JC Economics Essay Series #62 – Price Stability for Small & Open Economy

JC Econs Essay Price Stability for Small & Open Economy Model Answers 

One of the main macroeconomic objective for Singapore as a small and open economy, is to achieve domestic price stability. being resource-scare, maintaining mild inflation is even more crucial than others.

So will exchange rate policy be able to combat high inflation in S’pore, or would we need other macro policy measures?


(a) Explain why maintaining domestic price stability is likely to be more important than other macroeconomic aims in small, open and resource scarce economies. [10]
(b) Discus the extent to which exchange rate policy is the best measure in maintaining price stability in Singapore. [15]


JC Economics – Domestic Price Stability

Suggested answer (a)

An economy would like to achieve four macroeconomic goals, namely sustained economic growth, price stability, full employment and balance of payments equilibrium. This essay aims to explain why maintaining domestic price stability is more important for small, open and resource costs economies like Singapore


1. Promotes investment
Price stability is important as it provides certainty which makes it easy for investors to make projection on costs and returns of their investments Investments are important to small, open economies as they depend greatly on investment for economic growth Higher investments mean a rise in aggregate demand causing the national income to increase by a multiplier effect Cyclical unemployment would also decrease. Thus, price stability leads to the achievement of more than one other macroeconomic goal

This can be illustrated in Figure 1 below, where the increase in AD from AD, to AD, leads to an increase in national income from Y, to Y
(sketch diagram, as an exercise)


Also, low inflation encourages savings as the value of money is not quickly eroded. An increase in savings leads to a lower interest rates as the supply of loanable funds increase. This would increase the expected profit from investment, encouraging firms to invest more. In the presence of mild inflation,, caused by an increase in aggregate demand, firms may experience higher profit margins in the short-run. This is because factor costs are unlikely to increase due to contracts agreed upon earlier. Thus, an increase in prices would lead to an increase in revenue and profits since costs remain unchanged. This will encourage both investment and growth and in the long run, increase the productive capacity of the economy.


2. Promotes exports
Price stability is also important for small, open economies has it helps to keep exports price competitive in the international market. With relatively lower (and more stable) prices in the international market, there would be a more than proportionate increase in quantity demanded, assuming that the demand for exports is price elastic. This would raise export revenue which is important for a small, open economy as it depends highly on export revenue for growth. The increase in export revenue will lead to an increase in aggregate demand which would increase in national income more than proportionately via the multiplier effect.


3. Promotes exchange rate stability
This increase in export revenue also helps to achieve a favourable balance of payments equilibrium for the small, open economy. A favourable balance of payments equilibrium is important as this reduces the risk of currency instability. There is no fear of devaluation and potential capital flight if a country is able to export and earn sufficient to pay for their imports and other international obligations. This would enhance the level of investment and consumption in the economy, further fuelling economic growth.

An increase in export revenue would lead to an increase in the demand for the domestic currency leading to an appreciation in its value. This would help to further stabilize domestic prices imported. inflation is kept at bay.


From the above, we see that the maintenance of a stable domestic price level is important for a small, open economy. It will help the economy to achieve the other macroeconomic goals both in the long. and short run.



JC Economics – Singapore Dollar Policy & Inflation

Define exchange rate policy: strong S$


Make a strong S$ tackle inflation.

Lowers the prices of imports. Slows down cost-push inflation


Little room to raise the external value of the domestic currency of S’pore, as still need exports to be price competitive.

Unable to address other forms of inflation: wage push and demand-pull inflation

Thus, recommended to also include SSP


Which is the best polices to tackle inflation in SG?


For an economy who is considered small, open and resource scarce, controlling inflation is imperative to her =economic success. Depending of S$ policy alone is insufficient to achieve this critical macroeconomic goal. [10] 


JC Econs Tuition teacher’s Remarks: Most students should expect at least 20 out of 25m for this relatively simple essay question. More on this key point in our Econs revision lessons.)