While the impossible trinity is not in the A level assessment syllabus, it is a very useful framework to understand a key part of the syllabus – which is why Singapore uses exchange rates instead of interest rates to engage in monetary policy.
The above graph illustrates the conditions of the impossible trinity (also known as the open economy trillema). In a nutshell, it’s impossible for any economy to achieve free capital flow, fixed exchange rates and sovereign monetary policy (control of interest rates) at the same time and each economy will have to pick 2 out of 3. Note that Singapore is basically ‘a’ – free capital flow + control over exchange rates. Singapore IS NOT having a fixed exchange rate system but a managed float, which still means having to exert a degree of control over exchange rates.
Free capital Flow in Singapore
Let’s apply this model to Singapore. We decided to have free capital flow (mobility) – meaning that there are no restrictions to the flow of capital in and out of Singapore. This can include short term capital flows (hot money) and long term capital flows (foreign direct investment).
The benefits of Foreign Direct Investment (FDI)
Why did we chose this? Mainly due to the nature of our economy and our pursuit of growth and development. As a small country with minimal natural resources, making it easy for foreign capital to flow in and out of Singapore makes it easier for multinational corporations to do business in Singapore, i.e. more FDI flows into Singapore. This then stimulates the investment component of our aggregate demand (AD), creating jobs and actual growth. Not to mention the MNCs will build factories, import production machines/technology (capital goods accumulation) which will then help increase Singapore’s productive capacity aka long-run aggregate supply (LRAS). The employees of these MNCs will also learn soft skills like management techniques, systems of production, marketing etc. raising the quality of labour in general, further increasing our productive capacity. Note that free capital flows is not enough to attract FDI, we also had tax incentives, political stability and other factors in our favour.
Interest rates vs exchange rates
The importance of exports and imports
Since free capital flow is in a sense a non-negotiable for an international finance hub like Singapore. Based on the impossible trinity theory of only being able to have 2 out of 3 of the conditions as stated above, we now pit interest rates vs exchange rates. Again looking at the nature of our economy, it simply does not make sense to control interest rates while giving up control of exchange rates. Singapore is a small and open economy which relies on imports for daily necessities/luxuries and raw materials for domestic/export production. Net exports (x-m) is also the most important driver of Singapore’s growth since we can take advantage of the global market. As such control of exchange rates is a lot more important to us than interest rates.
The importance of imports in particular also leads to imported inflation (a form of cost-push inflation) being generally the main cause of inflation in Singapore. As such, control of exchange rates – slow and gradual appreciation of the Singaporean currency – is crucial in controlling imported inflation in Singapore and interest rates can’t help at all in this regard.
In a nutshell STABLE exchange rates is important for importers and exporters for their planning and operational purposes, hence Singapore prefers to control its exchange rates via a managed float.
The problem of free capital flow and a relatively small monetary base
Singapore is a “price taker” for interest rates, sometimes also known as interest-rate taker. This means we have little control of our interest rates due to the fact that we have free capital flows. The following short video illustrates the issue using the loanable funds diagram.
Doesn’t the scenario mentioned above apply to other economies?
Every country has a different monetary base which is directly correlated to the size of its economy. An analogy would be to think of the monetary base like water bodies. USA’s monetary base is like the sea, it would take A LOT of “water” (hot money flow) to cause a perceivable rise or fall in sea level. Singapore however is perhaps more like a puddle of water, where relatively a lot less “water” (hot money flow) is needed to cause an obvious change in the water levels. Furthermore, there are cases like China, which although having a huge monetary base, nevertheless restricts capital flows to allow more control over their interest rates.
Manipulating interest rates causes Exchange rate volatility
As mentioned above, due to our free capital flow status, hot money flows in and out of Singapore freely whenever there are interest rate changes. Before hot money enters or leaves Singapore however, they must go through the foreign exchange (forex) market. So taking the scenario in the video above, if hot money enters Singapore, that money must be changed into Singapore dollars (SGD) first. This hot money comes from all over the world, USA, China, Eurozone countries, India etc. So this means that they would have to use their currency to BUY Singapore dollars., thus increasing the demand for SGD and causing the currency to appreciate. On the other hand if Singapore were to reduce interest rates, hot money flows out of Singapore. But before it can flow out into other countries, the SGD must be converted/exchanged into foreign currencies. This means that the investors would SELL SGD for other currencies. This increases the supply of SGD and depreciates the Singapore currency.
Given the various reasons stated above, Singapore has thus decided on Free capital flow + controlling exchange rates while relinquishing control over interest rates.
Looking at the graph again here are some examples of a, b and c.
a – Singapore: Controls exchange rates (NOT fixed but managed) and allows free capital flow – gives up control over interest rates
b – USA: Controls interest rates and allows free capital flow – gives up control over exchange rates
c – China: Controls both interest rates and exchange rates – restricts capital flow.
Can you think of other examples of a, b or c? Do post your examples and comments/queries below. Thanks!