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To what extent is the policy of gradual appreciation of the Singapore Dollar always a desirable approach to maintain economic stability in Singapore?

When an economy seeks to achieve economic stability, the government strives to achieve low inflation rate and unemployment rate to ensure that the economy is able to attain sustainable economic growth. In Singapore, it is observed that the exchange rate management policy is most useful in attaining these aims, given the context of her economy being small and open. However, it is imperative to acknowledge the limitations and disadvantages of this policy.

Main Body

1) Explain how attaining price stability and low unemployment rate will allow Singapore to achieve sustainable and stable growth rate

In striving to attain price stability, the Singapore government seeks to attain low inflation rate which can be measured by the consumer price index on a year-on-year basis or base year comparison approach. To do so, the government is trying to maintain low cost of living and cost of production to sustain the livelihood for the workers and maintain her external competitiveness. As for low unemployment rate which is measured by the ratio of the unemployed workers to the total working population, it will enable the economy to have higher level of production and thus, raise the rate of utilization of resources. In achieving these two aims, the economy of Singapore will be able to attain economic growth at a sustainable and stable growth rate when real Gross Domestic Product (GDP) grows without experiencing inflationary condition.

2) Explain how the Singapore government uses exchange rate system to achieve to achieve low inflation

To achieve these aims, the government adjusts its managed-float exchange rate system which is based on a trade-weighted effective rate to focus on the strategy of gradual and most appreciation of the exchange rate. To do so, the exchange rate system is managed to fluctuate within a lower and upper range and based on a basket of currency to avoid excessive fluctuation while it is gradually appreciated over the economic periods so as to influences, the external economic activities of trade and investment. The Singapore government achieves this through direct intervention into the foreign exchange market by buying Sing dollar with the selling of foreign currency like US dollars to sustain the sing dollars at a higher rate when there is pressure for it to depreciate due to changes in the demand and supply of Sing dollars due to market activities.

3) Explain how exchange rate policy can benefit Singapore

Through this strategy of gradual and modest appreciation of Sing dollar, the government is able to keep imported inflation at bay as the price of imported good in foreign value is kept low for Singapore. This will help Singapore in maintaining a lower cost of production as most of her resources are imported. The cost of living is kept low too since most of our daily necessities and consumer durables are imported and this will help to prevent wage increment as the real purchasing power of the workers is kept low due to lower cost of living. Furthermore, a strong and stable exchange rate will enable Singapore to keep the wage cost of foreign workers low as the real earnings in their foreign value will be higher and this will lower the cost of production, ensuring our poll of supply of foreign workers are available and kept at a low cost of production to raise potential growth.

4) Explain how the use of exchange rate system may also be able to achieve low unemployment by the other complementary measures the government has adopted

As for low unemployment rate, Singapore needs to focus on maintaining strong export demand and inflow of Foreign Direct Investment (FDI) as her production and employment level depends on external demand given that export demand is 2.5 times of GDP while the main source of investment is from FDIs. Although a strong exchange rate may undermine our international competitiveness and thus, lower the export demand and inflow of FDI, this adverse effect can be avoided as Singapore focuses more on high-valued production, implying that our export demand is price-inelastic which enable Singapore to gain a higher export revenue despite having higher price of exported goods in foreign value as a result of the strong exchange rate. Besides, the lower cost of imports and domestic cost of production attained through our stable and strong exchange rate policy will help to prevent price of exported goods in foreign value from rising excessively.

This export sustainability will enable Singapore to continue to attract FDIs since its export capacity is sustained or raised as Multinational Corporations (MNCs) base their decision on the flow of FDIs and how Singapore can export since the MNCs are not depending on the small local market for demand. This explains why the appreciation of the Sing dollar may not be a strong deterrence in undermining the inflow of FDIs into Singapore Therefore, as long as Singapore is able to create itself as a more attractive investment centre for MNCs with her intellectual property laws, efficient infrastructure and availability of skilled labors, Singapore’s inflow of FDI will not be minimized despite a strong and stable exchange rate.

5) Explain, with aid of a diagram, how the use of exchange rate system can allow Singapore to achieve sustainable growth

Given our capacity to attain greater production and low cost condition through the managed-float exchange management policy, Singapore will be able to achieve economic stability as there will be sustainable economic growth where real GDP will increase without sustaining a rise in price level.

Economics Tuition - International Trade, Globalization, Foreign Exchange and Balance of Payment - Q8 - Sustainable Economic Growth Diagram

As seen from the diagram, the expansion of resources due to higher degree of import will cause the LRAS to shift outwards from LRAS0 to LRAS1, which will enable the real GDP to increase from Y0 to Y1 while price level is kept at P2 which is equal to P0.

6) Explain the limitations and disadvantages of exchange rate system in achieving economic stability

Nonetheless, the exchange rate management has limitations and disadvantages which we need to take note as they may undermine the policy from achieving the aim of economic stability. Firstly, the managed-float exchange rate system requires a large pool of foreign reserves which means that fewer funds are available for other aspects of economic development and this may also undermine the wealth of Singapore as we keep the wealth of Singapore in foreign value. Furthermore, the effectiveness of the exchange rate management policy is subjected to the price–elasticity of export demand which is price-elastic and thus, the appreciation of exchange rate will not help Singapore to raise export revenue and may contribute to a fall in export demand that will undermine production and thus, affect employment. As the demand for import is also price-inelastic for Singapore, given our high reliance on imported resources and goods and services as it lacks natural endowment, the import expenditure will be higher and at a higher price due to our price-taking behavior.

It must also be noted that the exchange rate management policy has no direct control of domestic inflation, such as asset-based inflation or cost-push inflation contributed by rising wage cost or structural rigidities. Thus, price stability may not be attainable. Furthermore, our strong stable exchange rate will attract more inflow of hot money which will increase the supply of money in the local money market as the foreign saving will be injected into the local banking system. This will lower the interest rate, lowering the cost of mortgage loan and thus inducing the demand for more housing loan which will raise the price of houses. As stated by the Monetary Authority of Singapore (MAS) core inflation, our inflation rate will rise from 2.9% to 5.2% for 2011 with the inclusion of housing cost.

There is also a limit on how price of imported resources can be suppressed as Singapore is a price-taker in the international resource market. Foreign supplier is likely to raise the price of resources like oil, given that their value of worth of payment for resources in US dollar will be at a lower value. This will mean that Singapore government may have to further raise the appreciation of Sing dollar and thus, there will be greater depletion of foreign reserves available which will undermine our capacity to control exchange rate.

7) Explain the limitations and disadvantages of sustaining low unemployment rate to achieving economic stability

As for the aim of sustaining low unemployment rate, appreciation of exchange rate will contribute to structural unemployment whereby the rate of unemployment is low but can be quite devastating in the impact, given that structural unemployment is prolonged and difficult to eradicate. This happens because there is a need to focus on high-valued industries which demands sectoral adjustment and technological advancement and this will lead to skill incompatibility and displacement of workers due to higher degree of use of capital equipment. Thus, the stability of the economy in term of employment may be compromised.

It is also quite difficult for Singapore economy to focus on high-valued production due to our lack of skilled labour, given the higher degree of education disparity among the working population. This will imply that some industries like service industries’ export demand is price-elastic and subjected to contraction of export revenue when the price of the exported services or goods are raised due to appreciation of the Sing dollar. The failure to raise revenue will contract these industries and may induce unemployment which can undermine our economic stability.

In sum, it is noted that the managed float exchange rate policy, focus on gradual and modest appreciation of Sing dollar is of great significance in helping Singapore to achieve economic stability but its policy is not without criticism, given that there is certain degree of limitations and inappropriate in the implementation.