1 Question 55 (a) How does the exchange rate vary with interest

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					Question 55
(a) How does the exchange rate vary with interest rates?
                                                                                  [10]
(b) To what extent would a rise in interest rates in Singapore lead to problems in the
    Singapore economy?
                                                                                  [15]


(a)    The exchange rate of a currency is the rate at which the currency can be
exchanged for another currency. Interest is the cost of borrowing and the reward for
lending.

       In a large economy, the exchange rate usually varies directly with interest
rates. When interest rates rise, hot money inflows will increase and hot money outflows
will decrease which will lead to an increase in the demand for domestic currency and a
decrease in the supply resulting in a rise in the exchange rate.




In the above diagram, an increase in the demand for domestic currency (D$) from D$0 to
D$1 and a decrease in the supply (S$) from S$0 to S$1 leads to a rise in the exchange rate
(E) from E0 to E1. Conversely, when interest rates fall, hot money inflows will decrease
and hot money outflows will increase which will lead to a decrease in the demand for
domestic currency and an increase in the supply resulting in a fall in the exchange rate.

        The exchange rate sometimes varies inversely with interest rates in a large
economy. If people expect the exchange rate to rise, hot money inflows will increase and
hot money outflows will decrease which will lead to an increase in the demand for
domestic currency and a decrease in the supply resulting in a rise in the exchange rate.
The increase in hot money inflows and the decrease in hot money outflows will also lead
to an increase in the supply of loanable funds resulting in a fall in interest rates.




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       In a small economy, the exchange rate usually varies inversely with interest
rates. As an interest rate-taker, interest rates in a small economy usually change due to a
change in foreign interest rates. When foreign interest rates rise, interest rates in a small
economy will become relatively lower which will lead to a decrease in hot money inflows
and an increase in hot money outflows resulting in a decrease in the supply of loanable
funds and hence a rise in interest rates. The decrease in hot money inflows and the
increase in hot money outflows will also lead to a decrease in the demand for domestic
currency and an increase in the supply resulting in a fall in the exchange rate.

        The exchange rate sometimes varies directly with interest rates in a small
economy. If the currency of a small economy comes under speculative attack, the
exchange rate is likely to fall below the policy band. If this happens, the central bank may
decrease the money supply continually to push up interest rates to increase hot money
inflows and decrease hot money outflows which will bring the exchange rate back into
the policy band.

        In conclusion, the exchange rate usually varies directly with interest rates in a
large economy. The opposite is true in a small economy.




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(b)    The question on whether a rise in interest rates in Singapore would lead to
problems in the Singapore economy can be discussed in terms of the effects on the
balance of payments, the national income, unemployment and the general price level.

        A rise in interest rates in Singapore may lead to a deterioration in the
balance of payments. The balance of payments is a record of all the transactions
between the residents of the economy and the rest of the world over a time period and is
made up of the current account and the capital and financial account. When interest rates
in Singapore rise, hot money inflows will increase and hot money outflows will decrease
which will lead to an increase in the demand for Singapore dollars and a decrease in the
supply of Singapore dollars resulting in a rise in the exchange rate. When the Singapore
dollar appreciates, Singapore’s goods and services will become relatively more expensive
than foreign goods and services which will lead to a decrease in the net exports of
Singapore resulting in a deterioration in the current account and hence the balance of
payments, assuming the Marshall-Lerner condition holds. Further, an appreciation of the
Singapore dollar will increase reduce the costs of investing in Singapore in foreign
currency which will lead to a decrease in inward foreign direct investments resulting in a
deterioration in the capital and financial account and hence the balance of payments.

        When interest rates in Singapore rise, the aggregate demand and hence the
national income will fall. Aggregate demand is the total demand for the goods and
services produced in the economy over a period of time and is comprised of consumption
expenditure, investment expenditure, government expenditure on goods and services and
net exports. Higher interest rates in Singapore will increase the incentive to save which
will lead to a decrease in the consumption expenditure. Higher interest rates in Singapore
will also lead to less profitable planned investments resulting in a decrease in the
investment expenditure. Coupled with a decrease in net exports and inward foreign direct
investments, they will lead to a decrease in aggregate demand and hence national income.




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In the above diagram, a decrease in aggregate demand (AD) from AD0 to AD1 leads to a
decrease in national income (Y) from Y0 to Y1. When aggregate demand falls, firms will
employ less factor inputs to produce less output and hence pay less factor income to
households. Household income and hence consumption expenditure will fall. Due to the
decrease in consumption expenditure, firms will employ even less factor inputs to
produce even less output and hence pay even less factor income to households.
Household income and hence consumption expenditure will fall further. Therefore, the
decrease in aggregate demand will lead to a larger decrease in national income and this is
commonly known as the reverse multiplier effect.

      Since national income is equal to national output, the decrease in national
income due to the decrease in aggregate demand will lead to a rise in unemployment,
assuming the size of the labour force remains the same.

        The decrease in aggregate demand will lead to a surplus of goods and
services and hence a fall in the general price level. In the above diagram, a decrease in
aggregate demand (AD) from AD0 to AD1 leads to a fall in the general price level (P)
from P0 to P1. When the general price level in Singapore falls, people may expect it to fall
further. If this happens, the consumption expenditure in Singapore will fall which will
lead to a further decrease in the aggregate demand.

        A rise in interest rates in Singapore may not lead to problems in the
Singapore economy. Interest rates in Singapore may rise due to a rise in foreign interest
rates. When foreign interest rates rise, interest rates in Singapore will become relatively
lower which will lead to a decrease in hot money inflows and an increase in hot money
outflows resulting in a decrease in the supply of loanable funds and hence a rise in
interest rates. The decrease in hot money inflows and the increase in hot money outflows
in Singapore will also lead to a decrease in the demand for Singapore dollars and an
increase in the supply of Singapore dollars resulting in a fall in the exchange rate. When
this happens, the net exports of Singapore will increase which will lead to an
improvement in the balance of payments and a rise in the aggregate demand.

        In the final analysis, higher interest rates in Singapore will not lead to a
significant decrease in the consumption expenditure due to the culture of thrift. Further,
higher interest rates in Singapore will not lead to a significant decrease in the investment
expenditure as most of the investments are made by foreign firms with foreign sources of
funds. As a small and open economy, interest rates in Singapore usually fall due to a fall
in foreign interest rates which will lead to a fall in the exchange rate of the Singapore
dollar. A depreciation of the Singapore dollar will lead to a large increase in the net
exports of Singapore due to the large total trade relative to the national income. Due to
these reasons, a rise in interest rates in Singapore is unlikely to lead to problems in the
Singapore economy.




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Author’s comments

Part A

Students should distinguish between the way interest rates are determined in a small
economy and the way interest rates are determined in a large economy. This is because
although a large economy is an interest rate-setter, a small economy is an interest rate-
taker.

Students should understand that although the exchange rate and interest rates usually
move in the same direction, the converse is true in a small economy.


Part B

When the question asks about the effects of an economic event on the economy, students
should discuss the effects on the four key macroeconomic indicators (i.e. the balance of
payments, national income, unemployment and the general price level) and, if applicable,
the effects on the two microeconomic goals (i.e. efficiency and income equity).

Due to time constraint, students need not discuss the effects on the economy via the effect
on aggregate supply.

Students should explain the reverse multiplier effect when explaining the effect of a
decrease in aggregate demand on national income.




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Outline

Part A

Paragraph 1
Introduction
           define
                 exchange rate
                 interest

Paragraph 2
Explain the direct relationship between the exchange rate and interest rates in a
large economy.
           r  HMIs & HMOs  D$ & S$  E

Paragraph 3
Explain the inverse relationship between the exchange rate and interest rates in a
large economy.
           expect E  HMIs & HMOs  D$ & S$  E
           HMIs & HMOs  SLF  r

Paragraph 4
Explain the inverse relationship between the exchange rate and interest rates in a
small economy.
           foreign r  HMIs & HMOs  SLF  r
           HMIs & HMOs  D$ & S$  E

Paragraph 5
Explain the direct relationship between the exchange rate and interest rates in a
small economy.
           r  HMIs & HMOs  D$ & S$  E

Paragraph 6
Conclusion


Part B

Paragraph 1
Introduction
           give an overview of the approach

Paragraph 2
Negative effect (I) of a rise in interest rates in Singapore on the Singapore economy:
deterioration in the BOP
            HMIs & HMOs  D$ & S$  E


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             E  (X  M)  current a/c  BOP
             Marshall-Lerner condition
             E  inward FDI  C&F a/c  BOP

Paragraph 3
Negative effect (II) of a rise in interest rates in Singapore on the Singapore economy:
decrease in national income
            [(X  M) & inward FDI]  AD  Y
            reverse multiplier effect

Paragraph 4
Negative effect (III) of a rise in interest rates in Singapore on the Singapore
economy: rise in unemployment

Paragraph 5
Negative effect (IV) of a rise in interest rates in Singapore on the Singapore
economy: decrease in national income
           expect P  C  AD

Paragraph 6
Positive effect of a rise in interest rates in Singapore on the Singapore economy
            foreign r  HMIs & HMOs  SLF  r
            HMIs & HMOs  D$ & S$  E  (X  M)  (BOP & AD)

Paragraph 7
Conclusion




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