Monetary policy (Exchange rate policy)

Explain the use  of  exchange rate to achieve EG (sustained EG)

Use depreciation of the exchange rate

Depreciation makes the price of exports relatively cheaper in foreign currency and price of imports relatively more expensive in the domestic currency. Assuming Marshall-Lerner condition, where PEDx + PEDm >1, a fall in price of exports lead to a more than proportionate rise in quantity demanded for exports, and a rise in price of imports lead to a more than proportionate fall in quantity demanded for imports. There is a rise in export revenue and a fall in import expenditure respectively. This leads to a rise in net exports (X-M).  The increase in C and I will lead to an increase in aggregate demand in the economy. This leads to a multiplied increase in real GDP. (Explain the short multiplier process).  An injection or autonomous increase in expenditure will generate income for individuals employed by firms in the capital goods industry. These individuals will spend a proportion of the additional income on consumption, depending on their marginal propensity to consume (MPC). This spending further creates income for individuals employed in the consumer goods industry who will further spend their additional income on consumption. This cycle of spending and re-spending on consumption will continue. The eventual increase in the real national income is several times the initial increase in expenditure. Actual Growth rises in the short run. The rise in investment increases the capital accumulation / capital stock of the economy, and the productive capacity rises leading to rise in LRAS; potential growth in the long run. This helps the Singapore economy to get out of the recession. (If question asks how fiscal policy raises standard of living, have to add in material and non material standard of living here)

As domestic production rises, more jobs are created. Demand for labour  rises since demand for labour is a derived demand. More workers are employed, hence reducing cyclical unemployment.

OR

(pg 57) When the S$ depreciates, goods and services produced in Singapore will be more competitively priced in world markets in the short term. Price of Singapore exports (in foreign currency) falls. The amount of Singapore goods and services exported to the rest of the world increases. At the same time, imports will become more expensive. Price of Singapore imports (in S$) increases. The amount of goods and services imported into Singapore falls. As a result of the relatively more expensive imported goods and services, Singapore households and firms will switch to relatively cheaper domestically produced goods and services. 

As seen from above, a depreciation of the S$ results in an increase in the amount of Singapore exports and a decrease in the amount of Singapore imports. This results in an increase in the amount of net exports which contributes to an increase in Singapore’s AD in the short run, causing AD curve to shift to the right in Figure 10. 

This leads to a multiplied increase in real GDP. (Explain the short multiplier process).  An injection or autonomous increase in expenditure will generate income for individuals employed by firms in the capital goods industry. These individuals will spend a proportion of the additional income on consumption, depending on their marginal propensity to consume (MPC). This spending further creates income for individuals employed in the consumer goods industry who will further spend their additional income on consumption. This cycle of spending and re-spending on consumption will continue. The eventual increase in the real national income is several times the initial increase in expenditure. Actual Growth rises in the short run. The rise in investment increases the capital accumulation / capital stock of the economy, and the productive capacity rises leading to rise in LRAS; potential growth in the long run. This helps the Singapore economy to get out of the recession. (If question asks how fiscal policy raises standard of living, have to add in material and non material standard of living here)

As domestic production rises, more jobs are created. Demand for labour  rises since demand for labour is a derived demand. More workers are employed, hence reducing cyclical unemployment.

[DRAW DIAGRAM]

At the same time, the costs of production increases due to the higher prices of imported raw materials used by Singapore firms. As such, the aggregate supply curve will fall from AS0 to AS1. This dampens the increase in real national income (arising from the increase in aggregate demand) from Y1 to Y2.

The overall effects of a depreciation of the Singapore dollar are a ‘dampened’ increase in real national output (Y0 to Y2), lower unemployment, and a higher general price level (P0 to P1).

Explain the limitation/evaluation of exchange rate policy

Evaluation:

1. Time Lag

It will take some time before any macroeconomic problem is fully recognised (recognition

lag) and for the Central Bank to implement the appropriate exchange rate policy

(implementation lag). In addition, it can take a fairly long time for the policy action to affect

the economy (impact lag).

However, as in the case of monetary policy using the interest rate, the implementation

lag for exchange rate monetary policy is a lot shorter compared to fiscal policy for reasons

explained earlier.

Because of the time lags in exchange rate policy, MAS has to formulate and conducts

the exchange rate policy in a forward-looking manner. This is accomplished by

evaluating the impact of the policy over the medium term based on reasonable

assumptions of economic outlook and possible negative shocks.

2. Imperfect Information

Despite the best effort of the national account statisticians, the central bank does not have up-to-the-minute information about the state of the economy. Latest economic data is limited by the time taken to collect and compile this information.

Secondly, the Central Bank does not have perfect knowledge of how the economy works. This includes its multitude of linkages, causes and effects. Constant changes in the conditions of domestic and international economies compound the problem of imperfect information.

Lastly, predictions of the future are always fraught with difficulties due to the lack of information and uncertainties associated with the future. The need for exchange rate policy to be formulated in a forward looking manner (see previous Section, ‘b. Time Lag’) compounds the difficulties of planning and implementing exchange rate policy.

What are the strengths and weakness of monetary policy?

Strengths of monetary policy (note: expansionary montery policy aka loose/easy monetary policy. Contractionary monetary policy aka tight monetary policy)

1. Relatively quick implementation. Monetary

policy  can be implemented more quickly than

fiscal policy  because it does not have to go through the political process, which  is very 

cumbersome and time consuming, though monetary policy is subject to some time lags, central banks can react swiftly to economic changes by adjusting interest rates, which directly affects borrowing costs and investment. This is due to central bank independence, which means the

central bank can take decisions that are in the best

longer term interests of the economy, and therefore

exercises greater freedom in pursuing policies

that may be politically unpopular such as higher

interest rates making borrowing more costly.

2. No political constraints. Even if a central bank

is not independent of the government, monetary

policy is still not subject to the same kinds of

political pressures as fiscal policy, since it does not

involve making changes in the government budget,

whether in terms of government spending that

would affect merit and public goods provision, or

government revenues (taxes).

3. Ability to adjust interest rates incrementally

(in small steps). Interest rates can be adjusted

in very small steps, making monetary policy

better suited to ‘fine tuning’ of the economy in

comparison with fiscal policy. However, it should

be stressed that it is also subject to limitations, and

that there is in fact no policy tool that economists

can use to fully ‘fine tune’ an economy.

Whereas fiscal policy can lead the economy in a general

direction of larger or smaller aggregate demand,

it cannot ‘fine tune’ the economy; it cannot be

used to reach a precise target with respect to the

level of output, employment and the price level. If

fiscal policy were successful, it would be possible

to use it to keep the economy’s real GDP at or

very close to its potential output level. However,

experience has shown that this cannot be done,

as there are many factors affecting aggregate

demand simultaneously that the government

cannot control.

Weaknesses of monetary policy

1. Time lags. Unlike fiscal policy, monetary policy can

be implemented and changed according to perceived

needs relatively quickly, because it does not depend

on the political process. However, like fiscal policy,

it remains subject to time lags (delays), including a

lag until the problem is recognised, and a lag until

the policy takes effect. Changes in interest rates can

take several months to have an impact on aggregate

demand, real output and the price level. By then,

economic conditions may have changed so that the

policy undertaken is no longer appropriate.

2. Possible ineffectiveness in recession. Whereas

monetary policy can work effectively when it

restricts the money supply to fight inflation, it is

less certain to be as effective in a deep recession.

Expansionary monetary policy is intended to

increase aggregate demand by encouraging

investment and consumption spending through

lower interest rates. This process presupposes that

banks will be willing to increase their lending to

firms and consumers, and that firms and consumers

will be willing to increase their borrowing and their

spending. However, in a severe recession, banks may

be unwilling to increase their lending, because they

may fear that the borrowers might be unable to repay

the loans. If firms and consumers are pessimistic

about future economic conditions, they may avoid

taking out new loans, and may even reduce their

investment and consumer spending, in which case

aggregate demand will not increase (it may even

decrease), and monetary policy will be unable to pull

the economy out of recession. This is not something

that happens often; however, it appears to have

occurred during the Great Depression of the 1930s,

in Japan in the late 1990s and early 2000s, and in the

global recession that began in the autumn of 2008.

3. Inability to deal with stagflation. Monetary

policy is a demand-side policy, and is therefore

unable to deal effectively with supply-side causes of

instability, just like fiscal policy.

FP has an inability to deal  with supply-side causes of instability. If instability is caused by supply- side factors, leading to stagflation, where there is falling real GDP and inflation simultaneously (see page 281), fiscal policy  is unable to deal with it effectively.  Inflation requires a contractionary policy,  while  the recession requires an expansionary policy.  A contractionary policy  could  address the problem  of inflation, but would  make the recession worse; an expansionary  policy could help get the economy out of recession, but would  worsen the problem of inflation.

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