How Interest Rates and Partner Incomes Affect a Managed-Float Currency

Question

The Monetary Authority of Singapore (MAS) operates a managed float exchange rate system, whereby the trade-weighted Singapore dollar (SGD) is allowed to fluctuate within a policy band.

(a) Explain how a currency in a managed float can be affected by rising global interest rates and rising incomes of its trading partners. [10]

Answer

Under a managed float, the exchange rate is set by demand for and supply of the currency in the foreign-exchange market, but the central bank allows it to move only within a policy band, intervening if it threatens to leave the band. Rising global interest rates and rising partner incomes act on opposite sides of that market.

Rising global interest rates depreciate the currency. If interest rates abroad rise while the domestic rate is unchanged, the expected return on foreign investments rises relative to domestic ones. Investors holding short-term capital domestically move it abroad to capture the higher yield — a net outflow of “hot money”. To invest abroad they must sell the domestic currency, so the supply of the domestic currency in the forex market rises. With demand unchanged, the price of the domestic currency in terms of foreign currency falls — the currency depreciates.

Forex market for SGD — interest-rate channel: hot-money outflow shifts the supply of SGD right from S₀ to S₁, lowering the exchange rate (price of SGD in USD) from e₀ to e₁ — a depreciation.

Rising incomes of trading partners appreciate the currency. When partners’ incomes and purchasing power rise, their demand for the domestic country’s exports rises. To pay for those exports — assuming export prices in domestic currency are unchanged — foreign buyers must first acquire the domestic currency, so the demand for the domestic currency rises. With supply unchanged, the price of the domestic currency rises — the currency appreciates.

Forex market for SGD — income channel: stronger foreign export demand shifts demand for SGD right from D₀ to D₁, raising the exchange rate from e₀ to e₁ — an appreciation.

The overall effect, and the managed-float constraint. Since the two forces push in opposite directions, the net movement depends on their relative magnitudes: if the rise in partner incomes dominates the rise in global interest rates, the currency appreciates on balance, and vice versa. Crucially, the managed float caps the outcome. So long as the resulting fluctuation stays within the central bank’s policy band, the bank does not intervene. If the currency threatens to move beyond the band, the bank intervenes in the forex market — buying back its own currency to arrest a depreciation, or selling it to arrest an appreciation — to return the rate to the permitted range.