Exchange-Rate-Centred Monetary Policy

Idea

For a small, very open economy the exchange rate is a more powerful lever than the interest rate, so the central bank manages the currency directly. The exchange rate is set in the foreign-exchange market by the demand for and supply of the currency; the central bank moves it by transacting in that market, and the move feeds through to both aggregate demand (via net exports) and short-run aggregate supply (via the price of imported inputs). This is the framework Singapore’s central bank, the Monetary Authority of Singapore (MAS), operates.

Mechanism

Determination. Foreigners must buy the domestic currency to purchase its exports or invest in its assets, so an inflow of hot money or foreign direct investment, or a rise in export demand, raises demand for the currency and appreciates it. Conversely, residents must sell the currency to buy imports or invest abroad, which raises its supply and depreciates it.

Appreciation (to curb inflation). To reduce inflation the central bank appreciates the currency by buying it in the foreign-exchange market. Two effects follow at once. On the demand side, dearer exports and cheaper imports cut net exports $(X-M)$ and switch domestic spending towards imports, lowering consumption, so aggregate demand shifts left. On the supply side, imported inputs are now cheaper in domestic currency, lowering firms’ unit cost of production, so short-run aggregate supply shifts right. Both effects pull the general price level down.

Depreciation (to boost growth). To raise growth and cut demand-deficient unemployment the central bank depreciates the currency by selling it. Cheaper exports raise export demand, dearer imports cut import demand, and domestic consumers switch from imports to home-produced goods — so $(X-M)$ and $C$ rise and aggregate demand shifts right, raising real output.

Diagram

Foreign-exchange market for the Singapore dollar against the US dollar. Equilibrium price of SGD (Pe) and quantity (Qe) are set where demand D₀ meets supply S₀; a managed appreciation raises demand or reduces supply, a depreciation the reverse.

Exchange-rate appreciation: AD shifts left from AD₀ to AD₁ (lower net exports and consumption) while SRAS shifts right from SRAS₀ to SRAS₁ (cheaper imported inputs); the general price level falls from P₀ to P₁ with little change in output.

Exchange-rate depreciation: higher net exports and consumption shift AD right from AD₀ to AD₁ in the horizontal (Keynesian) range, raising real output from Y₀ to Y₁ at a roughly constant price level — actual growth and lower demand-deficient unemployment.

Considerations

Foreign-exchange reserves. Appreciating the currency requires buying it with reserves; if reserves run out, the central bank cannot sustain the appreciation.
Export and import elasticities. If export demand ( $PED_X$ ) or import demand ( $PED_M$ ) is price-inelastic, an exchange-rate move changes trade revenues and expenditures less than proportionately, weakening the policy — the Marshall-Lerner condition is the formal version of this point for a depreciation.
Growth–inflation trade-off. An appreciation that curbs inflation also lowers aggregate demand, risking slower growth and demand-deficient unemployment; an overdone depreciation can overheat the economy into demand-pull inflation.
Competitive devaluation. A depreciation is a “beggar-thy-neighbour” move; trading partners may retaliate by devaluing their own currencies or raising protection, nullifying the intended gain.

Context

Singapore’s choice rests on its high trade dependence — exports and imports together exceed 300% of GDP — which gives the exchange rate a far stronger grip on inflation and on aggregate demand than the interest rate would have. Two features matter especially: high import dependence means the exchange rate is the natural tool against imported (cost-push) inflation, since appreciating the currency directly lowers the domestic-currency price of imported inputs; and high export dependence means MAS aims for a gradual, modest appreciation of the dollar rather than abrupt moves, to protect export competitiveness while keeping inflation low. In practice MAS manages the dollar against a trade-weighted basket of currencies (the Singapore dollar nominal effective exchange rate, S$NEER) within a policy band, rather than against a single currency; the single-currency demand-and-supply diagram above is the schematic version of that managed float.

The choice is forced by the trilemma of international finance (the impossible trinity): a country cannot simultaneously manage its exchange rate, manage its interest rate, and permit free cross-border capital flows — at most two of the three. As an international financial centre dependent on foreign capital, Singapore keeps free capital mobility and manages the exchange rate, thereby giving up control of domestic interest rates (which track world rates). Large economies such as the United States make the opposite trade, managing interest rates because domestic demand dominates; China instead forgoes free capital mobility so as to manage both its interest and exchange rates.