JC Economics Essay Series #88 – Currency Depreciation & Stagnation

JC Econs Essay Currency Depreciation & Stagnation Model Answers 

In economic terms, stagnation is a prolonged period of slow economic growth, usually accompanied by high unemployment. (Note: stagflation is worse than stagnation. On top of the lack of growth, leading to high unemployment and low wage growth, goods become more expensive due to inflation.)

Policy options to tackle stagflation depends on the nature of the economy in question, including expansionary fiscal policy, exchange rate policy, etc.

Reduction in interest rate affects the 4 key macroeconomic indicators (KEls):
economic growth rate
unemployment rate
inflation rate
balance of payments (BOP) position / exchange rate

For this question, recognise that interest rate (i/r) and exchange rate (e/r) are Monetary Policy tool of USA’s and Singapore’s respectively. ER policy is relatively more (compared to interest rate) effective as it influences X and M which are the two largest components of Singapore’s AD, where C and I are largest for USA.

In choosing to manage e/r and maintain free financial flows, Singapore has to give up control of interest rate. This is known as the Impossible Trinity Theorem or Open Economy Trilemma. State that Singapore economy is negatively affected by a weakening global economy and is expected to face challenges in terms of achieving its macroeconomic objectives.



Facing stagnation, the US Federal Reserve (‘Fed’) has allowed its interest rates to fall to near zero percent during COVID-19. Against the backdrop of a weakening global economy, business groups in Singapore have called for the Monetary Authority of Singapore (MAS) to allow for a depreciation of the Singapore dollar.

(a) Explain how the US monetary policy stance can affect its economy.

(b) To what extent can Singapore’s monetary policy overcome the challenges posed by a weakening global economy?



Demand Side Management – USA’s Monetary Policy


Define interest rates cost of borrowing, rate of returns on savings / opportunity cost of consumption

Identify that the US Federal Reserve’s MP stance is an expansionary one in which interest rate is reduced to near 0%.



Effects of reduction in interest rates on Aggregate Demand (AD) / Aggregate Supply (AS)

• Effect on consumption
A fall in interest rate results in an increase in consumption. When interest rate falls, the opportunity cost of consumption falls as the returns to savings fall. Households have less incentive to save out of a given level of income. As income is either consumed, save, used to pay taxes or buy imports, a fall in savings results in an increase in consumption, ceteris paribus. A fall in interest rates also results in a fall in the cost of borrowing. It is cheaper to borrow money to purchase consumer goods, especially on big-ticket items that are interest sensitive such as consumer durables (cars, electrical appliances, renovation). Hence, consumption increases.


Effect on investment
A fall in interest rate results in an increase in investment. MEI is defined as the expected rate of return of an additional unit of investment.

The MEI theory predicts an inverse relationship between interest rate and investment. There are various investment opportunities with varying MEI in the US economy. Profit-maximising firms will undertake an additional unit of investment if MEI > interest rate, as profit level increases when such an investment is undertaken. Similarly, they will not undertake an additional unit of investment if MEI < interest rate. When interest rate falls, there will be more investment projects with MEI> interest rates. Firms will borrow at the lower interest rates to undertake these additional investment projects. Hence investment increases.
(Note; for new syllabus of 9757, reference to MEI is no longer necessary.)


Effect on Net Exports
A fall in interest rate is likely to result in an increase in net exports (X-M).

When the US interest rate falls, it will be relatively lower than global interest rates. There will be less incentive for savers to hold US financial assets as the interest earned on such assets is relatively lower. This will cause a movement of “hot money” out of the economy to countries with relatively higher interest rates. Supply of USD in foreign exchange market increases causing the USD exchange rate to depreciate. Depreciation of the USD causes an increase in (X-M) if the sum of PEDx and PEDm is larger than 1. [aka Marshall-Lerner Condition (MLC)].
[Details of depreciation of currency causing an increase in (X-M) will be covered in (b)].
(Qn: is this a good point to explain here?)


A reduction in interest rates causes C, I and (X-M) to increase. As AD comprises C, I, G (X-M). AD increases as interest rate is reduced. This is represented by AD curve shifting from AD, to AD₁. As investment (I) involves the purchase of machineries and construction of factories, production capacity of the US economy increases in the LR as factories are completed and machineries are put into operation. AS increases as the US economy is able to produce more goods and services before experiencing supply bottlenecks. This is represented by AS curve shifting from AS, to AS₁
(sketch your own diagram).


Effects on US KEI:
Effects of an increase in AD in the SR

Effects on actual growth:
With increases in C, I and (X-M), there is an overall increase in AD represented by AD curve shifting from ADo to AD₁. This autonomous increase in AD will cause a more than proportionate increase in real national income via a multiplier effect, resulting in actual growth. The US economy is likely to have significant spare capacity given the weak economic conditions.


The multiplier is based on the concept that “one man’s spending creates another man’s income”. In this case, the increase in C, I and (X-M) results in a running down of firms’ inventories. Firms will increase their level of production by hiring more workers. Wages paid to these workers creates new income which is spent on domestic or imported goods, saved or used to pay in taxes. This cycle of induced consumption continues until the initial injection has been completely withdrawn from the circular flow of income in the form of leakages such as savings, taxes and imports. This series of induced consumption will further increase AD, causing the AD curve to shift from AD, to AD2, which causes real NY to increase more than proportionately from NY, to NY ₂.


Effects of unemployment
Demand for labour is derived from the production of goods and services. As firms increase production to cater to the increase in AD in the economy, more workers are hired and cyclical unemployment in the economy falls.


Effects of inflation
Given the weak economic conditions in the US, it is likely to have significant spare capacity. As such, increases in AD arising increases in C, I and (X-M) are likely to be result in more than proportionate increase in real national income via the multiplier effect, with minimal demand-pull inflation.


Effects on BOP / ER
Arising from the hot-money outflow, financial account of the US BOP will worsen. The USD will also depreciate as well, however, the depreciation of the USD will increase (X-M), hence its current account in the Balance of Payments. Overall, change in US BOP position is uncertain. It depends on the extent of change in its financial and current accounts in the BOP.

(Qn: Is the above organisation sound? Can it be improved?)


Effects of an increase in AS in the LR
As AS increases in the LR, the US economy is able to achieve sustained economic growth with low rates of inflation. This is based on the assumption that AD recovers from its current situation and increases in tandem with AS in the LR.


Overall, an expansionary MP is an appropriate policy response which can help the US economy in times of weak economic conditions. However, the extent to which expansionary MP can stimulate the economy depends on many factors including households’ and firms’ expectations of the future.



Mark Scheme:
L1: An answer that lacks the use of relevant economic concepts and framework; Irrelevant answer is mostly irrelevant with smattering of relevant points; -Listing of points with explanation. Glaring conceptual errors.

L2; -An answer that uses relevant economic concepts and framework: KEIS, and ADIAS framework; Relevant answer explaining effects of a reduction in interest rate on the US economy. Some explanation of the effects of a reduction in interest rate. Gaps in explanation of the effects of a reduction in interest rate;

L3:- Good elaboration of the effects of a reduction of interest rates, with key arguments well explained and linkages well established. – Good coverage of all SR effects of a reduction of interest rates; Good application to context presented in preamble.



Econs Tuition teacher’s Remarks:
1.Candidates should distinguish actual growth, potential growth and economic growth. Increase in real NY should be correctly associated with actual growth and not passed off as economic growth. Potential growth is an increase in production capacity. Economic growth comes about when there is actual and potential growth Some candidates related FDI to interest rate changes. It is incorrect to do so FDIs are also independent of domestic interest rate changes. By definition, FDI is money that flows into a country for the purpose of purchasing capital goods. It cannot be money that i borrowed from the local banks as FDI is money that is brought into the country.

2. It is incorrect to say that when interest rates fall, purchasing power of consumers increase / price of the consumer durables such as cars are cheaper to purchase. Interest rates neither affect consumers’ purchasing power nor the price of the items. It reduces the cost of borrowing funded for consumption. Candidates should also note that if the Marshall- Lerner condition was used in the analysis, price elasticity of demand for imports and exports should not be specified separately. For instance, some candidates wrote if PEDx>1 and PEDm > 1, then the Marshall-Lerner condition is fulfilled. This is incorrect as the individual elasticities of imports and exports need not necessarily be greater than 1 for the Marshall- Lerner condition to hold.

3. When analysing that an increase in would result in an increase in AS, candidates should be aware and make the effort to clarify that AS increases in the LR. This increase in production capacity takes place in the long run, after the machineries and factories are put into use. Note that the key point of the multiplier effect is that real NY increases more than proportionately. Quite a few students elaborated the multiplier effect but merely stated that real NY increased, omitting the key point behind the multiplier elaboration that real NY increased more than proportionately. Some candidates also stated the multiplier effect is a more than proportionate in AD, which again missed the key point behind the multiplier effect. Many candidates incorrectly pointed out that hot money outflow caused capital account in the BOP to worsen. It should be the financial account which is worsening. The capital account records international transactions involving non man-made assets such as land, not hot money nor FDI.

4. Some candidates elaborated on the direct transmission mechanism which is not the focus of this question given the preamble about interest rates decreasing to near zero. Potential growth analysis is good to have, but not essential for this question given the context provided in the preamble. The primary objective of this fall in interest rate was to mitigate the SR economic issues. 

5. There is no need to “discuss” an “explain” question. Some candidates brought in issues such as the responsiveness of investment to interest rate to discuss the extent to which a fall in interest rates improved the KEIS. Good economics was displayed, however it is not credited for an “explain” type of question. Precious time which could be used to answer part (b) or other questions was wasted. A serious mistake candidates made was to merely state the effects of an increase in AD on a KEI, without sufficiently explaining it. For example, such a candidate would write “This increase in C, I and X-M would shift AD to the right, and decrease unemployment”. An elaborated analysis should read “This increase in C, I and X-M would shift AD to the right. The increase in AD would mean firms have to hire factors of production in order to produce the increase output. Given labour is a derived demand, employment would rise, resulting in a fall in cyclical unemployment.”

6. Candidates should be careful with their expressions in essays. Careless expression can be sometimes misconstrued as conceptual errors. This often results in unnecessary (and painful) loss of credit, especially when the general impression gleaned from the answer is that the student does not understand the concept. These expression errors include:

A decrease in interest rates lead to an increase in the expected rate of return.
A decrease in (X-M) leads to a decrease in the current account.
Lower interest rates lead to a lower cost of purchasing.
Hot money outflows lead to an increase in money supply and hence, depreciation

Hot money outflows lead to exports being cheaper in foreign currency and imports more expensive in domestic currency.
The depreciation of the USD makes exports cheaper in foreign currency and vice versa for imports.
A decrease in interest rates leads to an increase in investments given the inverse relationship shown on the MEI diagram.

Corresponding Corrections:
A decrease in interest rates leads to an increase in the number of investments with expected rate of return higher than the interest rates, making these investments profitable.A decrease (X-M) leads to a worsening of the current account/an increasing deficit/a decreasing surplus.
Lower interest rates lead to a lower cost of borrowing.
Hot money outflows lead to an increase in the supply of USD in the foreign exchange market and hence, depreciation.



Singapore’s Demand Side Management – Monetary Policy & Global Economy


Brief explanation of the negative effects of a weakening global economy on Singapore

Weak global economy results in slower rates of increase or fall in real NY of Singapore’s trading partners. Firms’ expectations of the future also becomes pessimistic A fall in real NY of Singapore’s trading partners results in a decrease in demand for . Singapore’s X. Extent of fall of Qx depends on the YED of Singapore’s X. Worsening expectations of the future causes overseas firms to cut back on investments, including FDI to the Singapore economy. As there is less FDI available to purchase capital goods in Singapore, I decreases.


Given Singapore’s dependence on the external economy, the fall in X and I results in a significant fall in AD. This results in a more than proportionate fall in national income through the multiplier effect. an increase in cyclical unemployment as the fall in national output results in a fail in the derived demand for labour. risk of deflation arising from the falling AD. Worsening of BOP position as a result of worsening BOT and Financial Account positions due to the falling (X-M) and FDI respectively.


Thesis: Once-off depreciation of SGD can help to overcome challenges posed by global recession

Adopting a once-off depreciation of SGD policy helps to address the challenges faced by the SG economy. [Note: In the context of a weakening global economy, allowing the SGD to depreciate once-off against foreign currencies can help stimulate the Singapore economy. However, this is against Singapore’s conventional e/r policy of a modest and gradual appreciation of the SGD which aims to achieve low and stable inflation as a basis for sustained economic growth.]


Explain how a once-off depreciation of SGD affects Singapore’s KEIs. S’pore’s exports becomes cheaper in foreign currency (ie. Her exports becomes more price-competitive), Qx increases. Extent of increase in Qx depends on PEDX. Singapore’s imports becomes more expensive in SGD, Qm decreases. Extent of fall in Qm depends on PEDm. Assuming Marshall-Lerner Condition (MLC) holds, that is the sum of PEDx and PEDm >1, net export (X-M) will increase, ceteris paribus.

An increase in (X-M) results in an increase in AD. This is represented by AD curve shifting rightwards. Through the multiplier effect, there is a more than proportionate increase in real national income from NY, to NY₁. This increase in economic activity will require firms to hire more workers, hence raising employment levels in the economy. This reduces cyclical unemployment in the economy. The current account position of Singapore’s BOP improves as an increase in (X-M) improves the Balance of Trade which is a sub-account in the current account.


Explain how a once-off depreciation of SGD can be effective in overcoming challenges. Depreciating the SGD targets X, which is one of the causes of Singapore’s weakening AD in a weakening global economy. . As Singapore is X-oriented, with X/GDP at approximately 175-200%, an increase in X can significantly contribute to increasing AD and hence real NY.


Anti-Thesis: Depreciation of SGD is limited in its effectiveness in overcoming challenges posed by global recession / Depreciation of SGD incurs significant trade-offs

Limitations of/ Trade-offs incurred in a depreciation of SGD. A depreciation of SGD results in cost-push inflation, specifically imported inflation. Prices of imported raw materials are higher in terms of the SGD. COP of Singapore’s goods and services increases. This results in a fall of Aggregate Supply where firms are able and willing to produce a given quantity only when offered higher prices. This is represented by an upward shift of the AS curve from AS, to AS₁. This increase in COP of Singapore’s goods and services partially off-sets some of the price-competitiveness gained by Singapore exports as a result of the depreciating SGD. Hence, the extent to which (X-M) increases from a depreciation of the SGD is reduced. The extent to which real NY increases and unemployment falls is consequently reduced. Singapore’s real NY increases from NY, to NY2, instead of NY₁. This reduces the effectiveness of a once-off depreciation of the SGD.

S$ Depreciation & Consequences | JC Econs Tuition Singapore

An increase in (X-M) arising from a once-off depreciation is contingent on the MLC being satisfied. However, Qx may not increase much in response to a fall in Px. Similarly, Qm may not fall much in response to an increase in Pm in the immediate term. This is due to a combination of factors including the presence of trade contracts, the time required to change taste and preferences of consumers and the time required to seek suitable substitutes. Hence, PEDx and PEDm values can be relatively low in the immediate term. MLC may not hold, a depreciation could result in a decrease in (X-M) in the immediate term. This is known as the J-Curve effect where Singapore’s BOT worsens as a result of a depreciation of the SGD, before it improves over the longer term. The J-Curve effect results in a fall in Singapore’s AD in the immediate term. This causes its real NY to fall and cyclical unemployment to increase in the immediate term.


In a weak global economy, where national incomes have fallen significantly and pessimism prevails, a depreciation of the SGD may not be sufficient to offset the large fall in (X-M) and FDI experienced by the Singapore economy. Additionally, the depreciation of SGD has caused Px to fall, but Qx may increase to a limited extent due to pessimism. Hence, the expansionary effect of a depreciation of SGD is moderated by the prevailing pessimism in the global economy.


Suggest alternative macroeconomic policies which can help overcome challenges. Expansionary fiscal policy can help to overcome challenges. Expansionary fiscal policy involves running a budget deficit through increasing G and reducing T. . An increase in G results in a direct increase in AD which increases real NY and reduces cyclical unemployment.


A fall in corporate tax increases post-tax profits of firms. This incentivises firms to increase investment. A fall in income tax increases households disposable income which increases their purchasing power and consumption of goods and services. An increase in C and I results in an increase in AD which increases real NY and reduces cyclical unemployment. Supply-side policies focused on reducing COP can help to overcome challenges.


Income policy which recommends a temporary reduction in wages can help to decrease COP. Firms are more likely to be able to cover variable cost in the short run, allowing them to continue to operate. This can help to reduce the number of workers laid off due to firms shutting down. Decreasing COP also allows Singapore’s exports to be priced more competitively. This can help to increase its (X-M), helping to increase in real NY.


Overall judgement of the effectiveness of a once-off depreciation of SGD A once-off depreciation of SGD can help overcome the challenges of falling real NY, increasing unemployment and worsening BOP position to some extent. The stimulatory effect of depreciating the SGD is unlikely to offset the fall in X and FDI arising from global weakening. It can at best reduce the negative effects of the weakening. Moreover, this policy cannot be used repeatedly over a period of time due to the risk of wage-price spiral that can arise from compromising the management of imported-inflation when the SGD depreciates.

Other appropriate policies such as expansionary fiscal policy and supply-side policies should be implemented simultaneously to help Singapore overcome the challenges. Given its small and open nature, Singapore’s economic performance is significantly affected by the global economy. Stabilisation policies, while important and relevant, can only reduce the severity of economic downturns. Long term supply side policies which seek to strengthen Singapore’s economic capabilities are effective in improving Singapore’s production capabilities to fully benefit from global economy when it recovers.



Marking Rubrics:
L1: An answer that lacks use of relevant economic concepts and framework Answer is mostly irrelevant with smattering of relevant points; Listing of points; glaring conceptual errors.

L2: An answer that uses relevant economic framework, relevant answer explaining how exchange rate policy can help to overcome challenges posed by a weakening global economy. A balanced answer which Explains how exchange rate policy can help to overcome challenges & limitations of Singapore’s monetary policy in overcoming challenges; Some explanation of key arguments Gaps in analysis.

L3; A balanced answer with breadth of arguments; Good elaboration of key arguments which Explains how exchange rate policy can help to overcome challenges & limitations of Singapore’s monetary policy in overcoming challenges. Good application to context presented in preamble; Effectiveness of Singapore monetary policy in the context of Singapore’s small and open nature as well as the weakening global economic conditions.

E1: Suggestion of alternative policies, or limitation of alternative policies Comparison of effectiveness of Singapore’s monetary policy, with suggested policies Overall judgment of effectiveness of various macroeconomic policies
E2: Substantiated and insightful evaluation which includes an overall judgment.



JC Econs Tutor’s Comments:
1. Some candidates mistook Singapore’s MP as interest rate policy. This was a critical error as S’pore managed the exchange rate rather than the interest rate. Quite a few candidates cited the Impossible Trinity Theorem as the reason why Singapore preferred exchange rate over interest rate policy. This was incorrect. The Impossible Trinity Theorem explained why Singapore cannot control interest rate given that it has decided to manage the exchange rate and allow free movement of financial flows across country barriers. SG chose to manage exchange rate rather than interest rates because managing the exchange rate was more effective in influencing level of economic activity in Singapore. X and M are largest components of its AD, and managing exchange rate allowed the policy makers to influence X and M directly. Whereas interest rate influenced C and I, which are relatively smaller components of Singapore’s AD. It is important to note that depreciation should be a once-off policy. Persistent depreciation is detrimental to the Singapore economy as it will lead to poor management of inflation over the long term.

2. Some A-Level Economics students proposed that a modest and gradual appreciation was the appropriate policy response. Often, these candidates went on to analyse that a modest and gradual appreciation helped to achieve low and stable inflation which helped Singapore to gain export competitiveness in the long run. However, such an answer is not persuasive as a modest and gradual appreciation in such circumstances would deepen Singapore’s economic contraction due to the increasing Px caused by an appreciation. Many candidates raised the issue of demand-pull inflation as a macro goal trade-off. However, this was unlikely given that a weakening of the global economy meant that the Singapore. economy was likely to be operating with significant spare capacity. There was a common conceptual misconception that depreciation runs down a country’s foreign reserves. This is not true, only appreciation (resulting in an over-valued currency) leads to a depletion of a country’s foreign reserves.

3. Among candidates who were specific about supply side policies to be implemented, many chose to focus on the increase in Singapore’s production capacity arising from these supply side policies. However, in the context of a weak AD recession, increasing production capacity was unlikely to help the economy as there was already spare capacity. Good candidates chose to focus on how supply side policies helped improve productivity and/or reduced COP. This would help Singapore sell more exports which would help stimulate level of economic activity, thus helping the Singapore economy in times of weakening global economy. Similarly, structural unemployment is not a key problem arising from weakening global economy, cyclical unemployment is. Hence, supply side policies such as re-training for the purpose of reducing structural unemployment were less relevant.

4. Challenges posed by the weakening global economy onto Singapore were not explicitly explained. While full analysis is not required, a brief explanation of the challenges significantly improved the structure and flow of the answer. There are many limitations of exchange rate policy. Rather than regurgitating all the limitations, candidates should choose the most important and relevant (to the question and context provided in preamble). In the context of this question, the most relevant limitations of the depreciation policy are the imported inflation limitation and the J-curve effect. Limitations like time lag and small multiplier size are less important. Also, little specifics of SSP.

5. Some candidates saw alternative policies as antithesis and wrote excessively on ‘to what extent other policies, such as FP and SS-side policies, can help Singapore overcome the challenges posed by a weakening global economy’. Antithesis for this question should be the limitations of a depreciation of SGD.