(2022) A Level H2 Econs Paper 2 Essay Q5

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5. A low rate of inflation is a key macroeconomic policy objective for most governments. During the first quarter of 2020, interest rates in most countries throughout the world fell to very low levels.

(a) Explain why a rise in interest rates is used as a macroeconomic policy tool to control inflation in some countries but not in Singapore. [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. Specifically, in the case of controlling interest rates, the central bank would potentially decrease money supply by buying back government bonds;

4. Decrease MS —> higher interest rates —> decrease C&I (consumers will find that saving is more beneficial than taking up loans to buy large ticket items, so they cut back on consumption. Investors will find that fewer investments are profitable at a higher interest rate, thus they will cut back on investments) —> since C & I are part of AD → decrease AD —> decrease GPL —> lower inflationWhy interest rates are ineffective & undesirable for SingaporeInterest 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)

   1. Given the trilemma 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 change in interest rates in other countries is likely to have a significant impact on Singapore’s domestic and external economy. [15]

• Introduction

1. Singapore is an interest rate take

2. A change in interest rates of major global economies e.g. U.S / China / Eurozone / Japan will have an impact on SG’s interest rates in the same direction

3. We will discuss and analyse this essay assuming an impact of an increase in world interest rates

• 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 in these economies 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 (impact on domestic economy)

3. Firms hire less factor inputs —> higher unemployment (impact on domestic economy)

4. (X-M) fall → current account worsens (impact on external economy)

• 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

4. This would actually be a positive development since it actually helps to address the demand-pull inflation problem that the Singapore economy would have been facing (which is true as of March 2022 where CPI-All Items inflation rate was 5.8%)

• Impacts of higher interest rates on mortgage payments in Singapore (domestic economy)

1. Singapore is an interest rate taker ; this means that interest rates will rise in Singapore when world interest rates start rising

2. Given that home ownership rate is high (87% in 2020) in Singapore, and most homeowners would take a mortgage loan to finance their homes, the higher interest rates will mean effectively higher monthly installment payments they will need to make for their homes → this reduces disposable income available for spending on other goods & services → decrease in Consumption → decrease AD → fall in real NY → lower economic growth

3. Such an impact on the economy would likely be small given that Singapore has high leakages to begin with and Consumption is not a key driving force affecting economic growth in Singapore given that we are more reliant on trade & investments for growth.

• Conclusion

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

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