2012 A-level Macroeconomics Qn 5. During 2009 the Bank of England engaged in what is known as ‘...

1. a) Explain why exchange rates rather than interest rates are the preferred choice as the instrument of monetary policy in Singapore.

1.1. Keywords: Explain, exchange rates, interest rates, preferred choice, monetary policy, Singapore

1.1.1. Briefly explain how exchange rate policy works in Singapore - the managed float.

1.2. Singapore: perfect example of a small and open economy with perfect capital mobility.

1.2.1. Interest rate taker, supply and demand of loanable funds not enough to affect world interest rates.

1.2.2. An attempt to maintain domestic interest rates different from world interest rates will lead to huge short-term capital inflows, and large exchange rate changes that are not sustainable in the long term.

1.2.2.1. The impossible trinity theorem

1.3. More importantly, we are dependent on trade which favours using fixed or managed exchange rate policy.

1.3.1. 1. Factor inputs for production.

1.3.1.1. Managing the exchange rate will create more certainty for firms and businesses employing imports as factors of production.

1.3.2. 2. Consumer goods, many of which meeting basic needs of survival.

1.3.2.1. Cost of living and citizens' welfare are affected because we import many primary products.

1.3.2.2. Exchange rate policies allow Singapore to respond to supply side shocks directly.

1.4. Other benefits of having a managed-float exchange rate policy

1.4.1. Having a managed float exchange rate allows Singapore some control over fiscal policy.

1.4.1.1. An attempt to increase output through G will not be crowded out completely by an appreciation of the exchange rate (that will lead to a fall in the current account).

1.4.1.2. Under a managed float exchange rate system, Singapore has fiscal autonomy in the sense that MAS is obliged to intervene in the exchange rate market to maintain the upper bound by purchasing more foreign assets (which increases the supply of SGD) and thus increasing the money supply in the economy. This will lead to a corresponding expansion in aggregate demand and output in the short-run (no crowding out effect because currency is not allowed to appreciate)

1.4.2. Part of a policy regime to attract FDI

1.4.2.1. Coupled with low corporate and capital gains tax, stable exchange rates help to attract foreign investment to Singapore.

1.4.2.2. Reduce uncertainty for foreign investors

1.4.2.3. Increasing I can have both short run and long run benefits for Singapore's growth.

1.4.2.3.1. Elaborate briefly using AD-AS framework if possible.

2. b) Discuss the likely impact on the Singapore economy of quantitative easing and low interest rates in the US and the UK

2.1. What is your stand? (remember there are usually many possible lines of argument) ***FYI: For this discussion I am going to use the model of a small and open economy, with managed exchange rates, no restriction on capital mobility together with an underlying Keynesian framework for aggregate demand and supply analysis. (Aligned with A-level Syllabus)***

2.1.1. Possible stand: Quantitative easing and a global low interest rate environment is likely to create beneficial short term aggregate demand growth through investment in Singapore. However, in the long run, the rapid expansion of the interest sensitive sectors and the disincentive to save is likely to cause problems for our production capacity and supply side as well as create long run balance of payment problems when world interests rates rise in the future.

2.1.1.1. Short term aggregate demand growth

2.1.1.1.1. 1b. A fall in world interest rates will encourage investment in Singapore, both FDI and domestic investment.

2.1.1.1.2. 1a. A fall in world interest rates also mean that there will be a short-term capital inflow as rates in Singapore equilibrate to world interest rate levels.

2.1.1.1.3. 2. The net impact of both of the above is that AD will increase in the short-run. Unemployment will fall. Illustrate with Diagram.

2.1.1.2. Long-run constraint

2.1.1.2.1. While investments are increased, we should bear in mind that these investments made under cheap money conditions might be less tenable in the long run when interest rates rises.

2.1.1.2.2. Fall in world interest rates and domestic interest rates will discourage savings and lower marginal propensity to save in the long run.

2.1.1.2.3. Eventually we will face inflation as bottlenecks appear in production.

2.1.2. Evaluation: While this is a comparative statics problem, we should also consider type of policy response taken by the government and how that might influence the outcomes.

2.1.2.1. Encouraging productivity growth, moderating wage increases.

2.1.2.2. Moderating expectations of the future, preventing over-optimism.

2.1.2.2.1. Increasing CPF contributions to prevent a fall in savings rate?

2.1.2.3. Supply side investments

2.1.2.3.1. Retraining programmes

2.1.2.3.2. Infrastructure development

2.1.2.3.3. Increasing population growth

2.1.2.3.4. Developing new technology

2.1.2.4. Divert focus away from growth??

2.2. Keywords: likely impact, Singapore economy, quantitative easing, low interest rates in US and UK.

2.2.1. Think about the different channels that Singapore can possibly be affected.

2.2.1.1. Think about 4 macroeconomic objectives.

2.2.2. Explain what is meant by quantitative easing and place it into the AD-AS model.

2.2.3. Explain briefly what low interests rates in the US and UK mean for an interest rate taker like Singapore.