How Exchange-Rate Changes Affect the Domestic Price Level, and Whether Inflation Hits the Domestic or External Sector More

Answer

Part (a) — How exchange-rate changes affect the price level [10]

The external value of a currency is its price in terms of another currency; a change is either a depreciation or an appreciation. Taking a depreciation of an import-dependent economy like Singapore:

Demand-pull channel. A weaker dollar lowers the foreign-currency price of exports and raises the domestic-currency price of imports. If the Marshall-Lerner condition holds, net exports rise, raising aggregate demand. With spare capacity, output and employment rise via the multiplier; but near full employment, the rise in AD bids up prices, generating demand-pull inflation.

Demand-pull: depreciation raises net exports, shifting AD right (AD₁→AD₂) near full capacity; the price level rises with little output gain — demand-pull inflation.

Cost-push channel. Because Singapore is resource-poor and import-dependent — and its exports have high import content — a depreciation raises the domestic-currency cost of imported inputs, raising firms’ production costs. SRAS shifts up/left, raising the price level while lowering output — imported cost-push inflation.

Cost-push: depreciation raises imported input costs, shifting SRAS up/left (SRAS₀→SRAS₁); the price level rises from P₀ to P₁ while output falls from Y₀ to Y₁.

So a depreciation raises the domestic price level through both demand-pull and cost-push channels; an appreciation works in reverse, easing inflation.

Part (b) — Domestic or external sector more affected by inflation? [15]

The domestic sector is the home economy (consumption, investment, output); the external sector is trade and capital flows. A rise in the general price level affects both.

Domestic sector. Desirable (mild inflation): if prices rise faster than costs, firms’ profits rise and optimism stimulates investment; low or negative real interest rates lower debt burdens and encourage consumption — raising C, I, AD and national income. Undesirable (high inflation): menu costs; reduced incentive to hold money and lower saving and investment; uncertainty that lowers business confidence and investment; a redistribution of income (borrowers gain, lenders and fixed-income earners lose, widening the income gap); a wage-price spiral; and misallocation of resources as prices cease to signal reliably.

External sector. Desirable: if domestic inflation is below competitors’, exports become more price-competitive, raising net exports and improving the balance of trade. Undesirable: if domestic inflation exceeds foreign inflation, exports become dearer and imports cheaper; with elastic trade, export revenue falls and import spending rises, worsening the current account. Cost-push inflation also raises production costs, prompting FDI outflow and relocation (long-term capital outflow), while high inflation triggers capital flight (short-term outflow) — worsening the capital and financial account.

Judgement. First, whether inflation is harmful at all depends on its extent: mild inflation is broadly positive for both sectors, high inflation negative. Second, which sector is more affected depends on the nature of the economy. For Singapore — small domestic market, heavy dependence on exports, imported inputs and capital/FDI flows — inflation causes more problems for the external sector, because export competitiveness and capital inflows are so central. But the two are not separable: external damage spills back domestically. Uncompetitive exports lower export demand, raising cyclical unemployment and, via the reverse multiplier, lowering domestic production, employment and growth. So for an open economy the external sector bears the first and larger blow, but the domestic sector ultimately shares it through these spillovers — which is precisely why Singapore guards price stability so closely.