Why Singapore Chooses Exchange Rates over Interest Rates, and Whether Openness Limits Fiscal and Supply-Side Policy
Answer
Part (a)
Monetary policy influences the macroeconomy through an instrument — the interest rate or the exchange rate. Singapore has centred its monetary policy on the exchange rate since 1981. This essay explains why, on two grounds: the exchange rate is the more effective instrument given Singapore’s openness, and the interest rate is in any case not independently controllable.
The exchange rate is the more effective instrument for an open economy. Singapore is small and extremely open — gross trade is several times GDP and a large share of domestic spending falls on imports — so the trade-weighted exchange rate has a powerful influence on prices and output. A gradual appreciation lowers the domestic price of imported raw materials, cutting firms’ unit costs and easing imported cost-push inflation — the dominant inflation channel for an import-reliant economy. Appreciation also raises export prices in foreign currency and lowers import prices in domestic currency; provided the Marshall–Lerner condition holds, net exports fall, aggregate demand falls, and demand-pull inflation eases. By contrast, the interest rate works on C and I, which are a smaller share of AD than net exports in Singapore, and it does nothing for imported cost-push inflation. So the exchange rate is the more potent lever for price stability here.
The interest rate cannot be set independently. Because Singapore is an open financial centre with free capital flows, it is an interest-rate taker: under the policy trilemma, a country with free capital mobility and a managed exchange rate cannot also run an independent interest rate. If the MAS tried to set domestic rates below world rates, short-term capital (“hot money”) would flow out, the small pool of domestic loanable funds would shrink, and rates would be bid back up to the world level. Domestic interest rates are thus pinned to foreign rates, and investment in Singapore — much of it foreign direct investment — is in any case relatively interest-inelastic. The interest rate is therefore neither controllable nor especially effective.
Consolidation. Singapore chooses the exchange rate because its openness makes the exchange rate the strongest influence on domestic prices and output, while the same openness, combined with free capital flows, deprives it of independent control over the interest rate.
Part (b)
Governments raise employment by managing aggregate demand through fiscal policy and by raising aggregate supply through supply-side policy. The question is the extent to which an economy’s openness — to trade, capital and competition — limits these in achieving low unemployment. My thesis is that openness does limit both, but the limit is significant only for small, very open economies, and even then openness also enhances policy in some respects; the net constraint depends on the nature of the economy and the government’s adeptness.
Openness limits fiscal policy through the multiplier. Facing demand-deficient unemployment, a government can run expansionary fiscal policy — higher G, lower taxes — to raise AD, output and the derived demand for labour. But an open economy has a high marginal propensity to import, so the multiplier — — is small: more of each round of spending leaks abroad. A given fiscal injection therefore produces a smaller rise in national income and employment, limiting fiscal policy’s reach in an open economy like Singapore.
Openness limits supply-side policy through the pace of restructuring. Facing structural unemployment, a government can retrain workers to match the skills demanded by sunrise industries. But in a very open economy, exposed to global competition and free capital mobility, foreign firms relocate quickly when costs are lower elsewhere, and the economy’s structure shifts faster than workers can be retrained. The dynamic environment created by openness can outrun the retraining schemes meant to address it.
However, openness also enhances these policies, and other factors matter too. Supply-side policy that builds a skilled workforce attracts FDI, which openness makes more mobile; FDI brings expertise that trains domestic workers and capital that raises AD, reducing both structural and demand-deficient unemployment. A competitive corporate-tax cut similarly draws mobile foreign investment. And openness lets the government tap inflows of skilled foreign labour to fill skill gaps directly, easing structural unemployment. Meanwhile, the scope of fiscal policy is limited by factors other than openness — notably crowding out, where deficit-financed spending bids up interest rates and reduces private C and I, blunting the expansion regardless of openness.
Judgement. Openness limits both policies, but the degree depends on the economy. For a small, very open economy like Singapore, openness is a significant constraint: a small multiplier weakens fiscal policy, and fast restructuring strains supply-side policy, while the country has little domestic buffer against external shocks. For a large, less trade-dependent economy like the United States — a bigger domestic market and a larger multiplier — the constraint is milder. Yet even for Singapore, openness is double-edged: the same openness that shrinks the multiplier also lets the government attract FDI and import skilled labour to enhance its supply-side efforts. The net effect therefore turns on the government’s ability to exploit the opportunities openness brings while managing its constraints. On balance, openness limits fiscal and supply-side policy to a large extent for small open economies and a modest extent for large ones — but in neither case does it eliminate their usefulness, and a capable government can turn openness partly to its advantage.