Monetary Policy:

Monetary policy refers to a Central Bank’s actions to influence the availability and cost of
money and credit, so as to achieve macroeconomic goals of sustained rate of economic
growth, low inflation, full employment and favourable balance of payments.

1. In large economies like the USA, where C and I make up a large part of AD,
interest rate or money supply is used as a tool of monetary policy (conventional
MP).
2. In small and open economies like Singapore, where the value of its total trade
(X-M) is close to 4 times its GDP value, the Central Bank may choose to anchor its
monetary policy to the exchange rate (Exchange Rate Policy).

1. Monetary Policy using Interest Rates:

- Changes in interest rates will affect C, I, and Net Exports, and hence AD.

Expansionary Monetary Policy Contractionary Monetary Policy

- The central bank increases money - The central bank reduces money
supply or lowers interest rate to supply or increases interest rate to
make credit more easily available limit the availability of credit and
and borrowing cheaper. make borrowing more costly.
- Targets recession and cyclical - Targets inflation.
unemployment.

How it works: How it works:

Internal effects: (C, I increases) Internal effects: (C, I falls)
- Households are more likely to - Households find it more costly to
borrow to purchase big ticket items obtain loans from the banks to
such as cars. finance the purchase of big-ticket
- Households are also less items. C decreases.
incentivised to save as the rewards
from saving have decreased.
- Hence C increases.

- For firms, there will now be more - Firms are also left with fewer
profitable projects due to lower cost investment projects with EROR high
of borrowed funds used to finance enough to cover the high cost of
these projects. borrowing. I decreases.
- With more projects, there will be
increased investment in plants and
machines as well as inventories.
- Hence I increases.

External effects: (X-M increases) External effects: (X-M falls)

- When the interest rate falls relative - When the i/r increases, ‘hot money’
to that of other countries, there will will flow into the country to take
be an outflow of hot money from the advantage of the higher interest
country in search of higher interest returns.
rates in other countries. - Increases the demand for the
- Increases the supply of the country’s country’s currency, appreciation of
currency in the FOREX market. its exchange rate.
 - In a free/managed float exchange - Exports become less price
rate regime, the result is a competitive, net exports fall. AD
depreciation of the country’s falls.
currency.
- The fall in the exchange rate
makes a country’s exports
more price-competitive in the
international market.
- This results in an increase in
exports and decrease in
imports. Increase in net
exports -> increase in AD.

Impact on RNY, Employment and Impact on RNY, Employment and

Inflation: Inflation:
- The increase in C, I and NX will - Fall in C, I and NX shifts AD curve
cause a more than proportionate leftwards. Inflationary pressures
increase in the equilibrium level of dampened.
RNY via the multiplier effect - As output produced falls, fewer
(assuming spare capacity), cet par. workers are demanded, resulting in
- Graph! higher cyclical unemployment and
hence, a lower national income.
Graph!

- As the increase in output 0Y2

requires the employment of more
FOPs, including labour, the level of
cyclical unemployment is reduced.
- However, the rise in AD may lead to
demand-pull inflation if there is no
spare capacity, with an overall
increase in GPL from p1 to p2.
- Increase in export price
competitiveness improves BOT
position. CA improves, hence
position of BOP improves.

Effectiveness of Expansionary MP: Effectiveness of Contractionary MP:

- How effective is it as a demand - Like expansionary MP, effectiveness
management tool? of contractionary MP will also
- Factors below may limit the depend on factors such as the
effectiveness of this policy. interest elasticity of demand for
investments, time lags, and
a. Liquidity Trap: imperfect information of the
 i. At very low interest rates, the workings of the economy.
demand for money becomes - Some other factors include:
perfectly interest elastic
(Demand for money a. Short/long term basis of projects.
becomes a horizontal line). i. A firm’s long-term investment
ii. The extreme region is known projects cannot be
as a liquidity trap, where an abandoned easily without
increase in the supply of incurring greater losses.
money from MS1 to MS2 will - Hence, I may continue to be
not have any effect on the high due to investment
rate of interest as it is difficult projects that cannot be easily
for interest rates to fall below reversed.
zero.
iii. Hence, AD and RNY will b. Conflicts with other macroeconomic
remain the same. Under goals.
such circumstances, i. Eg. inflation-unemployment
conventional MP will be trade-off. When the central
ineffective. bank raises i/r to control
Graph! inflation, it often results in
lower national income and
higher unemployment.
- Central banks hence have to
decide which goal should
take precedence at any point
in time.

b. Interest Elasticity of Demand for

Investment.
i. The demand for investment
is inversely related to the
rate of interest (known as the
MEI Theory). (draw graph to
understand!)
- In the Keynesian framework,
demand for investment is
said to be interest inelastic
(MEI1). A fall in interest rates
will be met by a less than
proportionate increase in
investment. Hence a
decrease in i/r not effective
in stimulating I and hence
AD.

ii. Moreover, a fall in i/r will not

 increase the level of
long-term investment
extensively if a large
proportion of an economy’s
investments are FDIs. (FDI is
the flow of funds from
external sources into a
country for the purpose of
buying capital goods.)
- Foreign MNCs have their
own sources of funds and
may not borrow from local
banks.
- Hence, demand for
investment if
interest-inelastic - it is not
affected by decreases in
local i/r. Impact of
conventional MP limited.
Graph!

However, some monetarists argue that

investment is interest elastic. They believe
that it is possible to use reductions in i/r to
effectively increase investments. (MEIe)

c. Expectations of the Future State of

the Economy.
i. In a period of business
pessimism, the adoption of
an expansionary MP may not
be effective should
businessmen be pessimistic
about the future.
- Keynesian belief - that the
lowering of interest rates will
not induce an increase in
investments.
- MEI curve shifts left due to
 increasing business
pessimism.
- Investment falls instead of
increasing. Expansionary MP
ineffective.
Graph!

d. Time lags between Implementation

and Impact on the Economy.
i. Recognition, Administrative,
Operational lags
- Cut in i/r may take effect
when the economy is already
recovering.
- Exp MP could be mis-timed,
may cause Demand-pull
inflation instead as the
economy is already moving
towards Yf.

e. Inability to Achieve Specific

Macroeconomic Objectives.
i. MP targeted at influencing
AD.
- It is ineffective in tackling
supply-side problems such
as structural unemployment.
(though it can help cyclical
unemployment)
- Hence, specific SSPs, such
as the retraining of workers
who are out of jobs, are
required.

2. Exchange Rate Centred Monetary Policy in Singapore

- The Monetary Authority of Singapore (MAS) usually adopts a policy stance of a

gradual and modest appreciation of the Singapore dollar.
- The primary objective of such an exchange rate centred MP is to promote price
stability (ie. low and stable inflation) as a sound basis for sustained economic
 growth in the long run.

Reasons for choice of Exchange Rate Policy:

- Due to Sg’s small and open economy.

a. Susceptible to Imported Inflation

i. Singapore’s lack of natural resources means that even the most basic
necessities need to be imported.
- Due to our small size, we are a price taker in the global market.
- Hence, changes in world prices have a significant and direct impact on our
COP and GPL.
- Thus, the exchange rate is a powerful tool to moderate imported inflation
and influence our overall inflation.

b. High dependence on the external sector.

i. Total trade is around 400% of our GDP.
- Singapore’s small domestic market results in a very open trade policy, with
few import restrictions.
- Singapore’s economic development strategy has always focussed on
producing exports, and it makes up for about three quarters of total
demand in Singapore.
- Hence, exchange rate directly affects the largest components of
Singapore’s AD.

c. Inability to control the interest rate due to openness of international capital flows.
i. Due to Singapore’s role as an international financial centre, it is important
that Singapore maintains relatively free movement of financial capital.
- The result is an open economy with free capital mobility in and out of Sg.
- Small differences between domestic and foreign interest rates can lead to
large and quick movement of funds.
- Hence, interest rates in Sg are largely determined by foreign interest rates
(as it must stay around the same range as foreign interest rates), and
hence cannot be controlled.

How it works in Sg:

- The SGD is managed against a trade-weighted basket of currencies of our major
trading partners.
- This is known as the Nominal Effective Exchange Rate (S$NEER). Real
Effective Exchange Rates (S$REER) refers to the trade-weighted
exchange rate with effects of inflation taken into account.
- The SGD is allowed to fluctuate within an undisclosed band. As long as the dollar
remains within this band, MAS does not intervene. If the exchange rate moves out
of the band, MAS steps in by buying or selling foreign exchange so as to prevent
excessive fluctuations in the exchange rate. This is known as the managed float
exchange rate.

Graph!
If there is an increase in demand from DD0 to DD1, the value of S$ will rise beyond the
upper limit of the band if left to free market forces. However, since the MAS is committed
to keeping the value within the band, they will hence sell more S$ in the FOREX market to
increase supply, resulting in the S$ transacted increasing as well as a slight appreciation
of the SGD.

Effect of Exchange Rate Policy on the Macroeconomy.

Effect of Depreciation of the SGD: Effect of the Appreciation of the SGD:

Effect on Aggregate Supply: Effect on Aggregate Supply:

- Imports become more expensive in - Imports become cheaper in local
terms of local currency. Singapore’s currency terms. Imported inflation is
CPI increases. The Sg economy reduced.
experiences imported inflation. - Prices of imported raw materials fall,
- Prices of imported raw materials causing COP to fall. Increase in AS
increase, causing COP to increase. represented by a downward shift of
This results in a fall in AS the AS curve.
represented by an upward shift of
the AS curve.

Effect on Aggregate Demand: Effect on Aggregate Demand:

- Lower Exchange Rates - Higher Exchange Rates.
- Lower export prices (in terms - Higher export prices (in
of foreign currency) -> higher terms of foreign currency) ->
demand for exports -> lower demand for exports ->
increase in AD. decrease in AD.
- Higher import prices (in - Lower import prices (in terms
terms of local currency) -> of local currency) -> higher
lower demand for imports, demand for imports, lower
higher demand for local demand for local substitutes
substitutes (Cd) -> increase (Cd) -> decrease in AD in
in AD. the short run (assuming it's a
one time appreciation).

Effect on Economic Growth, Unemployment

Effect on Economic Growth, Unemployment and Inflation:
and Inflation: - Actual growth compromised due to
- Firms increase their production the fall of RNY from Y0 to Y1.
levels as there will be a rundown on - Increase in cyclical unemployment.
stocks and inventories. Economy - BOT worsens as X decreases and
grows. However, an increase in real M increases,
 national output will be dampened - However, appreciation of the SGD
(Y0 to Y2) due to an increase in achieves low, stable inflation which
COP resulting from higher prices of over the LR, contributes to
imported raw materials. sustained economic growth.
- Lowers cyclical unemployment as
labour is a derived demand,
resulting from an increase in AD for
goods and services.
- However, there will be higher
inflation (higher GPL) due to higher
COP from imports.
Effects on Balance of Payments:
Effect on Balance of Payments: - Appreciating the SGD will cause
- Effect of exchange rate on BOP quantity demanded of exports
depends on the PED of exports and (because it’s related to price!) to
the PED of imports. decrease and that of imports to
increase. The extent of change in
1. Depreciation of currency to correct a quantity demanded of exports and
BOP deficit. imports depend on PEDx and
- The Marshall-Lerner condition states PEDm.
that as long as the sum of the price - Assuming that the MLC holds, Sg’s
elasticities of demand for exports BOT will worsen.
and imports is greater than one
[PEDx + PEDm >1], a depreciation
of the country’s currency can lead to
an improvement in the BOT, and
hence the BOP, cet par. (you have
to make this important assumption
when explaining changes in
exchange rate on CA!)
- While depreciating the currency may
improve export competitiveness in
the short run, it is not the best policy
as it does not address the root
cause of the BOP deficit.
- Hence, a long term solution is
needed to target the root cause,
such as restructuring of the
economy and implementing policies
which will boost productivity.

2. The J-curve effect.

- In the short run, the Marshall-Lerner
Condition may not be satisfied due
to the price inelastic demand for
exports and imports. (PEDx +
PEDm) <1, which leads to the
worsening of the BOT.
- This is because consumers
take time to change their
 consumption patterns and
producers may have to fulfil
the terms of prevailing
contracts.

- However, over a longer time period,

consumption patterns will change as
consumers find local substitutes.
Contracts binding domestic
producers expire.
- Hence, demand for exports and
imports can become less price
inelastic. This allows for the
Marshall-Lerner Condition to be
fulfilled, which will result in an
improvement of the BOT.
Graph!

Does a weaker exchange rate allow our exports to become more competitive?
● Yes, if depreciation is one-off.
● No, in the long run. This is because:
1. Depreciation causes higher inflation as supply cannot meet high export
demand.
- Higher actual inflation creates expectations of higher future inflation.
- Workers hence demand higher wages.
- This leads to a wage price spiral.
- Higher inflation rates over LT erodes price-competitiveness conferred by
depreciation of currency.
2. Moreover, the higher costs of imported inputs for manufacturers caused by
depreciation would offset the gains in export competitiveness.

Limitations of Exchange Rate Policy:

a. Conflict with other macroeconomic goals:
i. Conflicts arising from Depreciating SGD:
1. Increases RNY and lowers unemployment. However, there will be
higher imported inflation, which may cause a wage-price spiral, and
inflation may further escalate.
2. Hence, it is only a once-off and short term policy option for the
purpose of stabilising the economy in times of a recession.
ii. Conflicts arising from Appreciating SGD:
1. Appreciation of SGD is most desirable during a period of economic
 boom where increases in AD can be dampened to prevent
excessive dd-pull inflation.
2. However, in the short run, the CA may deteriorate (assuming MLC
holds), which will worsen the BOP. There may also be higher
cyclical unemployment and losses in terms of output, which will
slow down economic growth.
3. Policy makers have to weigh the costs and benefits and prioritise
certain macroeconomic aims.
- However, it must be noted that in the long term, there will not be a conflict
of aims from appreciating the SGD. This is because it allows low and stable
inflation to be targeted, allowing it to gain export competitiveness in the
long run. This increases AD which helps to achieve sustained growth in the
economy. Low inflation also minimises the risk of a wage price spiral.

b. Time lag
- Recognition lag, implementation lag, operational lag.
- Because of the lags in exchange rate policy, MAS conducts the exchange
rate policy in a forward looking manner. (forecasting)

c. Imperfect Information
- Firstly, the latest economic data is limited by the time taken to collect and
compile these information.
- Secondly, the Central Bank does not have perfect knowledge on how the
economy works.
- Thirdly, the dynamic nature of domestic and international economies adds
to this problem.

d. Availability of reserves (only relevant to appreciation of currency!)

- Intervention in the FOREX market to keep external value of local currency
above the market equilibrium exchange rate is possible only if the country
has sufficient reserves.
- A country with insufficient reserves is not able to sustain the high external
value of its currency. (as the country has to sell foreign currencies to
purchase local currency to reduce its supply in the FOREX market, which
will then allow it to appreciate).
- Moreover, speculators may expect an eventual devaluation (as they may
find the depletion of foreign reserves unsustainable) and begin to
aggressively sell the currency in exchange for other currencies (which they
expect to increase in value). This is likely to trigger the eventual
devaluation of the currency once a country exhausts its foreign reserves.
(speculators increase demand when they expect appreciation of a currency
- they may not increase demand due to the appreciation of the currency)

Coordination of Macroeconomic Policies:

- The exchange rate policy does not work alone in Singapore.
- In the long run, the growth of an economy is also determined by supply-side
factors such as technological progress, capital accumulation and the size and
quantity of the labour force.
- Other than the need for a sound monetary ER policy, there also has to be a sound
fiscal policy (to stabilise the economy) as well as a sound supply-side policy (to
 improve the quality and quantity of FOPs).

Definition
Main points
Sub-main points
Important parts
Important for understanding
Quantity demanded changes when the cause is related to PRICE.
Demand changes when the cause is NOT RELATED TO PRICE.