JC Economics Exchange Rates & BOP Essay Model Answers
Due 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. 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 and Policies, the Economics content topics found in the H2 Econs Syllabus (Code: 9757) states that JC Econs candidates have to be well- versed with Macroeconomic policies to achieve macroeconomic aims, in sub-section 3.2.3.
Inevitably, one of the macro Econs policy is the Exchange Rate Policy , which is the other type of Monetary Policy (the other monetary instrument for A-Level Economics is interest rate.) This is particular important for the Singapore Economy, mas we only adopt the former policy, not the latter.
The following question (with full length sample answers) demonstrates how Exchange Rate Policy achieves certain macro objectives and its relative effectiveness
(a) Explain how the balance of payments of a small and open economy like Singapore may be affected when it becomes more open to trade and investment. 
(b) The undervaluation of the Yuan is expected to worsen Singapore’s balance of payments. To what extent would you agree with this assertion? 
JC Economics Essay – Exchange Rates: Application & Analysis to S’pore Economy
Suggested Answer Part (a)
An economy’s balance of payments (BOP) records the monetary value of all economic transactions between residents of a country with the rest of the world. When an economy becomes more open to trade and investment, there is an increase in the monetary value of transactions that take place. Singapore, being a small and open economy, is highly dependent on the rest of the world for trade to encourage growth and survival. An increase in this openness also increases its vulnerability to the rest of the world. This essay aims to explain how the balance of payments of Singapore may be affected when it becomes more open to trade and investment.
Body: 3 main points
Topic Sentence (usually involves the economic concept to be used)
Explain (the economic concept)
Exemplify (using examples)
Exam Skills: As usual, focus on the scope and depth of you answers, will yield you Level 3 (i.e. a distinction grade response)
1. Current Account-trade
An increase in openness of a country to trade would result in an increase in the amount of both exports and imports traded between the country and the rest of the world. While trade volume may increase, the extent to which net exports (export revenue – import expenditure) increase would depend on various factors.
The first factor would be the state of the trading partners to which the country sells their exports. Although it is likely that export revenue increases with an increase openness to trade, it may also be adversely affected if the trading partners experience an economic recession. This can be especially true for small and open economies like Singapore that exports goods and services that have an income elastic demand. As the income of the trading partners fall, the demand for Singapore’s exports in the areas of high value-added manufactured goods, tourism and banking, may fall more than proportionately, leading to a fall in export revenue. This may result in a deterioration in Singapore’s BOP as export revenue is recorded as a credit item in the current account.
Another factor that would determine the value of net exports with an increased openness to trade would be the price competitiveness of imports into the country. As a small economy, Singapore is dependent on the rest of the world for factor inputs and necessities such as food. An increase in openness implies that Singapore is able to trade with countries that may offer more competitive prices for these goods and services. As demand for these goods tend to be price inelastic due to the lack of domestic substitutes, a decrease in price would result in a less than proportionate increase in quantity demanded (PED concept), causing import expenditure to fall. This would lead to an improvement in Singapore’s BOP as import expenditure is recorded as a debit item in the current account.
2. Financial Account
An increase in openness of a country to investment would result in an increase in both inbound and outbound investment flows. While the total amount of investment may increase, the final impact on the financial account would depend on the business expectations of the investors. When investors are more confident of Singapore’s economic performance in the future, they may expect an increase in the rate of return on their investment. This would encourage them to increase investment into Singapore, leading to an improvement to the BOP as FDI inflow into Singapore increases.
As the same time, if Singaporean firms expect other countries to outperform Singapore in terms of economic growth, they may decide to increase their outbound investment into these countries. This is especially true in industries that have lost their area of comparative advantage in Singapore. The increase in offshoring and relocation of firms to other countries with the appropriate comparative advantage may lead to a deterioration in Singapore’s BOP as FDI outflow increases. The increased openness to investment would also see an increase in the amounts of hot money flows in the country. While the total amount of hot money flows may increase, the final impact on the financial account would depend on the relative interest rates between the countries and the expected value of the currency.
A relatively higher interest rate in Singapore, as well as an anticipation of an appreciation of the Singapore dollar in the future, would lead to an increase in hot money inflows. Speculators would be keen to earn higher interest and make profits from the arbitrage of the Singapore dollar. This would result in a short-term improvement in the BOP. The converse is true if Singapore has a relatively lower interest rate or if speculators anticipate the Singapore dollar to depreciate in the future.
3. Current Account-net income flows
While the increased openness of the economy to investment may lead to an increase in FDI outflows, it may also experience an increase the income inflows as FDI sees a positive return in the future. With an economic expansion in the rest of the world, the returns on FDI outflow would increase. This would result in an improvement in the BOP as the income inflow is recorded as a credit item in the current account.
Similarly, when the Singapore economy does well, the income generated from the factors of production in Singapore that are owned by foreigners will flow out of Singapore as debit items in the current account.
Being more open to trade and investment would lead to an increase in the total monetary value of economic transactions to increase. Whether this results in an improvement or deterioration of the BOP would then depend on the states of economies of Singapore and the rest of the world.
JC Econs tutor’s comments: This is a relatively simple question. You ought to try and complete this question under timed conditions. If you still have problems finishing this full length answer under 20 minutes, remember to try out the ‘Dual Writing Strategy’, I suggested in our Econs lesson classes.
JC Economics Exchange Rates Essay – Impact & Limitations
Suggested Answer Part (b)
An undervalued Yuan can be defined as the situation where the value of the Yuan is kept artificially lower than the market equilibrium by deliberate government intervention. This would make Chinese exports to the rest of the world relatively cheaper in foreign currency terms and foreign imports into China relatively more expensive in domestic currency terms. The extent to which this undervaluation would affect Singapore depends on the relationship between Chinese and Singapore goods and services. This essay aims to discuss whether the undervaluation of the Yuan would worsen Singapore’s balance of payments.
(As before, if you are running out of time, you can decide to skip the Introduction, and go to your main analysis and evaluation. However, remember the caveat I mentioned a few times in our H2 Econs class…)
1. Impact on Current Account
Direct impact on Singapore’s X & M
An undervalued Yuan makes Chinese goods relatively cheaper to Singaporeans in domestic currency terms. Assuming the demand for Chinese imports into Singapore is price elastic, due to the availability of substitutes, this would increase the quantity demanded of imports, leading to an increase in import expenditure for Singapore.
At the same time, Singapore’s goods are now relatively more expensive in terms of Chinese Yuan. Since the demand for SG exports may also be price elastic, due to the presence of domestic substitutes, the quantity demanded of Singapore goods may fall more than proportionately, resulting in a fall in export revenue. In this case, we see that the undervalued Yuan directly worsens our BOT and BOP, ceteris paribus.
However, the demand for Singapore’s goods and services into China may be relatively price inelastic as we provide them with the necessary capital goods and services needed to increase their production domestically. This implies that the quantity demanded of Singapore exports may fall less than proportionately with an increase in price. This may lead to an increase in export revenue for S’pore instead.
Also, China produces low-end manufacturing goods in the areas of textiles and electronics, as well as necessities such as food. Thus, the cheaper import prices due to the undervalued Yuan would lead to a less than proportionately increase in quantity demanded, lowering import expenditure instead.
From here, we see that the extent to which the undervalued Yuan would affect Singapore depends on the satisfaction of the Marshall-Learner condition. Regardless of the individual values of PEDx and PEDm, as long as the sum of both is greater than 1, the undervalued Yuan would lead to a deterioration. of our BOT and BOP, ceteris paribus.
Indirect impact 1 on Singapore’s X & M
The undervalued Yuan also affects Singapore’s BOP via trade with other countries. With relatively: cheaper goods and services from China, the rest of the world may not be keen to trade with Singapore, especially if we sold goods and services similar to that of China. In this case, our exports to the rest of the world would lose export price competitiveness, leading to a fall in demand and worsening of our BOT and hence BOP, ceteris paribus.
The extent of the deterioration of the BOP will depend on the value of cross elasticity of demand between our goods and Chinese exports. China’s area of comparative advantage has been evolving in recent years, moving up the value-added chain from labour – intensive to more capital intensive manufacturing. Singapore has also been keeping up, moving our area of comparative advantage from capital-intensive manufacturing to research, services and digital media. This has helped to reduce the substitutability and cross elasticity value between Chinese and Singaporean goods, mitigating the impact an undervalued Yuan has on the Singapore BOP.
Indirect impact 2 on Singapore’s X & M
With the rest of the world buying more goods and services from China due to the undervalued Yuan, some countries may start to experience a current account deficit with China. This can be seen in the case of US, where the high trade deficit it experiences with China has led to an increase in unemployment in certain industries where China now has the comparative advantage. In the event. of a recession, as seen in 2008-2009, the national income of the US has fallen and unemployment has increased further. This reduces the purchasing power of the people and it could translate to a fall in the demand for imports into the US. Singapore would then be adversely affected as the demand for our exports, such as high value-added manufacturing, tourism and banking, tends to be income elastic. The fall in income in the US would lead to a more than proportionate fall in the demand for our goods and services, worsening our BOT and BOP, ceteris paribus.
However, this can be mitigated by the increase amount of trade that is taking place in the region with the growth of China. The high economic growth of China has led to direct increases in the demand for Singapore goods and services, especially in the area of tourism. This increase in affluence of the Chinese has led to a more than proportionate increase in the demand for our services, allowing BOT to improve. Simultaneously, the growth of China has benefitted the region as smaller neighbouring countries also experience an increase in economic growth when the demand for their goods and services increase. This also increases the BOT of the Singapore economy as they increase the demand for Singapore exports.
The final impact on Singapore’s BOP will depend on the extent to which we are able to decouple from the US and Europe as out main trading partners. With the increase in amount of regional trade conducted, it seems likely that Singapore’s BOP may not be adversely affected by the undervalued Yuan in terms of trade with the rest of the world.
2. Impact on Financial account
China’s undervalued Yuan and large endowment of labour makes it a more attractive destination for low skilled manufacturing as compared to Singapore. With cheaper wages and lower cost of production in China, there may be an increase in the amount of foreign direct investment into China by various MNCs which used to invest in Singapore. This would then reduce the amount of FDI inflow into Singapore, worsening our financial account and BOP, ceteris paribus.
However, with a more-skilled labour force and increased incentives from the Singapore government in new areas of comparative advantage, firms may find the higher rates of returns on their investment if they invest in Singapore in areas of high value-added manufacturing, research and other services. The undervalued Yuan may not be able to compete with Singapore in these areas and the increase in FDI inflows from these areas may offset the loss of FDI in low-end manufacturing, mitigating the impact on Singapore’s BOP.
In summary, the undervalued Yuan does bring about both benefits and costs to the Singapore BOP. The extent to which our BOP may be affected will depend on factors such as the substitutability of our goods and services. It is clear that Singapore and China do have different areas of comparative advantage. In this case, our BOT may not be adversely affected by the undervalued Yuan. Instead, a booming Chinese economy may benefit Singapore tremendously as the demand for our goods and services increases with the rise of regional trade agreements. Although our financial account may see a deficit due to a net FDI outflow, the increase in BOT would be able to offset that decrease, resulting in an overall improvement in our BOP.
Remarks from our H2 Econs Essay tutor:
1. Is the above answer a bit too long? Yes. Do you nee all the points? No.
2. What’s more important are the evaluation points. Can you spot it? Are you able to internalise it for yourself, and then use it for subsequent essays for JC Econs assessment and tests?
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More full length essays examples: JC Econs Essay Series #2