(2023) A Level H2 Econs Essay Q4 Suggested Answer by Mr Eugene Toh (A Level Economics Tutor)
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4a.
How appreciation may affect aggregate demand
An appreciation of a country's exchange rate can have significant effects on its aggregate demand (AD). When the domestic currency strengthens, it becomes cheaper to import goods, as fewer units of the domestic currency are needed to buy the same amount of foreign currency. This makes imported goods more affordable for local consumers, likely leading to an increase in import expenditure. Simultaneously, the country's exports become more expensive for foreign buyers, as they now need more of their currency to purchase the same amount of domestic currency. This price increase can reduce the global demand for the country's exports.
Aggregate demand, represented by the equation AD = C + I + G + (X - M), where C is consumption, I is investment, G is government spending, and (X - M) is net exports (exports minus imports), can be affected by these changes. Typically, an appreciation in the exchange rate leads to a decrease in net exports (X - M), as exports (X) decrease and imports (M) increase, which in turn leads to a fall in aggregate demand.
However, the impact on AD may vary for countries that are major exporters of goods with price inelastic demand, such as oil. In these cases, even though the price of exports rises due to the appreciation, the quantity demanded might fall less than proportionately due to the inelastic nature of the demand. This could lead to an increase in export revenue. If this increase in export revenue outweighs the increase in import expenditure, there may be an overall increase in net exports (X - M), potentially leading to an increase in aggregate demand.
How appreciation may affect aggregate supply
An appreciation of the exchange rate can have an impact on a country's short-run aggregate supply (SRAS), particularly in economies that rely heavily on imported inputs for production. When the domestic currency appreciates, it gains strength relative to other currencies, making it less expensive to purchase the same amount of foreign currency. This change directly affects the cost of imported goods, including raw materials and intermediate goods used in production processes.
For countries like Singapore, which depend significantly on imports for their production inputs, an appreciation in the exchange rate can lead to a decrease in the cost of these imported inputs. As the costs of raw materials and components from abroad become cheaper due to the stronger domestic currency, producers face lower production costs.
The decrease in production costs due to a stronger currency results in an increase and thus rightward shift of the short-run aggregate supply curve.
4b.
Introduction + why interest rates is not an appropriate policy
Singapore is a small, open economy with a high degree of reliance on international trade. Its trade volume (sum of exports and imports) significantly exceeds its Gross Domestic Product (GDP), indicating the economy's deep integration into global markets. In such an environment, domestic interest rate adjustments are less effective as a policy tool due to the openness of the capital account and the high degree of capital mobility. Changes in domestic interest rates would quickly lead to cross-border capital flows, which could destabilize the financial system and have limited impact on domestic economic conditions.
Why exchange rates is an appropriate policy
To mitigate the impacts of both imported and cost-push inflation, the Monetary Authority of Singapore (MAS) can implement a policy of modest and gradual appreciation of the Singapore Dollar (SGD). In situations where this approach is already in place, MAS can intensify its efforts by increasing the slope of the policy bands or re-centering the policy bands upwards. These measures effectively guide the SGD to appreciate against other currencies.
A stronger SGD plays a dual role in curbing inflation
Reducing Imported Inflation: As the SGD appreciates, the cost of imported goods decreases. This is because fewer SGD are needed to purchase the same amount of foreign goods or currency. This reduction in the cost of imports directly mitigates the impact of imported inflation on the domestic economy.
Lowering Cost of Production (COP): Many businesses in Singapore rely on imported inputs for production. An appreciation of the SGD makes these inputs cheaper, leading to a fall in the cost of production. This decrease in production costs can shift the short-run aggregate supply (SRAS) curve to the right, indicating an increased supply of goods and services at each price level. The rightward shift of the SRAS curve can lead to a reduction in general price levels, thereby alleviating cost-push inflation.
However, this strategy is not without its downsides. A key consideration is the impact on Singapore's exports. As the SGD strengthens, Singaporean goods and services become more expensive for foreign buyers. This can lead to a decrease in demand for exports, potentially affecting the country's export-driven economic growth. This trade-off highlights the delicate balance MAS must maintain in using exchange rate management to control inflation while ensuring the competitiveness of Singapore's export sector.
Supply-side policies
In addition to managing the exchange rate, Singapore can adopt other strategies to control inflation, particularly in the context of imported goods and food items. One such strategy is diversifying import sources and establishing its own sources of production.
To mitigate the impact of imported inflation, Singapore can diversify its import sources. This approach becomes particularly relevant in situations like the recent Malaysian ban on chicken exports due to increased production costs. Singapore, heavily reliant on Malaysia for its supply of fresh chicken, experienced an increase in chicken prices as a result of this ban. By diversifying import sources and procuring goods from countries like Australia, Indonesia, and Thailand, Singapore can reduce the likelihood of supply shocks from a single source country substantially impacting local prices.
This strategy spreads the risk and ensures a more stable supply, as disruptions in one country can be offset by imports from others. However, it is important to note the limitations of this approach. If the supply shock is a global phenomenon, affecting multiple source countries simultaneously, diversification alone may not be sufficient to shield Singapore from inflationary pressures.
Another approach is for Singapore to boost its own production capabilities. For instance, the "30 by 30" plan aims to produce 30% of Singapore's nutritional needs locally by 2030. This initiative is geared towards increasing Singapore's resilience to global supply shocks and reducing dependence on imports. By enhancing local production, Singapore can buffer itself against external price volatilities and have greater control over its food supply chain.
However, there are constraints to this approach. Given Singapore's limited land space and high urban density, expanding local food production poses significant challenges. Innovative solutions, such as vertical farming and high-tech agriculture, are being explored, but these come with their own set of limitations and costs.
Note: Other supply-side policies can be brought in as well (e.g. subsidies to increase productivity / adopt use of technology to bring down production costs)
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