Why Singapore runs monetary policy through the exchange rate.

When you read that a central bank is fighting inflation, the next sentence almost always involves an interest rate going up. That is the standard machinery of monetary policy across the United States, the eurozone, Britain and most of the world. So it surprises people to learn that Singapore, one of the most sophisticated financial centres on the planet, does not set a policy interest rate at all. It manages the value of its currency instead, and in its most recent policy review the Monetary Authority of Singapore kept its long-standing setting: a policy of modest and gradual appreciation of the Singapore dollar. No rate announcement, because there is no rate to announce.

This is not an eccentric local quirk. It is one of the most-tested ideas in the whole A level macro syllabus, and one of the clearest examples of a principle examiners love: the right policy depends on the kind of economy you are running it in. Pull the story apart and you find a tight piece of reasoning about why a small, open, import-dependent economy reaches for the exchange rate when almost everyone else reaches for the interest rate.

The story: what MAS actually decides

Twice a year, the Monetary Authority of Singapore, which is the country's central bank, publishes a monetary policy statement. It does not tell you where interest rates are going. It tells you what it intends to do with the Singapore dollar. Specifically, MAS manages the trade-weighted Singapore dollar, the value of the dollar against a basket of the currencies of Singapore's main trading partners, weighted by how much trade is done with each. This trade-weighted measure has a name you should use in an essay: the Singapore dollar nominal effective exchange rate, or S$NEER.

MAS does not fix the S$NEER, and it does not let it float freely. It manages it within a policy band, a sloped corridor the currency is allowed to move inside. There are three levers it can pull: the slope of the band, which sets the pace of appreciation or depreciation; the width of the band, which sets how much the dollar may fluctuate; and the level or centre of the band, which can be shifted up or down in one move. In normal times MAS sets an upward slope, allowing a slow, controlled strengthening of the dollar. In its latest review it kept exactly that, a modest and gradual appreciation, judging it the right setting for the inflation outlook it faces.

The economics: monetary policy through the exchange rate

To see why this works, start with what an interest rate normally does. In a large economy, a central bank cuts the interest rate to encourage households and firms to borrow and spend, which lifts consumption and investment, raises aggregate demand and so supports output and jobs; it raises the rate to do the reverse and cool inflation. The whole channel runs through the cost of borrowing inside the domestic economy. That works well where domestic spending is the main engine of demand.

Now look at how an exchange rate fights inflation instead. When MAS allows the Singapore dollar to appreciate, every imported good becomes cheaper in Singapore dollar terms. Cheaper imports do two things at once. They lower the prices Singaporeans pay directly for imported food, fuel and goods, and they lower the cost of the imported raw materials and components that Singapore's firms build into almost everything they produce. Lower import prices feed straight through to a lower general price level. For an economy that imports a huge share of what it consumes and produces, strengthening the currency is a remarkably direct way to hold inflation down, and it is the cost-push, imported side of inflation that dominates here.

Mr Toh's take: why Singapore, of all places

Here is how I explain the choice to a class, because the question "why the exchange rate and not the interest rate" is one of the most reliably examined in the whole subject, and a strong answer rests on the same four features of the economy every time.

First, Singapore is a small and extraordinarily open economy. The combined value of its exports and imports is worth several times its GDP, far more than 300 percent. Trade does not sit at the edge of this economy; it is the economy. That alone tilts the most powerful lever toward the external price of the dollar rather than the internal cost of borrowing. Second, it is deeply import-dependent. It imports most of its food and almost all of its energy and raw materials, so when world prices rise, that inflation is imported, and the most direct defence against imported inflation is a stronger currency that makes those imports cheaper. An interest rate cannot do that job nearly as well.

Third, domestic consumption is a relatively small share of demand and investment is driven heavily by foreign firms whose decisions respond to global conditions and tax and infrastructure, not to small moves in the local interest rate, so the usual borrowing-and-spending channel is weak here. Fourth, and this is the elegant part, there is a hard constraint economists call the impossible trinity, or the open-economy trilemma: a country cannot simultaneously have free movement of capital, a managed exchange rate and an independent interest rate. Singapore wants open capital flows, and it has chosen to manage the exchange rate, so it gives up control of its own interest rate. Singapore's interest rates are therefore largely set by global conditions; the country is, in effect, an interest-rate taker. Trying to run monetary policy through a rate you do not control would be futile. So MAS runs it through the one powerful lever it does control, the exchange rate.

Trade is not at the edge of this economy. It is the economy. So the most powerful lever is the price of the dollar, not the cost of borrowing.

Put those four together and the policy is not exotic at all; it is the obvious answer for this particular economy. The lesson the syllabus wants you to draw is broader than Singapore: the best monetary tool depends on a country's size, openness and structure. The exchange rate suits a small, open, import-reliant Singapore precisely because the interest rate suits a large, domestically driven economy like the United States, and you should never claim either is universally best.

Read the policy off the figure. The band slopes gently upward, so the dollar is allowed to strengthen over time rather than in one jump, which is what "modest and gradual appreciation" means. The shaded corridor is the band the currency may move within, and MAS can tilt that slope steeper or flatter, widen or narrow it, or shift the whole band up or down, depending on what the inflation outlook demands. A steeper upward slope leans harder against inflation; flattening the slope to zero is what MAS does to support a slowing economy.

The limits, because there always are some

Exchange-rate policy is powerful for Singapore, but it is not a tool for every job, and the evaluation is where the marks separate. It is well matched to imported and cost-push inflation, the problem it was designed for. It is poorly matched to a collapse in domestic demand, the kind of shock a pandemic or a sudden export slump brings, because strengthening or weakening the currency does little to revive spending that has simply stopped. For that, Singapore turns to fiscal policy. It also has a cost: a persistently stronger dollar makes Singapore's exports dearer abroad, so there is a genuine trade-off against export competitiveness that MAS has to weigh each review. And it can do little about home-grown, demand-pull inflation in services like housing or transport. None of this makes the policy wrong; it makes it one instrument in a mix, which is exactly the judgement an evaluation question is asking you to reach.

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