6. Some countries like China use interest rates while others like Singapore choose exchange rates as their instrument for monetary policy.

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1 6. Some countries like China use interest rates while others like Singapore choose exchange rates as their instrument for monetary policy. (a) Explain how consumers, producers and government of a country could be affected by the appreciation of its own currency [10] Requirements of the question This part is not a question on Singapore, but general in nature. Candidates should examine the effects of export and import prices as well as some of its impact on the macroeconomy. This will in turn would affect the various economic agents favourably or adversely. Introduction An appreciation means that more foreign currencies are needed to buy the same amount of local currencies or lesser local currencies are needed to buy the same amount of foreign currencies. These will in turn have impact on the price of exports and imports and thus affecting consumers, producers and government differently. Body Consumer (households) gain in consumer surplus due to a fall in price, enjoy higher quantity and variety of goods and services An appreciation of currency would lead to a decrease in import price (P M ) of its good and services. Assuming demand for imports is price elastic due to availability of substitutes, a fall in import price would lead to an increase in quantity demanded by more than proportionate and the import expenditure will rise. With lower import price (P M ), consumers are able to buy more imported goods and services at lower prices, enjoying more consumer surplus and more variety of goods and services. Consumer welfare will therefore improve. For example, the appreciation of the Chinese RMB over the decade has led to the Chinese being able to import Japanese cars at lower prices and go for holidays in Singapore or neighbouring countries in large numbers. Assuming Marshall-Lerner condition which is the sum of elasticities of demand for exports and imports is more than one, is satisfied, balance of trade (BOT) and aggregate demand (AD) would decrease and it has a contractionary effect on the economy and increasing unemployment. This will affect the households which lose their income, and it will lower their material standard of living. Producers impact on revenue and cost (profits) For producers who are exporters, a currency appreciation would lead to an increase in their export price (P x ) in foreign currencies of its good. Assuming demand for exports is price elastic due to availability of substitutes, it would lead to a decrease in their export revenue (X) since quantity demanded will fall more than proportionate. Besides, when locals turn to imports, the demand will also fall reducing their revenue. This may lead to some of them closing down temporary if revenue does not cover variable costs or even leaving the industry in the long-run. Some firms may choose to invest overseas to take advantage of lower foreign currency. For example, a strong Japanese yen in the past had made its car manufacturer lost some of its advantage. Some of them turn to investing in Thailand took take advantage of the lower cost of labour and land, as well as relatively weaker Baht. But for producers that require high amount of imports as factor inputs and sell domestically, an appreciation of its own currency will lower down its cost of production, which is favourable to lower down the price and if demand is price elastic, revenue will rise for them and even profits. Government The government would be concerned about the indirect effects on its budget. With lower P M the government is able to purchase goods and services at lower prices that saves on its expenditure. For example, if S$ appreciates, she is able to buy F16 jets for its national defence from America that could potentially save millions. If the appreciation causes a fall in net exports, leading to national income contracts by a multiplier effect and unemployment increases as explained earlier, the government may spend more to provide unemployment benefits to its workers that are laid off. At the same time, it may also collect lower tax revenue from a contracting economy (workings of the automatic stabilisers). This will strain the government budget. (Little credit given if students assume government will conduct expansionary policy and its accompanying impact on the government s budget. Separately, impact on four macro goals will not be given full credit because they do not directly impact the government itself unless linked to government budget.)

2 Level Descriptor Marks L3 Theoretical analysis of impact on imports and exports must be present. Discussion must cover all 3 parties with good economic analysis for at least 2 of the parties. No GLARING conceptual errors L2 Theoretical analysis of impact on imports and exports must be present. Discussion must cover at least 2 parties with good economic analysis for at least 1 of the parties OR 2 adequate explanations. No GLARING conceptual Errors 5-6 L1 Some attempt to answer the question with conceptual errors 1-4 Examiner s Report Some students started the essay thinking that the appreciation must be a result of deliberate government intervention which is not necessary as it can be the result of changes in market forces for the currency. Some students mainly approached this question with a well-rehearsed AD-AS analysis that focuses on macro goals and not the impact on the three economic agents. Many thought that an appreciation will result in export price competitiveness if the exports have high import content. This is wrong. The fall in cost of production due to a fall in price of imports can at best mitigate the rise in export price and it cannot offset or make it cheaper. Quite a number of students mixed up a change in quantity demanded with a change in demand when there is a change in price of exports. E.g. When there is an appreciation, export price is relative expensive in terms of foreign currencies that will result in a fall in quantity demanded (not demand since it is a response to a price change and it is a movement along the demand curve). And since price in local currency does not change, this fall in output means a fall in demand of exports causing export revenue in local currency to fall. For impact on producers, students should use simple price change and elasticity to explain the impact on their revenue and not Marshall-Lerner condition as this apply for the country s entire balance of trade. It is necessary to show understanding that the impact is different for producers who are exporters, importers and selling to local market. Some actually thought that an appreciation will lead to lower pay-out to foreign labours as part of imports. Foreigners who are hired are paid in local currencies based on the contract and will not be affected by exchange rate. It is incorrect to call export expenditure it is export revenue and import expenditure. Do not mix them up. The use of Marshall-Lerner condition has run to many problems. First of all is without stating the condition clearly, which is the sum of demand elasticities of exports and imports is more than one. Next is merely gave it in short-form PEDx+PEDm>1 and it is insufficient. The more problematic one is still stating If or assume the condition is satisfied when it was explained earlier how demand elasticity of exports or/and import individually is more than 1 so the correct phrasing should be a confirmation that the condition is satisfied. For the impact on government, quite a handful only linked it to macro problems and nothing else. It is a must to link to the budget. Just like to explain the impact on consumers and producers. It is insufficient to say appreciation reduces import price push inflation and therefore consumers and producers benefit. You have to elaborate on how this will lead to fall in prices of goods and services and consumers can enjoy higher output and consumer surplus; for producers how this will lower their cost of production and assuming they only import and sell to locals, their profits will rise since variable costs fall. So for government, it is necessary to link to the budget. Some candidates wrote quite a bit of evaluative comments for this question which is not required since the command word is explain. Quite a number of students explain that appreciation would bring about increased business confidence and hence be able to attract FDI. This may be applicable to Singapore only because we have many other conditions in our favour, like political stability, a productive workforce, strong Singapore branding etc. This question, however, is a generic question and thus the impact of appreciation alone can go either way, while it may attract FDI due to increased profits in the future, it may also dissuade FDI due to increasing cost of investing. As such, students should not write that appreciation will definitely increase FDI.

3 (b) Discuss why governments use different instruments of monetary policy to control the rate of inflation. [15] Requirements of the question Candidates are to identify the main sources of inflation such as imported inflation and demand-pull inflation. In the traditional theory of monetary policy, the use of interest rate is often used to reduce inflation. However, in some limited cases (as in Singapore and Czech Republic), the use of exchange rate policy is preferred over interest policy. Candidates should examine how exchange rate policy as well as interest policy could be used to tackle inflation. More importantly, candidates need to demonstrate the factors and conditions why one instrument preferred is over another Introduction Inflation is the sustained increase in the general price level over a period of time and it can be caused by demand-pull or cost push reasons. Different governments use different instruments of monetary policy such as interest rate or exchange rate to control the rate of inflation because of the nature of the economy and the main type of inflation faced by the countries. Body Exchange Rate Policy to contain imported-price push inflation (such as for Singapore) Being a small and open economy, Singapore is particularly susceptible to import-price-push inflation. This is because Singapore has limited natural resources and is heavily reliant on imports of necessities, raw materials and semi-finished goods for consumption and production of goods for export and it stands at 1.5 times of Singapore s GDP. Imported inflation thus accounts for a significant portion of the overall inflation observed. As such, exchange rate appreciation is arguably the most important and effective policy instrument in managing inflation in Singapore. The Monetary Authority of Singapore (MAS) has had implemented a gradual modest appreciation policy of Singapore dollar since Appreciation of S$ will make imports relatively cheaper in terms of domestic currency. Cheaper import prices will lower the cost of production for firms in general. This has the effect of shifting the SRAS to the right, leading to a reduction in price levels from P to P 1 and thus reducing inflationary pressures. Figure 1a GPL SRAS SRAS 1 P P 1 AD Y Y 1 Real Output Evaluation: Supply-side policy to reduce reliance on imports/obtain cheaper alternatives may be used to complement the exchange rate policy in combating inflation.

4 Exchange Rate Policy to contain demand-pull inflation (such as for Singapore) Furthermore, as a small and open economy, much of Singapore s growth depends on external demand for Singapore s goods and services. A rise in X due to a pickup in demand from trade partners such as the US, Japan and the Eurozone (as was the case in 2013) will likely result in a sizable increase in AD since X is almost 2 times of Singapore s GDP, which could lead to demand-pull inflation when there is tight capacity. A strong S$ implies that our exports will be less price competitive, ceteris paribus, as exports now become more expensive in terms of foreign currencies. Assuming that the Marshall-Lerner condition which is the sum of demand elasticities of exports and imports more than 1, holds, Singapore s balance of trade will worsen, resulting in slower economic growth. With a fall in net exports, AD will fall from AD to AD 1, GPL falls from P to P 1, relieving demand-pull inflationary pressures. Figure 1b GPL AS P P 1 AD AD 1 Y F Real GDP Evaluation: Supply-side policies that aim to increase the productive capacity of the nation to support the huge rise in AD are necessary to prevent demand-pull inflation. Separately, demand-pull inflation in Singapore can also be due to higher demand from property and cars/coes. If so, macro-prudential policies such as curbing bank loans may be more appropriate than appreciation. Synthesis: To sum up, the use of exchange rate appreciation in Singapore is largely to address the imported inflation and to some extent, demand-pull inflation as it served as a basis of price stability for sustained growth. Interest Rate Policy to contain demand-pull inflation (such as for China) The main source inflation in large economies like China is demand pull inflation due to its large domestic consumption (C) and investment (I). Higher interest rates help keep cost of borrowing high for consumers who purchase durable goods or big-ticketed items, discouraging consumption. At the same time, higher cost of borrowing also decreases the expected rate of returns from private investment (MEI < r) and discourages investment by firms. Thus a fall in consumption and investment reduces AD from AD 1 to AD 2 and the General Price Level from P 1 to P 2 as show in Figure 1b. Note: Since the focus is on the large domestic market, there is no need to include the secondary impact on how a rise in interest rate will lead to appreciation and thus causing NX to fall. Moreover for China, there might be some form of capital control and it is a managed float system and appreciation may not happen. Evaluation: Consumer & Investor Optimism: Given the economic boom is still felt by the Chinese consumers and producers, it is likely that consumer and investor optimism will persist. This implies that despite a higher interest rates by the Central Bank of China adopting contractionary interest rate policy, consumers and investors will be continue to borrow. Thus in such a buoyant economic environment, firms and consumers may not reduce investments and spending respectively. Similar to Singapore, supply-side policies can be used to complement with a rise in interest rate to ensure AD and AS grow in tandem. And the root cause of the demand-pull inflation has to be examined so as to prescribe the correct policies.

5 Comparison of both instruments Why interest rate policy cannot be used in countries like Singapore. (a) Small capital market and Openness to capital flows making it difficult in controlling interest rate Singapore s role as an international financial centre means there is no capital control and that small changes in the difference between domestic and foreign interest rates result in large and quick movement of capital flow, making it difficult to target interest rate in Singapore. Assume that Singapore government increases interest rate to rein in demand-pull inflation. This rise in interest rate, assuming it is significantly higher than interest rate of big or large economies like the US will result in short-term capital inflow (i.e. hot money). This will mean, foreign investors e.g. US investors will sell their own currency (i.e. USD) and buy S$ to save with Singapore banks. Banks in Singapore will now have more cash or liquidity to create bank credit or loans. Thus, the supply of bank credit will rise, causing interest rate to fall, until the domestic interest rate equalises or is on par with global interest rates. At this point, there is no more incentive for foreigners to transfer their funds to Singapore since interest rates are identical or on par. Thus, it is not possible for the Singapore to set interest rate independently from the rest of the world. As a small and open economy, the MAS cannot control interest rate in Singapore and thus it is said to be an interest rate taker. In practice, interest rate in Singapore generally follows interest rate of big economies like that of the US. Conversely, large economies like China are better able to withstand more capital flows, or they may practise capital control, and hence are not interest rate takers. Note: A change in interest rate in big countries like China will also lead to capital flows but the difference between Singapore and them is that we are a small country and thus the impact is more profound. (b) Controlling interest rate will make exchange rate very volatile and will have adverse impact on trade. Adjusting interest rate will subject our exchange rate to volatility which in turn affects investors confidence and thus may affect our trade volume adversely. As mentioned above, a change in interest rate will result in short-term capital flows. This will have adverse impact on our exchange rate. E.g. a fall in interest rate that attracts huge capital outflow will mean a rise in supply of S$ causing our exchange rate to depreciate. Similarly, a rise in interest rate will attract huge capital inflow causing demand for our currency to rise, strengthening S$. If interest rate is often adjusted, our exchange rate will be very volatile and this is very detrimental to Singapore as we are an export-driven country and we are also heavily dependent on imports for survival and raw material. Conclusion: The appropriateness of the monetary policy instruments for a country depends on the main type of inflation of a country which is also closely related to the nature of the economy. Usually economies may choose interest rate policy if they have sizeable domestic economy and less open to financial flow. Countries like Singapore which is prone to imported inflation and has a large financial sector would prefer to use the exchange rate. Other sources of inflation such as wage push inflation would require policies other than monetary ones. Level Mark Descriptor L Well-elaborated answer with diagram(s) to explain the use of instruments to reduce inflation and a strong rationale on how the factors/conditions, i.e. nature of economy and the main cause of inflation, play the role to choose the instrument. L2 6-8 Answer shows adequate understanding of both instruments of monetary policies and some but underdeveloped attempt at analysing the factors/conditions, i.e nature of economy and the main cause of inflation, to determine the choice of instrument. L1 1-5 Answer shows some understanding of both instruments of monetary policies but little or no attempt at analysing the factors/conditions to determine the choice of instrument. Evaluation E2 3-4 Reasoned judgment on the use of the policies to tackle inflation. E1 1-2 Evidence of some evaluation.

6 Examiner s Report To do well in this question, students need to discuss the reasons why countries choose the type of monetary policy tools/instruments and not simply explain how raising interest rate or appreciation will help to fight inflation. As a result, those who only explained how these instruments worked would only score an L2 mark range. To score L3, it is a must to explain it depends on the nature of the economy and the main type of inflation in the country. For Singapore s case, many only explained how appreciation would combat import-price push inflation and left out demand-pull inflation due to excessive exports demand while others only explained the latter. While explaining how an appreciation can fight import-price push inflation, students tend to mix up the analysis on the impact on trade be it total trade volume (X+M) or net exports (NX). Remember that the key idea is to increase SRAS. Many students were either unable to explain well why it is neither feasible nor desirable for Singapore to use interest rate or they left it out totally. It is infeasible for Singapore to use interest rate not simply because of being open, as countries like US is also very open to capital flows. It is important to explain it is also because the country is small and to be a financial hub, we do not practise capital control. Some confused short-term capital flows aka hot money with FDI or any investors of long-term capital goods. Many thought that bring down import price will make our exports price competitive. This is wrong. Do refer to *below for details. For China s case, some students were still unable to explain well how a rise in interest rate would reduce consumption and investment. Some included the indirect impact on exchange rate and thus on net exports which is not needed as that is not the primarily objective of choosing interest rate as the instrument and also for that to happen, there must be no capital control and best under a flexible or free-floating exchange rate regime but China does practise some capital control and the Chinese Yuan is under the managed-float regime. Some students elaborated on quantitative easing (QE) which is irrelevant based on two reasons: firstly, it is not mentioned in the stem and next, QE is an expansionary policy and will not be used to fight inflation. Others elaborated on supply-side policies in great details which are not required. They are at best for evaluation when it is appropriate. Others went to great length of the choice of the instrument without the context of combating inflation and thus it could be on lowering interest rate and depreciation to stimulate growth instead of focusing on raising interest rate and appreciation. Many still did not draw diagrams or did not explain the diagrams. Some students mixed up state and nature of economy. Many still could not give sufficient or appropriate or timely evaluation. Note (IMPORTANT): The lowering of the cost of production in this case will not cancel out the entire rise in export prices in foreign currencies due to the appreciation unless import cost is 100% of the cost of production. A simple numerical example explains this assume the appreciation of 10% leads to a 10% fall in import prices and hence a 10% fall in the price of raw materials used to produce exports. If raw materials make up 50% of the production costs and all other costs remain constant there will, ceteris paribus, be a 5% fall in the price of the exports. But export prices have risen by 10% because of the appreciation the combined effect of these two changes is therefore a rise in the price of exports of 5%. To sum up: In theory an appreciation of a currency will erode export price competitiveness. As a result, Singapore uses supply-side policies to raise the non-price competitiveness of our exports. In addition any cost cutting measures implemented can also help to mitigate the erosion of export price competitiveness resulting from the appreciation of currency.