, the appreciation will hence have a significant impact on the extent of trade-off due to the fall in X. The loss in export competitiveness caused by th e stronger currency will bring about a more significant offsetting effect due to the fall in the cost of production and the extent of trade-off will be to a much smaller extent for Singapore. OR EV (consider the nature of exports in SG): However, if a large proportion of Singapore’s export revenue is contributed by exports in services, then the trade-off with a healthy BOP may be more significant. This is because in industries which export services, a relatively smaller proportion of its inputs would be imported and hence, these industries benefit less from the appreciated SGD in the form of cheaper inputs. The higher export prices due to the appreciation would lead to a significant fall in export revenue, hence giving rise to a more significant trade-off where the deficit in the BOP could be greater. Factor #2: Whether the M-L condition holds Whether or not the appreciation of the SGD leads to a fall in (X-M) and hence worsen the trade balance as well as lower AD depends on whether t he Marshall-Lerner condition holds. In the short run, the PEDx and PEDm may not be greater than 1 due to existence of contractual agreements bet ween SG and its trading partners. Hence, when there is an appreciation of the SGD, (X-M) increases in the short run, before decreasing later on. As a result, since (X -M) increases, the appreciation of the SGD doesn’t actually lead to a worsening of the trade balance or negative growth and demand-deficient unemployment in the short run but instead, may in fact promote an improvement in the trade balance and allow for actual growth. [Link to