(2018) A Level H2 Econs Paper 2 Essay Q5

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5. It was suggested by economists early in 2017 that world interest rates were likely to rise in the future. 

(a) Explain why Singapore chooses exchange rates rather than interest rates as its main tool of monetary policy. [10]

How monetary policy based on interest rates work 

1. Expansionary monetary policy —> used to increase economic growth / lower unemployment  

2. or Contractionary monetary policy —> used to curb inflation 

3. Increase MS —> lower interest rates —> increase C & I —> increase AD —> increase real NY —> higher economic growth and lower unemployment 

4. Decrease MS —> higher interest rates —> decrease C&I —> decrease AD —> decrease GPL —> lower inflation 

Why interest rates are ineffective for Singapore 

1. Interest rates target C & I —> C is small in Singapore (and high leakages due to imports) due to small domestic market, while I in Singapore may be interest rates inelastic (large % of I is FDI with parent firm backing from home country) 

2. given the trillemma of monetary policy, with free capital flows & if we set interest rates —> there will be large inflows and outflows of hot money which will make our exchange rates very volatile —> not desirable given its impacts on our imports and exports 

Why exchange rates are more appropriate 

1. Singapore is trade reliant (exports & imports take up >300% of our GDP) —> makes more sense to target exchange rates as a policy instrument to keep prices of both imports and exports stable 

2. Choosing to target exchange rates requires giving up of interest rates as a policy instrument 

(b) Discuss whether a rise in world interest rates would be of overall benefit to Singapore's economy. [15]

Impacts from a rise in world interest rates 

1. Increase in world interest rates would likely signify that many major economies such as U.S., Eurozone, Japan & China would have increased their interest rates 

2. An increase in interest rates in these economies —> fall in C&I —> fall in AD —> fall in real national income —> lower economic growth 

3. Firms hire less factor inputs —> higher unemployment 

4. As AD falls —> GPL falls —> lower inflation 

How such impacts will affect Singapore’s economy 

1. A fall in real national income caused by the ‘Contractionary’ monetary policy stance will reduce the incomes of Singapore’s trading partners —> reducing their ability to buy goods and services which includes exports sold by Singapore 

2. Fall in Singapore’s (X-M) —> fall in AD —> fall in real national income —> lower economic growth 

3. Firms hire less factor inputs —> higher unemployment 

What triggered the ‘Contractionary’ monetary policy stance would have had an impact on Singapore’s economy as well 

1. Countries typically carry out contractionary monetary policy in periods of high growth, high inflation to curb inflation. 

2. In periods of high growth and high inflation —> it would have likely been the case that major trading partners of Singapore would have been seeing an increase in incomes —> increasing demand for goods & services and therefore increasing demand for Singapore’s exports —> increases (X-M) —> increase AD —> increase real national income —> higher economic growth 

3. Given that Singapore has been operating at near full employment level —> this would have led to demand pull inflation 

Conclusion 

Thus, the net impact of the increase in world interest rates will depend on the extent of the interest rate increase 

If the interest rates increase is small, there may be little impact on growth / unemployment and may in fact help reduce demand pull inflation 

Vice versa, if the interest rates increase is large, it may have a negative impact on growth and unemployment 

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