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EXCHANGE RATE POLICY (To achieve macroeconomic goal (BOP equilibrium (Via…
EXCHANGE RATE POLICY
To achieve macroeconomic goal
Low Inflation
Via revaluation or appreciation
1)
Reduces cost push inflation
a)
Enables price of imports to not rise in terms of local currency when inflation occurs in other countries.
b)
Cost of production decreases
c)
Decrease in SRAS and also in GPL
2)
Reduces demand pull inflation
a)
Fall in price competitiveness of export and rise in demand for imports as imports become relatively cheaper
b)
Net export decreases and a fall in AD results
c)
Fall in demand-pull inflation, assuming that Marshall Lerner condition holds
Limitations
a)
Balance of trade may worsen
b)
Result in a fall in national income
c)
Unemployment level may rise.
Conclusion
If import price push inflation is the main reason for inflation, strengthening the exchange rate and sourcing for alternative imports are the most effective solutions
BOP equilibrium
Via devaluation and depreciation that leads to BoP improvement
Current Account
Limitations
1)
Long term investment may not increase as there are many factors affecting business sentiments.
2)
Trade partners may retaliate.
3)
Marshall Lerner condition may not hold in the short run and imports and exports may be price-inelastic due to existing contracts.
Conclusion
1)
Price advantage by devaluation is only temporary. Effects may be nullified when countries retaliate.
2)
The government needs to improve quality and price competitiveness of exports to increase AD.
3)
There is a need for good infrastructure, skilled labour and political stability.
a)
Balance of Trade improves
b)
Exports cheaper in terms of foreign exchange
c)
Price competitiveness of export increases
d)
Price of imports increases
e)
Export revenue increases and import expenditure decreases. Hence net exports revenue increases, assuming Marshall Lerner condition holds.
Financial Account
a)
Lower cost of setting up business in foreign lands
b)
Increases FDI
Low Unemployment
Economic growth
BOP improvement
Since net exports and investments are part of AD
1)
Increase in AD
a)
Increase in national income by multiplier
b)
Actual economic growth achieved
c)
Increase in AD causes unplanned decrease in stocks. Hence firms hire more factors of production and employment increases
2)
Long term investment
a)
Increases productive capacity
b)
Increases LRAS
c)
Both actual and potential growth are achieved.
d)
Non-inflationary growth is achieved.
Singapore's exchange rate system
AIM
: To achieve sustained non inflationary growth
Uses a managed float sytem
During Recession (bad times)
Zero appreciation
a)
To prevent fall in export price competitiveness
b)
But does not appreciate currency heavily to prevent imported price push inflation
Slight depreciation
a)
Demand for exports tend to be more price-elastic due to cost cutting measures to find cheaper alternatives.
b)
Depreciation results in a more than proportionate increase in quantity demanded for exports.
c)
Increase in export revenue and increase in net export
d)
Increase in AD and increase in national income by multiplier effect
During Economic boom (good times)
Adopts a gradual and moderate appreciation.
Attracts FDI
a)
Due to increase in expected growth in the economy.
b)
Greater profits and returns for firms
c)
Increase in financial account and improvement in BOP, ceteris paribus
EVALUATION
1)
If currency is too strong, it may deter investments, as more foreign currency is needed to buy one unit of SGD. This increases the cost of doing business.
2)
Also, there are other reasons for increase in business sentiments.
Keeps out import price push inflation
a)
Appreciation reduces price of import in Singapore
b)
Decreases cost of production in firms
c)
SRAS increases and GPL decreases so price stability is achieved.
d)
Ability to control cost of living and production by gradual appreciation due to Singapore's reliance on imports
EVALUATION
1)
During a recession, the price of raw materials does not rise too high and hence imported price-push inflation may not be a big threat when depreciation is carried out.
LIMITATIONS
Marshall Lerner condition leads to fall in balance of trade and a fall in AD, causing a fall in actual growth. This results in a conflict of macroeconomic goals.
However, Marshal Lerner condition may not hold as imports and exports are likely to be price inelastic. This causes a less than proportionate increase in import expenditure and a decrease in export revenue. Thus, net exports rise and AD rises.
Limitations mitigated due to a fall in price of imported inputs, leading to a fall in cost of production. Also, with supply side policies to improve the quality of exports, demand for exports will increase.