(2012) A Level H2 Econs Essay Q5 Suggested Answer by Mr Eugene Toh (A Level Economics Tutor)
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5. During 2009 the Bank of England engaged in what is known as ‘quantitative easing’ by pumping more than 200 billion pounds into the economy. Record low levels of interest rates have also been maintained within the UK economy. Quantitative easing and low interest rates were also adopted by the US.
(a) Explain why exchange rates rather than interest rates are the preferred choice as the instrument of monetary policy 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. 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 the likely impact on the Singapore economy of quantitative easing and low interest rates in the US and the UK. [15]
What would quantitative easing and low interest rates in the US and the UK do to the US & UK economy
Quantitative easing & low interest rates would encourage an increase in Consumption as consumers in US/UK find it cheaper to borrow → increase purchase of large ticket items → increase in C → increase AD → increase real NY via k → higher economic growth
Quantitative easing & low interest rates would also result in credit becoming more readily accessible as well as making a higher volume of investments to be profitable → increase Investments → increase AD → increase real NY via k → higher economic growth
Lower interest rates in the US / UK will also result in hot money outflow → decrease in demand / increase in supply of USD/GBP on the foreign exchange market → depreciation of USD / GBP against foreign currencies (including SGD)
Impacts on the Singapore economy
US & UK are major trading partners of Singapore
US is Singapore’s largest trading partner (in 2020) - we export S$30.5b worth of goods to US and import S$71.3b worth of goods from the US
UK is Singapore’s 6th largest trading partner (in 2020) - we export S$11.3b worth of goods to US and import S$11.7b worth of goods from the UK
An increase in disposable incomes by consumers in the US & UK due to quantitative easing & lower interest rates → increased demand for goods & services → this includes an increased demand for exports from Singapore → (X-M) increases → AD increases → real NY increases via k → higher economic growth → firms hire more factor inputs to produce the higher level of output → fall in unemployment
SG’s currency will likely appreciate against the USD & GBP
As the USD / GBP depreciates, the SGD will likely appreciate against the USD / GBP
This can result in SG’s exports becoming less competitive while locals finding US & UK imports becoming cheaper → fall in (X-M) → AD decreases → real NY decreases via k → lower economic growth → higher unemployment
This may offset some of the increase in demand for our exports caused by a rise in incomes of US / UK consumers
SG is an interest rate taker - impact of lower interest rates in Singapore
SG is an interest rate taker - when Central Banks of major world economies, especially that of US were to make interest rate changes, interest rates would also adjust in the same direction, although by a lesser extent.
Thus, when interest rates in the US falls, interest rates in Singapore would fall accordingly.
This happened in 2009 in light of the Global Financial Crisis, and also in 2020 due to the COVID-19 pandemic. When Federal Reserve lowered interest rates, interest rates in Singapore also fell.
Consumption & Investments are relatively interest rates inelastic
Small domestic market + high leakages, thus impact on Consumption not significant
Large % of investments in SG are FDI, which has parent firm backing and can take loans from home countries, thus may not be significantly affected by interest rate changes in SG
Yet, however, close to 90% of Singaporeans are home-owners. When interest rates fall, prices of mortgages become cheaper (monthly instalments for home purchases fall) → Increasing demand for properties → resulting in residential-property price inflation
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