Exchange Rate Policy
1. Introduction to Exchange Rate Policy
What Is Exchange Rate Policy?
Exchange rate policy refers to the strategies used by a government or central bank to influence the value of its currency relative to other currencies. It helps achieve economic goals such as controlling inflation, boosting exports, and stabilizing the economy.
Types of Exchange Rate Systems
There are three main types of exchange rate systems:
Fixed Exchange Rate – The currency’s value is tied to another currency or a basket of currencies. Example: The Hong Kong Dollar (HKD) is pegged to the US Dollar (USD) at a fixed rate.
Floating Exchange Rate – The currency’s value is determined by supply and demand in the foreign exchange (forex) market. Example: The US Dollar (USD) and Euro (EUR) follow this system.
Managed Float Exchange Rate – The currency is mostly market-driven but with occasional intervention by the central bank to prevent excessive volatility. Example: The Singapore Dollar (SGD) follows this system, where the Monetary Authority of Singapore (MAS) adjusts its value when necessary.
2. What Causes Currencies to Appreciate and Depreciate?
A. Demand and Supply of a Currency
Like any other good or service, a currency's value is determined by demand and supply.
Increased demand for a currency → Appreciation
Increased supply of a currency → Depreciation
Example: If many foreign tourists visit Japan and exchange their currencies for Japanese Yen (JPY), demand for JPY increases, causing the Yen to appreciate.
Diagram: Currency Appreciation and Depreciation
A simple demand and supply diagram can illustrate how currency movements occur.
B. How Trade and Investments Affect Exchange Rates
Trade (Exports and Imports)
A country with strong exports will experience currency appreciation because foreign buyers need its currency.
A country with high imports may face currency depreciation because it must supply more of its currency to buy foreign goods.
Example: China’s high export levels often increase demand for the Chinese Yuan (CNY), strengthening its currency.
2.Foreign Direct Investment (FDI)
When foreign investors set up businesses or factories in a country, they need its currency, increasing demand and causing appreciation.
Example: When Tesla built a factory in Germany, demand for the Euro (EUR) increased, leading to appreciation.
C. Hot Money Flows and Exchange Rates
Hot money refers to short-term capital moving between countries in search of high returns.
If investors move large sums into a country → Currency appreciates
If investors withdraw large sums → Currency depreciates
Example: In 2022, when the US Federal Reserve raised interest rates, investors pulled money out of emerging markets and bought USD, strengthening the US Dollar (USD) while weakening many Asian currencies.
3. Relationship Between Balance of Trade (BOT) and Exchange Rates
How Exchange Rates Impact the Balance of Trade
Depreciation → Exports become cheaper, imports become more expensive → Improves BOT
Appreciation → Exports become more expensive, imports become cheaper → Worsens BOT
Example: After Brexit, the British Pound (GBP) depreciated, making UK goods cheaper globally, increasing exports.
Key Economic Concepts
Marshall-Lerner Condition – A currency depreciation will only improve BOT if demand for exports and imports is elastic (i.e., responsive to price changes).
J-Curve Effect – After a depreciation, BOT may worsen in the short term before improving because contracts and trade agreements take time to adjust.
4. Why Exchange Rate Policy Requires Foreign Exchange Reserves
The Role of Foreign Exchange Reserves
Central banks hold foreign currencies to stabilize their own currency in times of volatility.
Why Foreign Reserves Are Important
Preventing Speculative Attacks – If investors believe a currency will fall, they may sell it aggressively. Reserves help counteract this.
Maintaining Stability – Sudden changes in exchange rates can disrupt business and trade.
Boosting Confidence – Investors feel safer knowing a country has reserves to support its currency.
Example: During the 1997 Asian Financial Crisis, Thailand’s central bank spent billions in reserves defending the Thai Baht but ultimately failed, leading to its collapse.
5. Singapore’s Monetary Policy and Exchange Rate Management
A. Why Singapore Uses Exchange Rates Instead of Interest Rates
Singapore’s Economy Is Highly Open – Trade is more than 300% of GDP, making the exchange rate a key tool for managing economic stability.
Interest Rate Policy Is Less Effective – Unlike the US or Europe, changing interest rates would have limited impact on Singapore’s economy.
Example: The Monetary Authority of Singapore (MAS) manages the Singapore Dollar Nominal Effective Exchange Rate (S$NEER) instead of setting interest rates.
B. What Modest and Gradual Appreciation Does
Definition: The MAS allows the SGD to appreciate slowly over time.
Benefits:
Reduces imported inflation (foreign goods become cheaper).
Encourages companies to increase productivity rather than rely on a weak currency.
Example: Over the past 20 years, the SGD has strengthened against regional currencies, keeping inflation low.
C. Why Singapore Avoids Depreciation
Depreciation would increase the cost of imports, leading to inflation.
It could also reduce investor confidence, leading to capital outflows.
Example: Some countries, like Argentina, have faced high inflation due to repeated currency depreciation.
D. How the Managed Float Exchange Rate Regime Works
MAS allows the SGD to fluctuate within a policy band.
If SGD is too strong, MAS sells SGD and buys foreign currencies.
If SGD is too weak, MAS buys SGD and sells foreign reserves.
Example: During the COVID-19 pandemic (2020), MAS flattened the appreciation path of the SGD to support economic growth.
6. How Governments Use Exchange Rate Policies
To Control Inflation
A stronger currency (appreciation) makes imports cheaper, reducing inflation.
A weaker currency (depreciation) makes imports more expensive, potentially increasing inflation.
2. To Boost Exports
A weaker currency makes exports cheaper and more competitive in global markets.
Example: Japan has historically kept the yen weaker to help its exporters.
3. To Maintain Economic Stability
Governments intervene if exchange rates fluctuate too much, which can disrupt trade and investment.
7. Conclusion
Exchange rate policy is a crucial tool for managing a country’s economic stability. Currencies appreciate or depreciate due to trade, investments, and hot money flows. Exchange rates also affect a country’s balance of trade, requiring foreign reserves to stabilize the currency. Singapore’s managed float exchange rate policy focuses on a modest and gradual appreciation to keep inflation low while maintaining export competitiveness. Unlike other countries, Singapore does not use interest rates as its primary monetary tool, making its approach unique.
8. Discussion Questions
What factors cause a currency to appreciate or depreciate?
How do foreign direct investments (FDI) influence exchange rates?
Why does Singapore use exchange rate policy instead of interest rate policy?
What are the advantages of a modest and gradual appreciation of the Singapore Dollar?
How do foreign exchange reserves help in managing a country’s exchange rate policy?
