Suggested Answers of BT2 Revision Package - ASKnLearn

(16) 2011 MI Prelim H2 Paper Q4The Monetary Authority of Singapore revalued the currency in April 2010 and said inOctober 2010 it would steepen and widen the currency’s trading band while seeking amodest and gradual appreciation.(a) Explain Singapore’s choice of using exchange rates rather than interest rates as aninstrument for its monetary policy. [10](b) Assess the impact of the revaluation and the changes made to the currency’s tradingband on the Singapore economy. [15]Suggested Answer Scheme:(a) Explain Singapore’s choice of using exchange rates rather than interest ratesas an instrument for its monetary policy. [10]Exchange rate measures the price of domestic currency in terms of another foreign currencywhereas interest rate is the cost of loans or borrowing.Changes in exchange rate can be used as an instrument for monetary policy by altering theprice of exports and imports and hence, causing changes in export revenue and importexpenditure to influence economic growth and unemployment.However, interest rate can be used as an instrument for monetary by changing the cost ofborrowing. For instance, an increase in interest rate can increase the cost of borrowing andin turn, cause returns from investment to decrease and hence, lower investment. This in turninfluences AD to affect economic growth and employment.However, interest rate is ineffective as a choice of monetary policy.Singapore’s small and open economy results in a lack of monetary control and hence,interest rates would be volatile. Singapore’s vulnerable to capital flows is due to Singapore’sposition as an international financial centre. This can result in an inflow of ST capital whichwould negate any increase in interest rates and push interest rates down. Hence, interestrates would not be a useful instrument for its monetary policy in Singapore due to itsopenness to capital flows.Singapore’s GDP is mainly contributed by export growth. Hence, keeping exchange ratescompetitive in the short term would reduce price of exports and assuming Ex +Em >1 i.e.Marshall Lerner condition holds, this would result in an intended increase in AD i.e.