During 2009 the Bank of England engaged in what is known as quantitative easing by pumping more than 200 billion pounds into the economy. Record low levels of interest rates have also been maintained within the UK economy. QE and low interest rates were also adopted by the US.

Explain why exchange rates rather than interest rates are the preferred choice as the instrument of monetary policy in Singapore? [10m]

Changes in the exchange rate are transmitted to the economy in the following

• First, the exchange rate acts directly to dampen imported inflationary pressures.
Given that Singapore imports most of what it consumes, domestic prices are
very sensitive to world prices. The exchange rate thus provides an important
buffer against external price pressures at the borders, especially in periods of
escalating global commodity prices, thereby contributing significantly to the
objective of medium-term price stability.
• Second, the exchange rate acts indirectly to tackle domestic sources of inflation.
A stronger currency moderates the external demand for our goods and
services, and as the demand for domestic factor inputs eases, factor incomes
rise more modestly. This in turn reduces the domestic demand for non-tradable
goods and services, and puts downward pressure on prices.

The exchange rate represents an ideal intermediate target of monetary policy for
several reasons.
• First, it makes sense in the context of the small and open Singapore economy.
Singapore has no natural resources, and is almost completely dependent on
imports for necessities such as food and energy. The import content of
domestic consumption is correspondingly high, with nearly 40 cents out of
every $1 spent going to imports. Singapore has to export to pay for these
imports. The economy is thus extremely open to trade, which totalled more
than 300% of GDP in 2011.
• Second, the economy’s openness means that the exchange rate bears a stable
and predictable relationship to price stability as the final target of policy over
the medium-term.
• Third, the exchange rate is relatively controllable through direct intervention in
the foreign exchange markets. An exchange-rate-based monetary policy thus
allows the government to retain greater control over macroeconomic outcomes
such as GDP and CPI inflation, and thus over the ultimate target of price

Conversely, the structure of the Singapore economy reduces the scope for
using interest rates as a monetary policy tool. First, the corporate sector is
dominated by multinational corporations (MNCs), which rely on funding from their
head offices (typically in developed economies) rather than on local banking
systems or debt markets. Second, Singapore’s role as an international financial
centre has led to a large offshore banking centre that deals primarily in the G3
currencies, and it is one where assets denominated in those currencies far exceed
those of the domestic banking system. As there is no control on capital flows
between the offshore (foreign currency) and domestic (Singapore dollars) banking
system, small changes in interest rate differentials can lead to large and rapid
movements of capital. As a result, it is difficult to target interest rates in Singapore,BIS Papers No 73 309
as any attempt by MAS to raise or lower domestic interest rates would be foiled by
a shift of funds into or out of the domestic financial system.

Discuss the likely impact on the Singapore economy of quantitative easing and low interest rates in the US and the UK [15m]

Central banks are responsible for keeping inflation in check. Before the financial crisis of 2008-09 they managed that by adjusting the interest rate at which banks borrow overnight. If firms were growing nervous about the future and scaling back on investment, the central bank would reduce the overnight rate. That would reduce banks’ funding costs and encourage them to make more loans, keeping the economy from falling into recession. By contrast, if credit and spending were getting out of hand and inflation was rising then the central bank would raise the interest rate. When the crisis struck, big central banks like the Fed and the Bank of England slashed their overnight interest-rates to boost the economy. But even cutting the rate as far as it could go, to almost zero, failed to spark recovery. Central banks therefore began experimenting with other tools to encourage banks to pump money into the economy. One of them was QE.

To carry out QE central banks create money by buying securities, such as government bonds, from banks, with electronic cash that did not exist before. The new money swells the size of bank reserves in the economy by the quantity of assets purchased—hence “quantitative” easing. Like lowering interest rates, QE is supposed to stimulate the economy by encouraging banks to make more loans. The idea is that banks take the new money and buy assets to replace the ones they have sold to the central bank. That raises stock prices and lowers interest rates, which in turn boosts investment. Today, interest rates on everything from government bonds to mortgages to corporate debt are probably lower than they would have been without QE. If QE convinces markets that the central bank is serious about fighting deflation or high unemployment, then it can also boost economic activity by raising confidence. Several rounds of QE in America have increased the size of the Federal Reserve’s balance sheet—the value of the assets it holds—from less than $1 trillion in 2007 to more than $4 trillion now.