Explain why the Singapore government chooses exchange rate as a policy instrument over interest rate policy to manage inflationary pressures.
Singapore’s post-pandemic recovery continues to face various risks and uncertainties, both locally and globally. As global inflation rises—driven by border restrictions and supply chain disruptions—the Monetary Authority of Singapore responded by tightening monetary policy through a modest increase in the pace of appreciation of the Singapore dollar.
Adapted from MAS Monetary Policy Statement Jan 2022
a. Explain why the Singapore government chooses exchange rate as a policy instrument over interest rate policy to manage inflationary pressures. [10]
Introduction
In most economies, interest rate-based monetary policy is used by central banks to manage aggregate demand and overall economic activity. During periods of low economic growth or high unemployment, the central bank may adopt an expansionary monetary policy by lowering interest rates. This is often done by purchasing government securities on the open market, which increases the amount of loanable funds in commercial banks. As banks find themselves with excess reserves, they reduce interest rates to encourage borrowing.
Lower interest rates reduce the opportunity cost of consumption and make borrowing cheaper, which encourages households to spend on durable goods and firms to invest in capital. As consumption (C) and investment (I) rise, aggregate demand (AD) increases, leading to higher real national income and a reduction in unemployment. Conversely, when inflation is too high, the central bank may raise interest rates to curb AD by discouraging borrowing and spending, hence reducing inflationary pressures.
However, while this tool is effective in many economies, it is not the primary monetary policy instrument used by Singapore’s central bank, the Monetary Authority of Singapore (MAS).
Why interest rate-based monetary policy is not appropriate for Singapore
There are several structural features of Singapore’s economy that make interest rate policy relatively ineffective.
Firstly, Singapore’s domestic consumption forms a relatively small proportion of GDP due to the country’s high savings rate and open economic structure. Therefore, manipulating interest rates to influence consumption may have a limited impact on aggregate demand.
Secondly, investment in Singapore is often driven by foreign direct investment (FDI), which tends to be relatively interest-inelastic. This is because many multinational corporations (MNCs) investing in Singapore are backed by large parent companies that may raise capital from global financial markets or in their home countries. As such, they are not highly sensitive to local interest rate changes.
Thirdly, Singapore has an open capital account. This means that funds can move freely across borders. Any change in domestic interest rates could trigger large and volatile capital flows. For instance, an increase in interest rates could attract large volumes of short-term speculative capital, also known as “hot money,” into Singapore. This would lead to a sharp appreciation of the Singapore dollar (SGD), while a decrease in interest rates could lead to capital flight and sharp depreciation. These exchange rate fluctuations can be destabilising for a small, trade-dependent economy like Singapore.
Hence, using interest rates as the primary policy tool may not only be ineffective but may also introduce unwanted volatility in the financial and external sectors.
Why Singapore uses exchange rate-based monetary policy
Instead of manipulating interest rates, the MAS conducts monetary policy by managing the exchange rate of the SGD against a trade-weighted basket of currencies of its major trading partners. This approach is better suited to Singapore’s unique economic context.
Singapore is one of the most open economies in the world. Its exports and imports of goods and services collectively exceed 300% of GDP. Additionally, Singapore imports nearly all of its food, energy, and raw materials, due to its lack of natural resources. As a result, inflation in Singapore is often heavily influenced by external price developments — particularly imported inflation.
In such a context, controlling the exchange rate is an effective way to influence inflation. When MAS allows the Singapore dollar to appreciate, the following effects occur:
Imported goods become cheaper: A stronger SGD reduces the local currency cost of foreign goods. As Singapore imports the bulk of its necessities — such as food, manufactured goods, and fuel — a stronger currency lowers the domestic price of these imports, thus dampening imported inflation.
Production costs fall: Raw materials and intermediate inputs used in manufacturing become cheaper in SGD terms. This reduces the cost of production, shifting the short-run aggregate supply (SRAS) curve to the right. This, in turn, lowers the general price level, helping to alleviate cost-push inflation.
Export competitiveness declines: A stronger SGD makes Singapore’s exports more expensive in foreign currency terms. This may reduce external demand for Singapore’s exports, leading to a fall in net exports (X-M), which reduces aggregate demand. The fall in AD further contributes to a reduction in the general price level, addressing demand-pull inflation.
Hence, by adjusting the slope of the SGD appreciation path, MAS can fine-tune the degree of tightening or easing required, without triggering large swings in interest rates or speculative capital flows.
Conclusion
Singapore’s choice to target the exchange rate is also guided by the principle of the impossible trinity or policy trilemma in international macroeconomics. This principle states that it is impossible for a country to simultaneously have (i) free capital mobility, (ii) a fixed exchange rate, and (iii) an independent monetary policy. A country can only choose two of the three.
Singapore has opted for free capital mobility and exchange rate management, and therefore, it forgoes the use of interest rates as a monetary policy tool. This policy choice is rational, given the country’s high exposure to global trade and capital flows. Exchange rate stability and inflation control are paramount for maintaining investor confidence and preserving the purchasing power of households.
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