A Level Econs Model Essay: Macroeconomic Aims, Issues And Policies

March6, 2018
by admin

Examine the impact of a weakening currency on a country’s economic performance.

  • For greater relevance, the response to this answer considered recent economic conditions (i.e. from 2008-2012). We continue to discuss the case of a weakening exchange rate, although we argue towards the end of the essay that the Sing dollar had in fact been gaining strength in recent times. Recent macroeconomic problems may or may not be attributed to changes in the value of the exchange rate.

In recent years, Singapore had to tackle the twin threats of inflation and a global economic slowdown. The root causes of such problems are largely external in nature and cannot be attributed to a weakening of the Sing dollar. However, a weakening of the Sing dollar to boost economic growth may aggravate imported inflation in the country. Furthermore, recent quantitative easing efforts in US have led to pressure on the Sing dollar to appreciate, which may create other macroeconomic problems as well.

Due to the lingering effects of the US financial crisis and the onset of the Eurozone debt crisis, global incomes have been falling. This has resulted in falling purchasing power which triggers a fall in demand for Singapore exports, assuming that the country exports normal goods. The fall in net exports (X-M) from Singapore’s perspective leads to a fall in aggregate demand (AD) and a multiplied fall in national income through the reverse multiplier process. The fall in AD is aggravated by a fall in foreign direct investments since Western investors may need to preserve capital to tackle financial problems in their home countries.

As shown in Fig.1 below, a fall in AD from AD1 to AD2 leads to a multiplied fall in real GDP from Y1 to Y2. Given that demand for labour is derived from the demand for goods and services which the hired labour is used to produce, the decrease in actual growth also leads to a rise in cyclical unemployment (demand-deficient unemployment). In addition, potential growth may slow down with lower levels of FDI entering the country.

Fig.1: Impact of a fall in (X-M) and FDI

Notwithstanding the small size of Singapore’s multiplier, the fall in external demand is likely to hit Singapore especially hard, given that domestic demand is small and the country is largely reliant on exports for growth. In addition, Singapore’s balance of payments (BOP) will be adversely affected by the global slowdown. The BOP refers to the record of transactions between a country and the rest of the world over a period of time, and consists mainly of the current account and the capital account. A fall in net exports leads to a deterioration in the current account while a slowdown in FDI worsens the capital account.

While the above macroeconomic problems are due to external circumstances and are not triggered by exchange rate changes, a weakening of the exchange rate can in fact alleviate these macroeconomic problems. While Singapore generally focuses on maintaining a strong currency to mitigate imported inflation, during times of severe recessions, the central bank may maintain a zero-appreciation stance or depreciate the exchange rate slightly to boost net exports. For example, in the wake of the US financial crisis in early 2009, the MAS allowed a depreciation of the currency by about 2% in order to prop up external demand. By depreciating Singapore’s exchange rate, the price of Singapore’s exports in foreign currency will be relatively cheaper while the price of imports will be relatively higher in domestic currency. Assuming Marshall Lerner’s condition holds, where |PEDX+PEDM|>1, net exports (X-M) rises. This results in a significant increase in AD which results in an improvement in actual growth and a reduction in cyclical unemployment.

Fig.2: Depreciation of exchange rate to stimulate AD

As shown in Fig.2, an increase in net exports will lead to an increase in AD from AD1 to AD2. There is also a multiplied increase in national income from Y1 to Y2, signifying actual growth. Given that demand for labour is derived from the demand for goods and services which the hired labour is used to produce, the increase in real output within the economy also leads to a fall in cyclical unemployment. In addition, the BOP position will also improve (through the current account) with a rise in net exports.

However, there is still a limit to which the central bank can rely on a weak currency to stimulate AD without triggering other macroeconomic problems. With a weaker currency, the price of imported raw materials and finished products will increase in local currency. This can lead to lead to imported inflation, which is a form of cost-push inflation which occurs when the cost of production rises in the economy, independent of aggregate demand (AD). Coupled with instability in the Middle East in recent years which has disrupted the global supply of oil, significant inflationary pressures will be generated in Singapore. The rising cost of production can in turn lower export price competitiveness and offset any gains in export sales due to a weaker currency.

Fig.3: Imported inflation

Diagrammatically, this is represented in Fig.3 as an upward shift in aggregate supply (AS) from AS1 to AS2. Given an unchanged level of aggregate demand, firms will raise prices in line with an increase in production costs, leading to a rise in general price level (GPL) from P1 to P2.

Nonetheless, in recent years, the general price level in Singapore has been driven up by a number of domestic pockets of inflation, which are not related to the strength of the Sing dollar. For example, accommodation prices have spiked recently in Singapore due to a combination of factors. First, the low interest rate environment in Singapore has encouraged consumers to borrow to invest in housing. In addition, quantitative easing measures in US have resulted in flows of hot money into Singapore. Some of these funds are directed into property investments, fuelling higher housing prices. Aside from accommodation costs, private transport cost in Singapore has also been rising largely due to the increase in Certificate of Entitlement (COE) premiums as a result of the lower supply of new COE quotas. This is reflective of the government’s efforts to reduce car ownership and tackle congestion on Singapore’s roads.

Separately, instead of depreciating, the Sing dollar has been gaining strength in recent years, which has created other macroeconomic problems. This is a result of hot money inflows arising from quantitative easing measures being undertaken in US. Given the rate at which money supply is increased in the US (US$85bn per month), hot money has been flowing into Singapore in search of better returns. Some of this hot money is directed into property investments while others may flow into the equity market. Aside from causing asset price inflation as discussed earlier, the inflow of hot money results in higher demand for Sing dollar and may result in an appreciation of the currency.

An appreciation of the Sing dollar may then result in a contractionary effect on the Singapore economy. This is because with an appreciation of the currency, the price of exports increases in foreign currency while the price of imports decreases in local currency. This leads to a fall in the quantity demanded of exports and a rise in the quantity demanded of imports. Assuming the Marshall Lerner condition, net export earnings (X-M) fall overall. This leads to a multiplied decrease in national income, which reduces actual growth and increases cyclical unemployment. As mentioned earlier, the effects on the Singapore economy will be significant given its reliance on exports for growth.

In conclusion, the recent macroeconomic problems faced by Singapore are not a direct result of the weaker Sing dollar. However, it is undeniable that efforts to slow down the appreciation of the Sing dollar or the slight depreciation undertaken in 2009 in order to boost net exports have contributed to higher imported inflation in Singapore. In addition, the recent appreciation of the Sing dollar arising from quantitative easing in the US has also contributed to other macroeconomic problems for Singapore. Nonetheless, we note that any movement in the value of the Sing dollar is likely to be controlled. This is because Singapore maintains a managed float exchange rate system, where the Sing dollar is managed against a trade-weighted basket of currencies of Singapore’s major trading partners, and is allowed to float freely within a policy band. Hence, if the Sing dollar exceeds the upper or lower bound of the policy band, MAS will intervene by buying or selling foreign currency to influence the value of Sing dollar. This ensures that the value of the Sing dollar remains within the policy band, and any impact on export price-competitiveness or import prices will be limited.

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