Q2c: With reference to Extract 7, explain why Australia's central bank was expected to further reduce interest rates from their record low level of 1.5%, whereas Singapore's central bank announced "no change in its current zero appreciation policy for the Singapore dollar." (8 marks)

Comments: This question tests students' ability to identify the reasons for the differing monetary policy approaches of Australia and Singapore, in light of the different economic environment of the 2 countries. Students are also required to explain how interest-rate centred monetary policy works in Australia and exchange-rate centred monetary policy works in SG. Last but not least, students are expected to show analysis of the possible/potential conflicts in macroeconomic goals due to the policy undertaken by the respective central banks of these 2 countries. No evaluation is required because the command word given is "explain", NOT "discuss".

Suggested Answer:

Australia's central bank is embarking on an expansionary monetary policy, which involves increasing money supply to reduce interest rates to the "current record low level of 1.5%" with further expectations that "it will cut them further fairly soon". This is in light of the weakening economic conditions because of "consumer demand has grown relatively slowly, by 1.2%", and "inflation running at only 0.3% per annum". The slower rise in consumption in Australia could have due to weakening consumer confidence arising from expectations of future income reduction. This led to households curtailing their consumption in view of further cuts in purchasing power. Since AD = C + I + G + X - M, the slower rise in consumption will lead to slower rise in the aggregate demand (AD). While Extract 7 mentions that there is rising exports, it has been mitigated by weakness in investment. Also, there is a "pre-election rise in government spending", but it is not expected to last as it is mainly politically driven to garner votes. Hence, the expected slower rise in the AD will result in a widening output gap, and low inflationary pressures, assuming that the aggregate supply of the economy is expanding over the long term.

In view of weakening growth and inflationary pressures, the Australia central bank has cut interest rates to stimulate growth and employment. The fall in interest rates will cut the costs of borrowing for households and firms, thereby stimulating them to borrow to finance consumption and investment. It will also reduce incentive to save, so households who are net savers will choose to save less and consume more. The final effect is to increase consumption and investment, thereby leading to an increase in the AD and hence national income. This will kick-start the multiplier process, whereby the AD will increase multiple rounds due to increases in induced consumption when national income rises. This culminates in a larger proportional increase in national income, which is known as the multiplier effect. Accordingly, AD can expand faster than AS, national income will rise at a faster pace, thereby reducing demand-deficient unemployment. Inflation can also rise to a modest level at 2-3%, from the current 0.3%, thus avoiding the onset of deflationary expectations which could cause households to postpone consumption and potentially weaken economic growth further.

Meanwhile in Singapore, the external economic environment is weakening due to the "weakening in the global outlook in most key economies". As Singapore is export-oriented due to its small domestic consumer base, the weakening economic growth of her trading partners will dampen export growth, as purchasing power of foreign households rises at a slower pace. In view of this, AD of Singapore is expected to rise at a slower rate. Singapore central bank thus announced "no change in the current zero appreciation policy for the Singapore dollar". This means that Singapore is keeping the exchange rate policy band unchanged, thus the exchange rate is prevented from crossing the upper limit of the policy band as it appreciates slightly due to the weak export growth. The zero appreciation policy stance is meant to maintain export price competitiveness in view of a slower rise in exports, thereby supporting the current export growth and hence economic growth. There could also be another reason why zero appreciation policy is used instead of depreciation policy. It was mentioned that Singapore's core inflation is expected to rise gradually close to 2% per annum. Thus, keeping the SGD policy band unchanged, and hence keeping the SGD a strong currency can guard against the possibility of imported inflation which could further cause inflation to spike. It is thus worth concluding that the central bank is pursuing a zero appreciation policy to support export growth, yet also preventing the inflation from rising rapidly.

In conclusion, the monetary policy approaches differ for Singapore and Australia due to different economic conditions and the potential conflict with inflation goal. As Australia's inflation is low at 0.3%, there is further room to expand the AD without causing high demand-pull inflation. The same cannot be said for Singapore, with inflation nearing 2%, thus there is limited room to expand the AD and hence the central bank is maintaining a zero-appreciation exchange rate policy to support export growth and avoid high imported inflation.

For further questions on A level exam paper for 2018, you may consult our Principal Economics Tutor, Mr Clive Foo during his economics tuition classes conducted @ Toa Payoh Branch. As the H1 economics paper (subject code: 8823) is not available for sale in major bookstores, students can also email Mr Clive Foo at clive.foo@econsactually.com if they wish to have the Exam Paper and Suggested Answers.