(2021) A Level H2 Econs Essay Q5 Suggested Answer by Mr Eugene Toh (A Level Economics Tutor)
(2021) A Level H2 Econs Paper 2 Essay Q5
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5. Singapore currently has a low rate of inflation and a persistent surplus on the current account of its balance of payments. However, unexpected external developments such as the outbreak of the disease, natural disasters or increases in global raw material prices always represent potential risks to Singapore’s economy.
(a) Explain how a modest and gradual appreciation in Singapore’s exchange rate might affect Singapore’s rate of inflation and its current account balance. [10]
How modest and gradual appreciation of SGD affect SG’s rate of inflation
An appreciation of the SGD would:
Make imported goods cheaper → reduces imported inflation
Reduces cost of imported inputs → reduce cost of production → rightward shift of SRAS → fall in GPL → reduces cost push inflation
Make SG exports more expensive to foreigners → reduces demand for SG exports → fall in (X-M) → fall in AD → fall in GPL
As the appreciation is ‘modest and gradual’, the impact on the rate of inflation would not likely be significant
How modest and gradual appreciation of SGD affect SG’s current account balance
An appreciation of the SGD would:
Make SG exports more expensive to foreigners → reduces demand for SG exports → fall in (X-M) → worsens current account balance
Make cost of imported inputs cheaper → reduces cost of production → makes prices of exports cheaper → increase (X-M) → improves current account balance
The cheaper imported inputs would likely mitigate to some extent the fall in export competitiveness caused by the stronger SGD, such that SG’s current account balance would not likely worsen significantly, if any.
Given that the appreciation is only ‘modest and gradual’, this adds on to the likelihood that any worsening of Singapore’s current account balance would likely be small, if any at all.
Conclusion
“Modest and gradual appreciation of the exchange rates” in Singapore’s context refers to monetary policy by the MAS where the central bank guides the currency towards a modest and gradual appreciation of the exchange rates through changing the slope, level and width of the bands. MAS actually doesn’t directly intervene in buying and selling of the SGD unless exchange rate fluctuations caused by the free market results in the SGD falling outside stipulated bands.
Any appreciation of the SGD will be modest and gradual - which means that any impact on inflation rate OR the current account balances will also be moderate.
(b): Discuss whether the modest and gradual appreciation in Singapore’s exchange rate is likely to be the best policy to manage the effects of unexpected external developments. [15]
How modest and gradual appreciation can manage increase in global raw material prices
A modest and gradual appreciation of the exchange rate, can to some extent, help manage the increase in global raw material prices
Singapore has no natural resources and thus imports most of its inputs for production. Any increase in global raw material prices will thus cause production of most goods & services to become more expensive, causing cost-push inflation
A modest and gradual appreciation will help make imported raw materials cheaper and thus help reduce cost-push inflation
Yet, if there is a sharp rise in global raw material prices like in the case of 2022 due to COVID-19 related supply chain disruptions & the Russo-Ukrainian war, a modest and gradual appreciation of the SGD may not significantly mitigate the sharp rise in global raw material prices.
How modest and gradual appreciation may not address impacts from other unexpected external developments
The outbreak of diseases like in the case of the COVID-19 pandemic, has led to a significant fall in tourism, causing (X-M) to fall, while lockdowns in order to stem the spread of the disease would also result in a fall in both C & I as individuals are required to stay home, making in-person consumer purchases difficult as well as causing pessimism in investors sentiments → these result in a fall in AD → fall in real NY → lower economic growth. As firms hire less factor inputs to produce lesser output → unemployment rises as well
In the case of natural disasters, it could lead to a fall in the productive capacity of the economy if infrastructure for production is affected, reducing the ability of the economy to produces goods & services → causing a leftward shift of the LRAS → fall in real NY
A modest and gradual appreciation of the exchange rate may not be as appropriate in addressing such impacts. A stronger SGD would cause exports to become more expensive and thus less competitive → fall in demand for SG’s exports → fall in (X-M) → fall in real NY
This could exacerbate the problem and thus MAS usually moves towards a 0% appreciation of the exchange rate in the event of such unexpected external events with the potential of causing a recession.
How use of expansionary fiscal policy might be more appropriate to address some of these impacts
To address a fall in economic growth / rise in unemployment, the use of expansionary fiscal policy may be more appropriate
Expansionary fiscal policy, through either an increase in Government expenditure (G) or cutting of personal income taxes / corporate income taxes to encourage an increase in Consumption (consumers will experience increase in purchasing power → buy more large ticket items) & Investments (lower corporate taxes will result in investments becoming more profitable) → increase AD → increase real NY → higher economic growth → firms hire more factor inputs such as labour → fall in cyclical unemployment
For example, in the case of the COVID-19 pandemic, the government planned a close to SGD$100 billion fiscal stimulus package in order to address the negative economic impacts
As compared to a modest and gradual appreciation, this can be a more direct method to address issues arising from unexpected developments such as a disease breakout or a natural disaster.
How use of supply side policies might be more appropriate
Supply side policies can also be adopted to address impacts of a rise in global raw material prices, disease breakout or natural disasters
For example - subsidies to encourage research and development or attract investments in specific areas can help develop skills competencies or increase efficiency
Encouraging research and development to increase efficiency in production resulting in a fall in cost of production, can help to mitigate increases in cost of production from higher global raw material prices
Certain sectors such as tourism are also more susceptible to the impacts of a disease breakout - diversifying the sectors that the country are dependent on for exports growth can help to increase (X-M) when there is a fall in demand for tourism
In Singapore’s case, a pro-business environment and thriving R&D landscape has attracted firms such as Sanofi & BioNTech to setup vaccine production facilities in Singapore - this will help to mitigate fall in (X-M) in the case of any disease breakout as demand for such vaccine exports would increase.
This reduces Singapore’s vulnerability to external shocks such as a disease breakout
Conclusion
Modest and gradual appreciation is a key policy to address inflation in Singapore (if any) especially if unexpected external developments result in an inflation problem. This is, however, unlikely to be adequate as a standalone policy and needs to be supplemented with other policies such as fiscal & supply side policies to address any other negative economic fallout.
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