Factors MAS Considers in Appreciating the SGD, and the Effects on National Income

Question

The Monetary Authority of Singapore (MAS) manages the Singapore dollar against a basket of currencies within a policy band, allowing it to appreciate, hold steady or depreciate to achieve its objectives.

(a) Explain the factors that the Monetary Authority of Singapore should consider when deciding whether to appreciate the Singapore dollar. [10]

(b) Discuss the likely effects on Singapore’s national income and its components when its exchange rate appreciates. [15]

Answer

Part (a)

MAS operates an exchange-rate-centred monetary policy, managing the trade-weighted Singapore dollar — its nominal effective exchange rate (NEER) — within a policy band, with a stance of gradual and modest appreciation aimed at price stability as the foundation for sustained growth. In deciding whether to appreciate, MAS should weigh the expected benefits, the expected costs, the constraints it faces, and the possible unintended consequences.

Expected benefits — controlling imported and demand-pull inflation. Singapore imports almost all of its raw materials and necessities, so a stronger SGD lowers the domestic-currency price of imports: fewer SGD are needed to buy a given quantity of foreign currency, so import prices fall, lowering firms’ costs and raising short-run aggregate supply — this curbs imported (cost-push) inflation. An appreciation also tempers demand-pull inflation: dearer exports in foreign currency reduce export demand, and cheaper imports lead consumers, firms and the government to substitute towards foreign goods, so $C$, $I$, $G$ and $X$ fall and aggregate demand eases. Lower and stable inflation underpins consumer and business confidence and is the basis for sustained growth, which is MAS’s primary aim.

Expected costs and constraints — foreign reserves. Holding the SGD on an appreciating path may require MAS to buy SGD in the foreign-exchange market, which depletes its foreign reserves. The policy is therefore constrained by the size of those reserves: MAS can only sustain an appreciation it can defend. Singapore’s persistent balance-of-payments surpluses have built a large reserve buffer, so this constraint is rarely binding; and where the appreciation reflects underlying market forces rather than a forced move, MAS need not intervene heavily at all.

Unintended consequences — competitiveness and growth. A stronger SGD makes exports dearer in foreign currency, which can worsen the balance of trade and slow export-led growth. MAS must weigh the inflation benefit against this competitiveness cost, which is why the appreciation is kept gradual and modest rather than sharp.

Part (b)

The likely effect of an appreciation is a fall in national income, working through the demand components and amplified — modestly — by the multiplier; but the extent of that fall is limited. My thesis is that while an appreciation does lower national income on balance, the effect is small for an economy with Singapore’s structure.

The appreciation lowers the components of AD. A stronger SGD makes exports more expensive in foreign currency, so export revenue ($X$) falls where export demand is price-elastic. It makes imports cheaper in SGD, so domestic agents substitute towards imports: consumption of locally produced goods ($C$), domestic investment ($I$) and government purchases of local goods ($G$) all fall as expenditure switches abroad. (Imports themselves are not part of GDP, so the fall in AD comes through the fall in $C$, $I$, $G$ and $X$ on domestically produced output, not through imports directly.)

The multiplier amplifies the fall. The fall in these components lowers aggregate demand; through the multiplier, the reduction in income causes a further round of reduced induced consumption, so national income falls by a multiple of the initial drop, each round smaller than the last.

Evaluation — the fall is limited. The export contraction is unlikely to be large: dearer exports in foreign currency are partly offset by cheaper imported raw materials lowering production costs, and Singapore’s exports are largely high-quality and differentiated, so quantity demanded falls little when price rises (price-inelastic export demand). The fall in $C$, $I$ and $G$ depends on the substitutability between imports and domestic goods; because Singapore imports almost all of its raw materials and necessities, for which there are few or no domestic substitutes, the appreciation leads agents to buy more imports without much reduction in demand for the (limited) domestic alternatives. Finally, Singapore’s multiplier is small — large import leakages and high CPF saving mean each round of re-spending is heavily damped — so the amplification is weak.

Judgement. An appreciation does, on balance, lower national income by reducing export revenue and switching domestic expenditure towards imports, and the multiplier compounds the effect. But the extent is small for Singapore: export demand is price-inelastic, domestic substitutes for imports are scarce, the appreciation MAS engineers is deliberately gradual and modest, and the multiplier is small. The output cost is therefore a manageable price for the inflation control the appreciation delivers — which is exactly why MAS judges the trade-off worth making in its pursuit of price stability as the basis for sustained growth.