JC Economics Current Account & Exchange Rate Appreciation Essay Model Answers
One of the macroeconomic objectives of an economy is the balance of payments (see SG’s BOP data here.). As BOP summarises the transactions between Singapore and the rest of the world, many changes in the global economy may affect a country’s Current Account and Capital & Financial Account.
In the H2 Econs Syllabus (Code: 9757), the BOP and exchange rates are considered the external macro econs objectives.
(In some countries, exchange rate is not considered an macro goal. Why?)
The following question (with full length sample answers) demonstrates how Current Account (part of BOP) is affected, and its consequences on an appreciation of an economy’s exchange rate.
(a) Explain how how might a decrease in the level of interest rates and a decrease in the inflation rate affect the current account in the balance of payments of the Singapore economy. 
(b) Discuss the possible effects of an appreciation of economy’s exchange rate. 
JC Economics Essay – Current Account & Balance of Payments
Suggested Answer Part (a)
Define BOP: Records transactions between the residents of the country with the rest of the world in a year. It consists of current account (CAcc), capital and financial account (KFA), as well as foreign reserves account (FRA).
Current account comprises the Goods balance, Services balance, Primary income and Secondary income sub-accounts.
(i) Explain how a fall in interest rates affect the current account (CAcc) of Singapore’s balance of payments
Fall in interest rates -> fall in the price of money, so lowers cost of borrowing. Singaporean households maybe enticed to borrow more to consume goods, not just from the local SG economy, but also from overseas. Hence demand for imports rises , and CAcc deteriorates.
(ii) Explain how a fall in the rate of inflation affect S’pore’s current account (CAcc)
Fall in inflation rate -> SG exports more attractive to overseas consumers. export prices fall. quantity of exports rises my more than proportionate. (PED value for exports more than 1, surely)
Fall in interest rates and in inflation rate worsens and improves the current account respectively.
H2 Econs Tutor Remarks:
1. Do we assume PED value or justify it? Which PED determinant can we use?
2. Is there a diagram that we can use to illustrate the impacts in this question?
3. What possible stronger analysis is possible for the above?
(Link to more BOP essays)
JC Economics Essay – Exchange Rates & Macroeconomic Consequences
Intro: define exchange rates and appreciation.
Thesis: Positive Impacts
Solution to problems of inflation (lowers general price level or GPL)
Reduce import price-push inflation.-> Relative spending power of the country’s people rises; Foreign goods will cost less in domestic currency terms, help to cure import price-push inflation almost immediately and with widespread effectiveness if the country has very high Import content (eg. Singapore) Lowering import prices will also help to decrease the domestic prices directly in the case of imported consumer goods) or indirectly (in the case of imported raw materials). Either way, GPL rises slower. The lower AD will lead to a fall in GPL [Sketch AD-AS model].
While appreciating of the country’s currency does effectively help reduce Imported inflation, it does so by compromising on the export competitiveness of certain sectors, such as the service related sectors that tend to have very little to gain from cheaper import prices.
Thesis: Negative Impacts
May lead to deterioration in the BOP. (BOP: is a record of all the transactions between the residents of the economy and the rest of the world over a period of time and is made up of the CAcc and the capital & financial account or aka KFA) When domestic currency appreciates, domestic goods and services will become relatively more expensive than foreign goods and services. A, it will lead to a ↓ in net exports resulting in a deterioration in the CAcc and hence the BOP, assuming the Marshall Lerner condition holds (ie PED x+ PEDm > 1, or simply PED value larger than 1. Note that for the new H2 Econs 9757 syllabus, full knowledge of the MLC is no longer required. )
Furthermore, an appreciation of e domestic currency will increase the costs of Investing in the economy in foreign currency, leading to a in inward foreign direct Investments (FDI), resulting in a deterioration in the k and F account and the BOP.
When domestic currency appreciates, AD and hence NI will fall. [AD is the total demand for the goods and services (G&S) produced in the economy aver a period of time and is comprised of consumption expenditure, investment expenditure, govt expenditure on G&S and net exports.] The decrease in net exports and inward FDI will lead to a decrease in AD and hence NI.[Draw AD-AS model]
In your diagram sketched, the ↓ in AD from AD, to AD, leads to a fall in NI from Yo to Y₁ When AD falls, firms will employ less factor Inputs to produce less output and hence pay less factor income to households. Household incomes and consumption expenditure will ↓. With the decrease in consumption (C), firms will employ even lesser factor inputs to produce even lesser o/p and pay even lesser factor income to households . HH Y and hence consumption expenditure will fall further., the in AD will lead to a larger in NI, and this is commonly known as the reverse multiplier effect.
(D you need to explain the reverse multiplier process?)
Since NI = N o/p, the In AD will lead to a ↑ in unemployment, assuming size of labour force remains the same
Appreciation of the country’s currency limited in its effects in cases for wage-push, profit push, tax-push inflation. [Since these inflation types arise from problems with the supply side of the economy, they are best dealt with using SS policies.] [“profit-push inflation requires govt regulatory actions in the prices charged by monopolies. Ignore this is fine. deal with wage-push, tax-push and import-push inflation types will be sufficient.]
“wage-push inflation requires ways to reduce the bargaining power of firms or measures to raise productivity of workers, so that wager increase does not ↑COP. “Similarly, in the case of demand pull inflation where excessive increases in AD come from domestic sources such as high levels of disposable income or easy and cheap access to loans, an appreciation of the currency as a means to solve demand pull inflation would be very limited in its usefulness, unless the source of excessive AD comes from high export growth. (this will likely cause demand for the country’s exports to esp if PED > 1.
• Artificially appreciating the currency against the free market equilibrium is unnatural, especially if the currency is already severely over-valued and maintaining an over-valued currency will deplete a country’s stock of foreign reserves. In most countries, exchange rate changes act as a self-correcting mechanism for BOP disequilibrium.
(Is the above statement valid? Most economies adopt flexible or fixed ER regimes? More answers in our H2 Econs tuition lessons.)
If an exchange rate policy is used to address inflation / other macro problems instead, it will cause exports to lose competitiveness which will lead to a worsening BOP position. In usual cases, using exchange rates to solve inflation will create problems in the BOP, (exception: case of Singapore or a country with high Import content for its exports.) In Singapore’s context, there is a need to import cheaply, so as to maintain competitiveness of its goods in the global market.
- overall good or bad, depends on type of economy. For eg, you can compare a small and open economy (SOE) like S’pore, vs a large and less open (LLO) one like USA.
- overall good or bad, also depends on the exchange rate system adopted. If fixed, requires a large amount of foreign reserves. This becomes an opportunity cost for the economy. (See Singapore’s foreign reserves data here.)
- etc. (More evaluation techniques in our H2 Economics intensive revision lessons.)
An appreciation of the domestic currency will have mixed effects on the economy. For instance, a decrease in NI will lead to a fall in the SOL but a fall in GPL which actually increases the real value of savings. However, the effects on the economy of an appreciation of domestic currency is also dependent on the cause of the appreciation. If an appreciation of currency occurs due to a rise in exports or inward foreign direct investments, AD and hence NI will rise. The appreciation will only reduce the increase in AD and hence NI.
Comment by JC Econs Teacher:
(The following is submitted by an ex-JC Economics student. Do you like this analysis? If yes / no, why?)
Higher value of the currency means lower X-M and hence lower AD. The resultant fall in NI and GPL will lead to an improvement in the BOP. When NI falls, Imports will fall. Further, the In GPL will make domestic goods and services relatively cheaper than foreign s/s, resulting in an increase in net exports. CA and hence BOP will Improve An appreciation of domestic currency will lead to an in AS, JAS is the total supply of g/s in the economy over a period of time) When domestic currency appreciates, the price of imported Intermediate goods will fall. A, the COP in the economy will which will lead to an ↑ in AS.
The ↑ in AS will lead to a smaller decrease in NI, a smaller rise in unemployment and a larger fall in GPL However, effect on BOP is indeterminate (depend on PED)
In the long run (LR), AS will rise less rapidly in the LR. The In Investment expenditure will lead to a less than rapid in the production capacity of the economy in the LR, assuming net investment remains +ve. When this happens, assuming AD is rising, which is the normal state of the economy, NI will rise less rapidly, unemployment will be higher, and GPL will rise more rapidly. Therefore BOP will be indeterminate.
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More full length essays examples: JC Econs Essay #34