Discuss the relative significance of using interest rates, exchange rates and tax rates as instruments for economic policy in Singapore.

Discuss the relative significance of using interest rates, exchange rates and tax rates as instruments for economic policy in Singapore. [25]

Introduction

Tax rates form part of fiscal policy and is used by governments to address macroeconomic issues while most countries typically adopt either the use of interest rates OR exchange rates as instruments for conducting monetary policy. Singapore uses exchange rates in favour of interest rates for monetary policy.

INTEREST RATES

How interest rates could be used

·      Explain how interest rates could be used as instruments for economic policy. (monetary policy)

·      Explain that expansionary monetary policy could be used to stimulate growth and reduce unemployment (increase MS ài/r fall àC and I increase àAD increase àNY increase via k àhigher growth, lower unemployment)

·      Explain how contractionary monetary policy could be used to reduce inflation (decrease MS ài/r rise àC and I decrease àAD decrease àGPL falls)

·      State the limitations: interest elasticity of C and I, liquidity trap etc.

Why interest rates may not be an appropriate instrument for SG

·       (RWA) Changes in interest rates can bring about hot money inflow and hot money outflow. The extent of these inflows and outflows of hot money may be very significant considering the size of Singapore’s economy. Small changes in interest rates may bring large inflows / outflows. This will cause exchange rate to fluctuate.

·      Explain problems brought about by significant appreciation / depreciation of our country as a result of our reliance on trade (both imports and exports).

·      Furthermore, contractionary monetary policy, which tackles demand pull inflation caused by C and I, may not be appropriate since usual causes of inflation may not be due to C and I.

·      Therefore, interest rates may not be significant as a policy instrument in Singapore.

EXCHANGE RATES

How exchange rates could be used

·      Devaluation could be used during an economic downturn to bring down prices of exports in order to boost export competitiveness. This can be done through the selling of SGD to increase supply of the SGD.

·      Vice versa, an appreciation can bring about a fall in imported inflation, should prices rise too significantly. This can be done via the buying of SGD using foreign currencies to reduce the supply of the SGD.

·      However the interesting relationship between our imports and exports (imported inputs used to manufacture goods and services) makes it contradictory to use either policy.

Singapore uses a Managed Float Exchange Rate regime instead

(RWA) Singapore uses a managed float exchange rate.

·       Exchange rate allowed to fluctuate based on demand and supply

·       Major fluctuations kept to a minimal with the policy bands

·       Generally keeps to a modest and gradual appreciation of the exchange rate. Modest appreciation prevents imported inflation from being too high, keeping imported inputs cheap; but brings about a mild erosion of export competitiveness over time

·       Government can complement such a policy with supply side policy by increasing productivity to negate the negative effects

TAX RATES

Corporate income tax rates are kept low and constantly reviewed to keep in pace with competing economies such as Hong Kong.

·      Corporate tax rates are cut to encourage inflow of foreign direct investments.

·      Personal income tax rates are also kept low and constantly reviewed. 

Ø  Lower personal income tax rates give workers greater incentive to work àwillingness to work increases productivity

Ø  It can also draw in foreign talent 

Ø  Overall, it can increase the productive capacity of the economy

·       (RWA)  For instance, SG cut its corporate income tax rates over the past decade from 20% to 18% then 17% to keep its tax rates competitive. This should stimulate inward investments which can increase economic growth and reduce unemployment (via increase in AD)

Conclusion

As a country that allows free capital flows, Singapore has to make a choice between managing interest rates or exchange rates. It has chosen to manage exchange rates as its monetary policy instrument due to the nature of the economy, that has a heavy reliance on trade and foreign direct investments. For its monetary policy, it usually maintains a modest and gradual appreciation stance with a key objective of ensuring price stability. Tax rates in Singapore are kept competitive to attract and keep talent as well as to draw in foreign direct investments.