Q.55 exchange-rate-interest-rates-and-singapore

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Q.55 exchange-rate-interest-rates-and-singapore

  1. 1. (a) Explain how the exchange rate varies with interest rates. [10] (b) Discuss whether a rise in interest rates in Singapore would lead to problems in the economy. [15] (a) The exchange rate of a currency is the rate at which the currency can be exchanged for another currency. Interest is the cost of borrowing and the reward for lending. The relationship between the exchange rate and interest rates can be explained with reference to the size of the economy. In a large economy, the exchange rate usually varies directly with interest rates. When interest rates rise, hot money inflows will increase and hot money outflows will decrease. When this happens, the demand for domestic currency will rise and the supply will fall which will lead to a rise in the exchange rate. In the above diagram, an increase in the demand for domestic currency (D$) from D$0 to D$1 and a decrease in the supply (S$) from S$0 to S$1 leads to a rise in the exchange rate (E) from E0 to E1. Conversely, when interest rates fall, hot money inflows will decrease and hot money outflows will increase which will lead to a decrease in the demand for domestic currency and an increase in the supply resulting in a fall in the exchange rate. The exchange rate sometimes varies inversely with interest rates in a large economy. If people expect the exchange rate to rise, hot money inflows will increase and hot money outflows will decrease. When this happens the demand for domestic currency will rise and the supply will fall which will lead to a rise in the exchange rate. The increase in hot money inflows and the decrease in hot money outflows will also lead to an increase in the supply of loanable funds resulting in a fall in interest rates. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  2. 2. In the above diagram, an increase in the supply of loanable fund (S LF) from SLF0 to SLF1 leads to a fall in the interest rate (r) from r0 to r1. In a small economy, the exchange rate usually varies inversely with interest rates. As an interest rate-taker, interest rates in a small economy usually change due to a change in foreign interest rates. When foreign interest rates rise, interest rates in a small economy will become relatively lower which will lead to a decrease in hot money inflows and an increase in hot money outflows resulting in a decrease in the supply of loanable funds and hence a rise in interest rates. The decrease in hot money inflows and the increase in hot money outflows will also lead to a decrease in the demand for domestic currency and an increase in the supply resulting in a fall in the exchange rate. The exchange rate sometimes varies directly with interest rates in a small economy. Small economies typically operate under the managed float exchange rate system. If the currency of a small economy comes under speculative attack, such as the Singapore dollar in the Asian Financial Crisis, the exchange rate will fall below the policy band in the absence of central bank intervention. If this happens, the central bank may decrease the money supply continually to push up interest rates to increase hot money inflows and decrease hot money outflows which will bring the exchange rate back into the policy band. In conclusion, the exchange rate usually varies directly with interest rates in a large economy. The opposite is true in a small economy. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  3. 3. (b) The question on whether a rise in interest rates in Singapore would lead to problems in the economy can be discussed in terms of the effects on the balance of payments, the national income, unemployment and the general price level. A rise in interest rates in Singapore may lead to a deterioration in the balance of payments. The balance of payments is a record of all the transactions between the residents of the economy and the rest of the world over a time period and is made up of the current account and the capital and financial account. When interest rates in Singapore rise, hot money inflows will increase and hot money outflows will decrease which will lead to an increase in the demand for Singapore dollars and a decrease in the supply of Singapore dollars resulting in a rise in the exchange rate. When the Singapore dollar appreciates, Singapore’s goods and services will become relatively more expensive than foreign goods and services which will lead to a decrease in the net exports of Singapore resulting in a deterioration in the current account and hence the balance of payments, assuming the Marshall-Lerner condition holds. Further, an appreciation of the Singapore dollar will increase the costs of investing in Singapore in foreign currency which will lead to a decrease in inward foreign direct investments resulting in a deterioration in the capital and financial account and hence the balance of payments. When interest rates in Singapore rise, the aggregate demand and hence the national income will fall. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. Higher interest rates in Singapore will increase the incentive to save which will lead to a decrease in the consumption expenditure. Higher interest rates in Singapore will also lead to less profitable planned investments resulting in a decrease in the investment expenditure. The decrease in the consumption expenditure and investment expenditure in Singapore, coupled with the decrease in the net exports and inward foreign direct investments, will lead to a decrease in the aggregate demand and hence the national income. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  4. 4. In the above diagram, a decrease in aggregate demand (AD) from AD0 to AD1 leads to a decrease in national income (Y) from Y0 to Y1. When aggregate demand falls, firms will employ less factor inputs to produce less output and hence pay less factor income to households. Household income and hence consumption expenditure will fall. Due to the decrease in consumption expenditure, firms will employ even less factor inputs to produce even less output and hence pay even less factor income to households. Household income and hence consumption expenditure will fall further. Therefore, the decrease in aggregate demand will lead to a larger decrease in national income and this is commonly known as the reverse multiplier effect. Since national income is equal to national output, the decrease in the national income of Singapore due to the decrease in the aggregate demand will lead to a fall in the demand for labour resulting in a rise in unemployment, assuming the size of the labour force remains the same. The decrease in the aggregate demand in Singapore will lead to a surplus of goods and services and hence a fall in the general price level. In the above diagram, a decrease in aggregate demand (AD) from AD0 to AD1 leads to a fall in the general price level (P) from P0 to P1. When the general price level in Singapore falls, people may expect it to fall further. If this happens, the consumption expenditure in Singapore will fall which will lead to a further decrease in the aggregate demand. A rise in interest rates in Singapore may not lead to problems in the economy. Interest rates in Singapore may rise due to a rise in foreign interest rates. When foreign interest rates rise, interest rates in Singapore will become relatively lower which will lead to a decrease in hot money inflows and an increase in hot money outflows resulting in a decrease in the supply of loanable funds and hence a rise in interest rates. The decrease in hot money inflows and the increase in hot money outflows in Singapore will also lead to a decrease in the demand for Singapore dollars and an increase in the supply of Singapore dollars resulting in a fall in the exchange rate. When this happens, the net exports and inward foreign direct investments in Singapore will rise which will lead to an improvement in the balance of payments, assuming the Marshall-Lerner condition holds. Further, the increase in the net exports of Singapore will lead to an increase in the aggregate demand. In the final analysis, a rise in interest rates in Singapore is unlikely to lead to problems in the economy. Higher interest rates in Singapore will not lead to a significant decrease in the consumption expenditure due to the culture of thrift. Further, higher interest rates in Singapore will not lead to a significant decrease in the investment expenditure as most of the investments are made by foreign firms with foreign sources of funds. As a small and open economy, interest rates in Singapore usually rise due to a rise in foreign interest rates. The resultant depreciation of the Singapore dollar will lead to a large increase in the net exports of Singapore due to the large total trade relative to the national income, which will more than offset the decrease in the consumption expenditure and investment expenditure. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek

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