Introduction
In most economies, interest rate-based monetary policy is used to manage aggregate demand and overall activity. During low growth or high unemployment, a central bank may lower interest rates, often by purchasing government securities, increasing loanable funds in commercial banks. Lower rates reduce the opportunity cost of consumption and make borrowing cheaper, encouraging households to spend and firms to invest. As consumption and investment rise, aggregate demand increases, raising real national income and reducing unemployment. When inflation is too high, the central bank may raise rates to curb AD. However, this is not the primary tool used by Singapore's central bank, the Monetary Authority of Singapore.
Why interest rate policy is not appropriate for Singapore
Several structural features make interest rate policy relatively ineffective in Singapore. First, domestic consumption forms a relatively small proportion of GDP due to a high savings rate and open structure, so manipulating interest rates to influence consumption has limited impact on aggregate demand. Second, investment is often driven by foreign direct investment, which tends to be relatively interest-inelastic; many multinational corporations investing in Singapore are backed by large parent companies that raise capital from global markets, so they are not highly sensitive to local interest rates. Third, Singapore has an open capital account, so funds move freely across borders. A change in domestic interest rates could trigger large and volatile capital flows; a rate rise could attract speculative hot money, sharply appreciating the SGD, while a rate cut could prompt capital flight and sharp depreciation. These fluctuations are destabilising for a small, trade-dependent economy. Using interest rates as the primary tool may therefore be both ineffective and a source of financial and external volatility.
Why Singapore uses exchange rate-based monetary policy
Instead of manipulating interest rates, MAS conducts monetary policy by managing the exchange rate of the SGD against a trade-weighted basket of currencies of its major trading partners, an approach better suited to Singapore's context. Singapore is one of the most open economies in the world, with exports and imports collectively exceeding 300% of GDP, and it imports nearly all of its food, energy and raw materials. As a result, inflation is often heavily influenced by external price developments, particularly imported inflation.
Controlling the exchange rate is an effective way to influence inflation. When MAS allows the SGD to appreciate, imported goods become cheaper, as a stronger SGD lowers the local currency cost of foreign goods such as food, manufactured goods and fuel, dampening imported inflation. Production costs fall, as raw materials and intermediate inputs become cheaper in SGD terms, shifting the short-run aggregate supply curve rightward, lowering the general price level and easing cost-push inflation. Export competitiveness declines, as a stronger SGD makes exports more expensive in foreign currency terms, reducing net exports and aggregate demand and so addressing demand-pull inflation. By adjusting the slope of the SGD appreciation path, MAS can fine-tune the degree of tightening or easing without triggering large swings in interest rates or speculative capital flows.
Conclusion
Singapore's choice is also guided by the impossible trinity, or policy trilemma, in international macroeconomics, which holds that a country cannot simultaneously have free capital mobility, a fixed exchange rate and an independent monetary policy; it can choose only two. Singapore has opted for free capital mobility and exchange rate management, and therefore forgoes the use of interest rates as a monetary policy tool. This choice is rational given the country's high exposure to global trade and capital flows, since exchange rate stability and inflation control are paramount for maintaining investor confidence and preserving households' purchasing power.