2022 H2 Economics Paper 2 Essay 5: Suggested Answers

A low and stable inflation rate is a key macroeconomic objective. In many economies, monetary policy centred on interest rates is the main tool for controlling inflation. In Singapore, the Monetary Authority of Singapore (MAS) instead uses an exchange rate based monetary policy. The difference arises from the structure of Singapore's small and open economy and the constraints of the monetary policy trilemma.

Interest rate policy in other countries. When inflationary pressures rise, a central bank can raise the policy interest rate. Higher interest rates make borrowing more expensive and raise the return on saving, so consumption and investment fall and aggregate demand falls. On an AD-AS diagram the AD curve shifts leftward from AD0 to AD1, lowering the general price level from P0 to P1, which reduces demand-pull inflation. Higher rates can also ease cost-push inflation indirectly, and tend to cause the currency to appreciate as foreign investors seek higher returns, which lowers import prices and further eases inflation. In economies such as the United States or the United Kingdom, where domestic demand and credit drive inflation, this channel works well.

Why interest rate policy is unsuitable for Singapore. First, domestic demand is a relatively small part of total expenditure, and Singapore has a high marginal propensity to import, so income and consumption leak out through imports and the multiplier is weak; interest rate changes therefore have a weak effect on aggregate demand. Second, private investment is driven largely by foreign direct investment attracted by stability, skills and location rather than by the cost of credit, so the link from interest rates to investment is weak. Third, and most importantly, the monetary policy trilemma means an economy cannot simultaneously have free capital mobility, an independent monetary policy and a managed exchange rate. Singapore chooses free capital mobility and a managed exchange rate, using the Singapore dollar nominal effective exchange rate as its instrument, so it gives up independent control of interest rates. Trying to set rates independently would trigger destabilising flows of hot money and excessive currency movements, which for an economy where trade far exceeds GDP would be more damaging than the inflation it sought to control.