JC Economics Exchange Rate Policy & Inflation Essay Model Answers
Thanks, or no thanks to COVID-19, the Common Last Topic (CLT) of Theme 3.3: Globalisation and the International Economy has been removed from assessment in the final GCE A-Level examinations administered by Cambridge – UCLES – SEAB. (A quick poll with my JC Econs pupils suggested that they prefer MOE to remove the topic of Market Structures instead! hahaha…) This makes the remaining 2 topics of the External Economy (or the Global or International Economy) of Balance of Payments & Exchange Rates even more important.
Under Theme 3.2: Macroeconomic Aims & Policies, the JC Economic content topics found in the H2 Econs Syllabus (Code: 9757) expects “A” Level Econs candidates to be well – versed with Macroeconomic policies to achieve macroeconomic objectives, in sub-section 3.2.3.
Inevitably, one of the macro Econs policy is the Exchange Rate Policy, which is of paramount importance to the Singapore Economy. The following question (with full length model answer) analyses how Exchange Rate Policy in Singapore manages the macro Econs goal of low and stable inflation.
Many governments have utilised the exchange rate policy to achieve a low and stable inflation rate, but have not succeeded.
(a) Explain the factors that would reduce the effectiveness of the exchange rate policy to achieve a low and stabile inflation rate. 
(b) Examine alternative policies that might be more appropriate in helping an economy achieve a low and stable inflation rate. 
JC Economics Essay – Exchange Rate Policy: Application & Analysis to Tackling Inflation
Suggested Answer Part (a)
A low and stable inflation rate is one of the macroeconomic objectives that any government aims to achieve. Achieving a low and stable inflation rate would enable an increase in the consumers and investors’ confidence. This would encourage consumption and investment, leading to greater economic growth which improves the standard of living of the country. This essay aims to explain the factors that would reduce the effectiveness of an exchange rate policy a small and open economy could implement to achieve a low and stable inflation rate.
1. Cause of inflation
To achieve low and stable inflation, a government which decides to implement exchange rate policy might consider allowing its currency to appreciate. As a result of the appreciation, prices of imported raw materials will also be lower in domestic currency terms, causing a fall in economy’s cost of production. This leads to an increase in the SRAS, lowering import-price cost-push inflation. This way. the government would be able to achieve or maintain a low and stable inflation rate. Furthermore, prices of final goods and services imported from other countries will be relatively lower in domestic currency terms, effectively lowering imported inflation.
Thus, we see that an appreciation of the currency could be an effective method to control for import price cost-push inflation. However, if the root cause of a cost-push inflation is due to domestic factors such as rising unit labour cost, exchange rate policy might not be effective to reduce it. This is because even if there is an appreciation of currency, it only helps to reduce the price of imported factors of production. The overall cost of production in the economy will still be high as the domestic problem of rising unit labour costs is not being addressed at all. Instead of an appreciation of the currency. supply-side policies may be needed to rectify this inflationary problem.
2. Marshall-Learner condition (or known simply as price elasticity of demand for exports and also for imports)
With the appreciation of the currency, the price of exports is now relatively higher in foreign currency terms. This would lower the quantity demanded of exports. The lowered of prices of imported final goods and services would also see an increase in the quantity of imports bought. Assuming MLC or Marshall Lerner condition (PEDx + PEDm > 1) holds, an appreciation of the currency will lead to a fall in net exports, reducing demand-pull inflation in the economy. This is especially so if the economy is operating at full employment.
However, if the Marshall-Learner condition does not hold, demand-pull inflation may be worsened. This can be true for small, open economies like Singapore. In the short-run, immediately after an appreciation of the currency, the quantity demanded for exports may fall less than proportionately. This is because trading partners are unable to find viable substitutes for our high-end value-added goods and services. Also, the quantity of imports bought may increase less than proportionately as Singapore mainly imports necessities. This implies that the net export value could rise instead leading to an aggravation of demand-pull inflation.
Another factor would be that if the country that implements an exchange rate policy is not highly dependent on trade, net export earnings would not take up a large proportion of GDP. Hence, when there is an appreciation of exchange rate, the fall in net export earnings would not significantly AD. Thus, demand-pull inflation may only be alleviated slightly.
3. Lack of official reserves
To be able to successfully pull off an exchange rate policy, the government must be able to access large amounts of reserves to increase the demand for the domestic currency. If a country has been. experiencing a persistent balance of payments deficit, there might not be any or sufficient foreign reserves to enable the government to buy up its own currency in order for the revaluation to be effective. In such a situation, the government may not be able to lower down any form of inflation in the economy. Hence, the inability to achieve a favourable BOP position or a short-term BOP surplus might reduce the effectiveness of exchange rate policy to achieve a low and stable inflation rate.
While exchange rate policy could help to reduce both demand-pull and import-price cost-push inflation, the government needs to take note of the factors that might reduce its effectiveness and implement an exchange rate policy carefully.
JC Econs tutor’s comments: Again, this is a relatively simple question, merely focusing on the limitations of the exchange rate policy (ERP). You ought to try and complete this question under timed conditions. Use the ‘Dual Writing Strategy’, suggested in our Econs lesson classes, to aim to finish this answer under 20 minutes.
JC Economics Exchange Rates Essay – Alternative Macroeconomic Policies
Suggested Answer Part (b)
Given the limitations of an exchange rate policy, there are alternative policies a government can use to achieve a low and stable inflation rate. These include fiscal, monetary and supply side policies. This essay will assess which of these policies may be more appropriate than an exchange rate policy in reducing inflation.
1. Contractionary demand-management Policy If the inflation in the economy is caused by a lack of productive capacity in the economy (increases in aggregate demand near full employment), a possible policy to address the situation would be a contractionary demand-management policy. The government can consider reducing some of the government expenditure in the economy.
The government can reduce its expenditure by postponing less urgent projects such as the development of recreational parks or the renovation of buildings. The government could also reduce income and corporate tax rebates and holidays to slow down the increase in household spending and business investment. With less income tax rebates, the disposable income of the average person in the economy falls. This would reduce the wealth effect of the consumer, leading to them cutting back on consumption. The higher corporate taxes paid would reduce the expected rate of returns on investment projects. Investors would then reduce their investment expenditure.
Alternatively, the government could choose to raise the interest rates in the economy. This could be achieved through a decrease money supply by selling government bonds and securities in the open market. An increase in interest rates would mean that the cost of borrowing in the economy has risen. This means that the expected rate of returns on investment (or marginal efficiency of investment MEI) would be lower than the borrowing rate, giving firms less incentive to increase investment spending, causing a movement upwards along the MEI curve. At the same time, the increased cost of borrowing would reduce the consumer’s demand of consumer durables such as cars and housing. This would bring about a decrease in autonomous consumption. The reduction in government expenditure, consumption and investment would lead to a limited increase in aggregate demand, alleviating the inflation pressures in the economy.
The effectiveness of these policies may be limited by several factors. It may be difficult for the government to reduce spending in times of inflation. Much of government expenditure is tied to long term contracts, which cannot be changed easily as a means to influence aggregate demand. Also, in periods of inflation, firms’ expected returns on investment due to an optimistic outlook of the economy. This would shift the MEI function upwards making an increase in corporate tax and interest rate insufficient to curb rising investment. Consumers may also be willing to go into debt to purchase bigger cars and houses due to irrational exuberance. Thus, the contractionary demand-management policies may be limited in effectiveness during periods of rising AD.
2. Supply-side Policy
In the situation is the inflation is caused by domestic pressures, such as wage increases, the government could implement income policies to address the issue. The quickest way to deal with the problem would be to implement a wage freeze. This works to limit the increase in wages of the workers so that the cost of production of the firm does not increase further. The government could also consider a wage reduction for the public sector workers in the country, which would lower the cost of production in the economy. Both these policies would slow the increase in the SRAS, which lowers the pressure on the general price level in the economy, helping to achieve a low and stable inflation rate.
A limitation of the SSP would be the impact the wage freeze or reduction has on the labour market. Wage controls prohibit the market system from reacting to changes in the demand and supply of labour. The lowered wages imply that the quantity supplied of labour is likely to fall, reducing the availability of workers for hire. Without sufficient people in the economy to ensure production continues, the firms could end up with no output to sell. This would lower the national output, causing a contraction of the economy instead. Also, when the wage controls are removed, they tend to return to their original level before intervention. This would render the initial policy ineffective.
3. LR Supply-side Policy
Other than the above short-run policies, the government could put in place various long-run policies to increase the productive capacity of the economy. The productive capacity can be increased by increasing the quantity and quality of factors of production, such as capital and labour. This would address both demand-pull and cost-push inflation in the economy.
One possible such policy would be for the government to implement tax breaks and other incentives to increase the investment level in the economy. These incentives would raise the expected rate of returns on investment, making it more profitable for the firms to invest more in the country. An increase in investment, in terms of building more factories or accumulating inventories, would lead to an increase in the productive capacity of the economy. The effectiveness of the policy would depend on the willingness of the investors to inject more money into the economy, which depends on the business outlook of the economy. If the economy is expected to continue expanding, the investors would be more than willing to spend.
Alternatively, the government can offer subsidies to educate or re-train the population to increase the labour productivity in the economy. With higher educational qualifications, the wages would increase in tandem with productivity, increasing the purchasing power of the people. Consumption would then increase in the future. This move would shift both AD and AS, as seen in Figure 3, allowing the economy to achieve a low and stable inflation rate.
The effects of this policy would, however, take time to materialise. Education is a long-drawn process and it would be years before there are any returns on the investment on education. Also, the effects of the re-training of the current labour force would depend greatly on the attitude and aptitude of those undergoing the re-training. It also depends on whether the government is able to identify the appropriate courses to focus on for the next generation, given a changing and highly competitive world environment.
Ultimately, the policy that is more appropriate to help an economy achieve low and stable inflation would depend on the cause of the high inflation in the economy. It would appear that the SR contractionary DSP (demand side policies) may be more appropriate in reducing demand pull inflation and the short-run SSP more appropriate to reduce cost-push inflation.
However, very often, a government may need a combination of policies to reduce inflation completely and effectively. More importantly, short-run policies must be complemented with long-run supply-side policies to achieve a low and stable inflation rate. Even without high inflation in the economy, it is pertinent that the government ensures long-term growth to maintain the low inflation rate in the economy.
Remarks from our H2 Econs Essay tutor:
1.For a 15-mark part-B, a scope of 3 policies will suffice.
2. Regarding the evaluation points. Can you spot it? Can you suggest alternative judgement? How about ranking of policies? Are you able to internalise it for yourself, and then use it for subsequent essays for JC Econs assessment and tests?
Still struggling to get a good pass for H2 Economics? Recall that 605 of marks come from essays paper 2, so do NOT leave success to chance! Join me for your accelerated success to Economics NOW.