Download Economic Explorer 2 - Monetary Authority of Singapore

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economics
explorer series
MONETARY
POLICY
& THE
ECONOMY
http://www.mas.gov.sg
A closer look at the nuts and bolts behind
monetary policy in Singapore – what its
objectives are, how it is conducted by
MAS, and how it affects the economy.
Economic Policy Department
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The Monetary Authority of Singapore (MAS) is the
central bank of Singapore. Like any other central bank in the world, one of its
primary responsibilities is the conduct of monetary policy. This is clearly spelt
out in the mission and objectives of MAS as "to conduct monetary and
exchange rate policies to promote sustained non-inflationary economic
growth".
What Is Monetary Policy?
In its narrowest definition, monetary policy is the central bank's policy
regarding the supply of money in the economy. By changing the amount of
money available, the central bank hopes to influence the level of economic
activity, which in turn affects the general level of prices in the economy.
How Does a Central Bank Conduct
Monetary Policy?
There are a number of ways in which central banks can increase or decrease
the money supply. Some central banks affect money supply directly by
increasing or decreasing what is known as the monetary base. This is made up
of currency in circulation and cash reserves, which commercial banks keep
with the central banks. Other central banks influence the interest rates at
which commercial banks can borrow from them, otherwise known as the
discount rate.
In some small open economies, the central banks choose to anchor their
monetary policy to the exchange rate, either by pegging the value of the home
currency rigidly to another currency as in the case of a currency board, or by
managing it more flexibly against a basket of foreign currencies. The choice of
monetary policy instruments depends very much on the circumstances facing
each economy. The chart below shows that the central bank could use a
variety of instruments to attain its objective of price stability and sustained
economic growth.
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Objectives of Monetary Policy
Instruments of
monetary policy:
EXCHANGE
RATE
MONETARY
BASE
To achieve
price stability
As the
basis for
sustained
growth
INTEREST
RATES
Many economists now believe that the central bank should focus primarily on
achieving price stability, or low inflation, in its conduct of monetary policy.
This is based on cross-country experience over the last three decades, which
shows that price stability is essential for sustainable economic growth.
A Trade-off Between Inflation & Growth
Not too long ago, during the 1960s and 1970s, economists and
policy makers used to believe that they could bring down
unemployment by deliberately stimulating the economy with
monetary or fiscal policy, and incurring somewhat higher inflation
in the process.
This belief, however, was overturned by new economic theories
and empirical evidence which emerged subsequently. The trade-off
between a bit more inflation and a bit less unemployment can still
be made in the short run. But experience has shown that attempts
to apply it in the long run do not work. They simply result in everrising inflation.
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Output Growth & Inflation: No Trade-Off
(Average 1965-2003)
10
China
Singapore
Taiw an
Korea
Malaysia
Hong Kong
6 Thailand
Japan
Output Growth (% p.a.)
8
Iceland
Mexico
Malaw i
4
US
UK
2
Israel
Indonesia
Venezuela
Turkey
Chile
Ghana
Uruguay
Sierra Leone
Germany
0
Zambia
-2
0
5
10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85
CPI Inflation (% p.a.)
Price stability is now generally accepted as laying the best foundation for
sustained economic growth. Most economists and policy makers consider
price stability to be in the ballpark of 0-3% annual change in the consumer
price index (CPI). In such an environment, the prices of goods and services
are not distorted by inflation and can serve as clearer signals and guides so that
resources are allocated more efficiently. In addition, an environment of price
stability is believed to encourage saving and investment as it prevents the value
of assets from being eroded by unanticipated inflation.
Monetary Policy Framework in Singapore
Since 1981, monetary policy in Singapore has been centred on the exchange
rate. This reflects the fact that, in the small and open Singapore economy, the
exchange rate is a more effective tool in maintaining price stability.
Why Is Monetary Policy Centred on the
Exchange Rate?
The choice of the exchange rate – rather than money supply or interest rates –
as the principal tool of monetary policy has been influenced by Singapore’s
small size and its high degree of openness to trade and capital flows.
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Small Size &
Limited Resources
Openness
to Trade
Why the
Exchange
Rate Policy?
Openness to
Capital Flows
Singapore’s small size and lack of natural resources means that we have to
import even the most basic of our daily requirements, and export to pay for
these requirements. This has resulted in a very open trade policy, with very
few import restrictions.
Just How Open is Singapore to Trade?
As we can see from the chart on the following page, both imports and exports
amount to well over 100% of Singapore’s GDP. Another indication of the
openness of the Singapore economy is the high import content of final
expenditure. As a matter of fact, out of every $1 spent in Singapore, 51 cents
leak out as imports1.
Openness to Trade: Ratio of Exports & Imports to GDP
230
200
% of GDP
Imports
170
140
Exports
110
80
50
1965
1973
1979
1985
1991
1997
2003
What are the consequences of Singapore’s small size and openness?
First, because it is too small to influence world prices, Singapore is a price
taker. Producers in Singapore have to accept prices dictated by global supply
and demand conditions. In addition, the high import content of domestic
demand means that changes in world prices or in the exchange rate have a
1
According to the 1995 Input-Output Tables published by the Department of Statistics.
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powerful influence on domestic prices, either directly or indirectly. Changes in
the exchange rate to offset changes in foreign price levels would thus have a
significant effect on inflation.
Besides its direct impact on import prices, there is another, more indirect
channel by which the exchange rate can affect domestic inflation. Because of
the importance of exports in Singapore, the exchange rate can influence overall
demand in the economy, and thus affect the demand for domestic resources,
such as labour. For instance, a weak exchange rate can lead to stronger exports
and aggregate demand, overheating of the economy, a tighter labour market,
and consequently, higher domestic wages and other costs.
Managing the exchange rate is thus the most effective way of maintaining price
stability in a small, open economy like Singapore. It is relatively controllable by
the central bank and bears a stable and predictable relationship with the
objective of monetary policy, which is price stability. The importance of
external demand also means that traditional monetary policy instruments such
as money supply or interest rates, which largely affect domestic demand, have a
smaller influence on the overall level of economic activity and, therefore,
inflation in Singapore.
What are the implications of Singapore’s openness to capital flows?
In addition, because of Singapore’s role as an international financial centre, the
economy is very open to capital flows. As a result, small changes in the
difference between domestic and foreign interest rates can lead to large and
quick movements of capital. This makes it difficult to target money supply in
Singapore. Likewise, domestic interest rates are largely determined by foreign
rates and market expectations of movements in the Singapore dollar (S$). As
we can see from the chart below, the 3-month domestic interest rate has
closely tracked its US$ interest rate equivalent over the years. Thus, any
attempt by MAS to raise or lower domestic interest rates over a long period of
time, would be thwarted by a shift of funds into or out of Singapore.
US$ SIBOR & Domestic Interbank Rate
20
% per annum
16
12
3-m onth US$ SIBOR
8
4
3-m onth
Dom estic
Interbank Rate
0
1980
1984
1988
1992
End Period
5
1996
2000
2003
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In the context of free capital mobility, the choice of the exchange rate as the
focus of monetary policy in Singapore must imply relinquishing control over
domestic interest rates and money supply. This constraint is what economists
called the Open Economy Trilemma. In Singapore, therefore, monetary
policy is synonymous with exchange rate policy.
What about Inflation Targeting?
Inflation targeting is a relatively new member of the family of
monetary policy options. First adopted by New Zealand in 1990, a
growing number of central banks – both in industrialised and
emerging economies – have since implemented the inflation
targeting framework.
Characteristics of inflation targeting
Frederic Mishkin defines inflation targeting as a monetary policy
strategy that encompasses five key elements:
· Absence of other nominal anchors;
· An institutional commitment to price stability;
· Absence of fiscal dominance;
· Policy instrument independence; and
· Policy transparency and accountability.
The case for inflation targeting stems from the consensus that the
primary goal of monetary policy in any country ought to be
attaining and preserving a low and stable rate of inflation.
Pros and cons of inflation targeting
Inflation targeting is perceived to have several advantages as a
medium-term strategy for monetary policy. The explicit inflation
target is not only easily understood by the public, it is also highly
transparent and can therefore help to increase the accountability of
the central bank. Inflation targeting can also strengthen central
bank credibility and reduce the costs of lowering inflation. To the
extent that the government is actively involved in setting the
inflation target, inflation targeting can help to bring about
complementary fiscal policy.
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Inflation targeting is not without its problems, however. Since
inflation is ultimately an economic variable beyond central banks’
direct control, inflation targeting also faces difficulties in
implementation, both in the form of unforeseen shocks to the
economy, and the long and variable lags in monetary policy.
Should inflation targets fail to be achieved consistently, the central
banks’ credibility might be compromised.
Inflation targeting should therefore not be seen as a panacea for all
economic ills associated with either excessively high or excessively
low rates of inflation. It may fail to work if the underlying
economic conditions and institutional framework are not right.
Conversely, for monetary regimes that already enjoy a high degree
of success and credibility, the marginal benefits of switching to an
inflation targeting regime are not entirely clear.
Singapore and inflation targeting
In Singapore, our exchange rate centred monetary policy has served
us well in delivering low and stable inflation for more than two
decades. While the MAS does not prefer to operate a strict
inflation targeting framework, many of its core elements as
identified by Mishkin are present in Singapore’s monetary policy
system. Thus for example, MAS monetary policy objective is
firmly on attaining price stability, which is complemented by the
government’s prudent and conservative approach towards fiscal
policy. The MAS also has full independence in the formulation and
implementation of monetary policy.
Indeed, having achieved some degree of credibility in the financial
markets, there appears little to be gained by the adoption of a
formal inflation targeting regime in Singapore. Instead, a better
approach – and one that MAS has already been investing resources
in – is the adoption of some desirable features of the inflation
targeting system, including the strengthening of the transparency of
the monetary policy process.
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Characteristics of Monetary Policy in Singapore
The Singapore dollar is managed against a Basket of currencies of our major
trading partners and competitors. The various currencies are assigned weights
in accordance with the importance of the country to Singapore’s trading
relations with the rest of the world. The composition of the basket is revised
periodically to take into account changes in trade patterns.
MAS operates a managed float regime for the Singapore dollar. The tradeweighted exchange rate is allowed to fluctuate within a policy Band, the level
and direction of which is announced semi-annually to the market. The band
provides a mechanism to accommodate short-term fluctuations in the foreign
exchange markets and flexibility in managing the exchange rate.
The exchange rate policy band is periodically reviewed to ensure that it remains
consistent with underlying fundamentals of the economy. Thus, the policy
band incorporates a ‘Crawl’ feature. It is important to continually assess the
path of the exchange rate in order to avoid a misalignment in the currency
value. The length of the policy review cycle is typically six months. A
Monetary Policy Statement (MPS) is released after each review providing
information on the recent movements of the exchange rate and explaining the
stance of exchange rate policy going forward. An accompanying report, the
Macroeconomic Review, provides detailed information on the assessment of
macroeconomic developments and trends in the Singapore economy, and is
aimed at enhancing market and public understanding of the monetary policy
stance.
The Transmission Mechanism of Monetary Policy
As indicated earlier, there are two main channels or avenues through which the
exchange rate policy of MAS affects inflation and economic activity in
Singapore. These channels, along with several lesser ones, are collectively
known as the "transmission mechanism" of monetary policy.
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Import
Prices
A
B
External
Demand
Trade-weighted
S$ Exchange Rate
INFLATION
Total
Demand
Domestic
Demand
B
C
Interest
Rate
A
Expectations/
Confidence
Asset
Prices
Channel A: Impact on Import Prices
The first and most direct channel through which monetary policy in Singapore
affects inflation is via the effect of the exchange rate on import prices.
To understand how this channel works, let us look at a simple example.
Suppose MAS depreciates the trade-weighted value of the S$, by selling S$ in
exchange for foreign currency in the foreign exchange market. This means
that the prices of foreign goods and services which Singapore imports will be
higher when converted into S$. This has the direct effect of raising the prices that
an average Singaporean household has to pay for imported goods and services
that are consumed immediately. It also has the indirect effect of raising the prices
of locally produced goods and services that use imported inputs. Some of
these price changes, however, may take some time to work through the
economy, depending on the speed and extent with which importers and
retailers pass through the higher prices to consumers.
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Weaker S$
exchange
rate
B
Each S$
is worth
less in
US$ terms
Imported
goods cost
more when
converted
to S$
Domestic price of
imported goods
goes up
Price of locally
produced goods
that use imported
inputs also goes up
Inflation
goes
up
Channel B: Impact on External Demand
The second important channel through which monetary policy affects inflation
in Singapore is its effect on aggregate demand in the economy.
Continuing with our previous example, when MAS depreciates the tradeweighted value of the S$, goods and services produced in Singapore would be
more competitively priced in world markets in the short term. This would
increase the demand for Singapore’s exports from the rest of the world. In
addition, domestic demand would also be boosted by a substitution effect as
higher prices for imported goods increase demand for Singapore produced
goods.
This increase in domestic demand happens when Singapore
households subsequently switch to locally produced goods and services when
they realise that imported goods and services are relatively more expensive
compared to its domestically produced substitutes.
To meet the increase in export orders and domestic demand, companies in
Singapore would raise their level of production, and require more production
workers. As companies compete for the limited pool of workers in Singapore,
they would inadvertently bid up wages. This is particularly so when the
economy is operating at full or close to full capacity, as was the case in
Singapore during much of the 1980s and 1990s. The end result is higher
inflation, as companies pass on the higher wages that they have to pay, in the
form of higher prices that they charge consumers. This transmission
mechanism, i.e. Channel B, is somewhat more complex than Channel A and
may take longer to work through the economy.
Similarly, when MAS appreciates the trade-weighted value of the S$, inflation
would be lowered through this indirect but significant “whiplash” effect via the
output channel. For instance, with an exchange rate appreciation, goods
produced in Singapore would be less competitive in world markets in the short
term, thus lowering demand for Singapore's exports. In addition, domestic
demand would be dampened by a substitution effect as lower prices for
imported goods reduce demand for Singapore produced goods. The drop in
external and domestic demand for Singapore products would lead to lower
production and weaker demand for labour, which in turn results in moderating
wages and consequently lower prices. However, this takes place at the cost of
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reduced output. MAS’ internal studies have shown that this indirect channel
has a significantly stronger impact on inflationary outcomes through its
contractionary effects on economic activity compared to Channel A. This
implies that to pursue a disinflationary strategy, we have to sacrifice output in
order to lower inflation via the "whiplash" effect.
In this instance, reducing inflation would involve short-term costs associated
with a corresponding loss in output. Hence, policymakers in deciding the
timing and extent of inflation reduction would have to weigh the benefits of
lower inflation against the output cost of such a disinflationary policy. This is
usually referred to as the sacrifice ratio, which is the cumulative loss in output,
measured as a percent of one-year’s GDP, associated with a one percentage
point permanent reduction in inflation.
Weaker S$
exchange
rate
More
competitive
exports in the
short term
High export
growth &
overheated
economy
Rise in
wages
and
rentals
Surge in
labour
costs
A Weaker Exchange Rate for
More Competitive Exports?
At first glance, it appears tempting to depreciate the nominal
exchange rate so as to raise the competitiveness of our exports and
boost export growth. Upon closer inspection, however, we find
that because of the transmission mechanisms mentioned earlier, the
export competitiveness gained from weakening the exchange rate is
actually much lower than expected.
A weaker exchange rate would indeed cause exports to rise in the
short term as predicted. However, this high export growth would
cause the economy to overheat, pushing up the demand for
domestic resources like labour, and lead eventually to higher wages
and prices via Channel B of the monetary policy transmission
mechanism. A weaker exchange rate would also directly result in
the higher cost of imported inputs for manufacturers via Channel
A, and partially offset the gains in export competitiveness.
In addition, our internal estimates have also shown that income
effects on Singapore’s domestic exports are significantly larger than
price effects. In fact, the results suggest that export demand
responds twice as much to a change in income than an equivalent
change in prices.
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Inflation
goes
up
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C
Channel C: Impact on Domestic Demand
Besides the two main channels of transmission described above, MAS'
monetary or exchange rate policy also impacts the economy through its
influence on domestic demand, for example, via the interest rate, as can be
seen in the following box.
Changes in the monetary or exchange rate policy can also influence consumer
confidence, expectations about the future course of the economy, and asset
prices, although their ultimate impact on domestic demand and its timing are
even more difficult to assess.
How Do Interest Rates Affect the Economy?
How does a change in exchange rate impact interest rates?
The interest rate is the price at which money today may be traded
off for money at a future date. In other words, it is the rate of
return to savings or the cost of borrowing. The precise impact on
domestic interest rates of a change in the trade-weighted S$
exchange rate is uncertain, as it depends on people's expectations
about inflation, foreign interest rates as well as the exchange rate.
The central bank can affect interest rates through its influence on
market expectations of the future movement of the exchange rate.
For instance, during the first half of the 1990s, MAS had a policy
of appreciating the trade-weighted exchange rate so as to dampen
inflation. As a result, the market expected the S$ exchange rate to
appreciate over time, and this led to lower domestic interest rates.
And how do interest rates affect the economy?
Interest rates impact the economy via their effect on domestic
spending on investment and consumption. For example, a rise in
interest rates increases companies' borrowing costs, thereby
reducing profits and increasing the return that they will require
from new investment projects. As a result, this will make
companies less likely to undertake new investments. However, the
importance of this effect on companies depends on the nature of
their business, their size and sources of finance.
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In Singapore, it is reckoned that companies in the manufacturing
sector may be relatively less affected by interest rate increases, as
the sector is dominated by multinational corporations (MNCs)
which rely on their own sources of funds, e.g. from their head
offices. In contrast, companies in the building and construction
sector may be more severely affected as they are more reliant on
bank borrowing and their cashflows are much tighter given the
long duration of their projects.
Higher interest rates also affect the individuals and households, as
they face new rates on their savings and debts, in particular
mortgages. Any rise in mortgage interest rates will increase the
monthly mortgage payments of households. This will reduce the
amount of disposable income available to them to spend on goods
and services. Moreover, higher interest rates provide a greater
incentive for the individuals and households to save for the future
rather than to consume now. The end result is a decline in
domestic demand and lower inflationary pressures.
So How Does the US Federal Reserve Use the Interest Rate?
The central bank of the US, the Federal Reserve, uses the federal
funds rate as its primary instrument for monetary policy. This is
the rate at which banks borrow overnight reserves from one
another. As the US is comparable to a large, closed economy, it
can influence its own and worldwide interest rates. The Federal
Reserve is able to affect the rates by performing Open Market
Operations, which involve either the purchase or the sale of
securities. For example, by selling securities, the Federal Reserve
reduces the amount of reserves which banks hold. Banks then
have less money to loan out. This exerts upward pressure on the
federal funds rate, which in turn causes other interest rates in the
economy to rise. Hence, by raising or lowering the federal funds
rate, the Federal Reserve is able to influence interests rates, and by
extension, domestic consumption and investment as well.
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Transparency in Monetary Policy
In recent years, many central banks including MAS have gradually shifted
towards adopting greater transparency in monetary policy. The concept of
transparency in monetary policy is multi-dimensional; it encompasses the
clarification of policy goals, operating procedures and changes in policy stance,
as well as the timeliness in reporting policy decisions to the general public. It
also includes disclosing information on economic models and economic
conditions that the policy decision is based upon.
Why is transparency important?
The principal argument for greater transparency is to promote accountability,
improve market efficiency and enhance the clarity and efficacy of policy, which
leads to better economic outcomes. Monetary policy can be made more
effective if the public knows the goals and instruments of policy and if the
authorities make a credible commitment to meeting them. Good governance
also calls for central banks to be accountable for their actions, particularly in
free and democratic societies.
In establishing understandable rules and procedures, increased transparency in
monetary policy would help to improve the workings of financial markets by
eliminating unnecessary uncertainties and volatility, enhance central bank
credibility, and foster better monetary policymaking by reducing the chances of
policy being manipulated for political purposes. It therefore enhances the
independence of the central bank in pursuing its objectives.
What have we done to improve transparency?
In recent years, MAS has made significant progress towards a more open and
communicative policy on its monetary policy stance. We have devoted greater
efforts to communicating our policy decisions more clearly and frequently to
the market, media, and the wider public. One of the key initiatives is the
announcement of our exchange rate policy stance in a formal Monetary Policy
Statement (MPS) every six months since February 2001. In conjunction with
the MPS, MAS has also released the semi-annual publication Macroeconomic
Review (MR) since January 2002, with a view to share with the public our
assessment of economic developments and outlook in Singapore, and the basis
for the policy decision in the MPS. MAS also holds closed-door briefings with
the press and with private sector analysts, to clarify any questions they might
have on our policy stance.
MAS has generally taken a more active role in raising public awareness of
economic issues. It has reached out to its target audience through various
means, including releasing publications via its website (such as the “Economics
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Explorer” pamphlets and “Staff Paper” series), and conducting seminars and
presentations for students, private sector analysts, and representatives from
other local and overseas agencies. In addition, MAS released two monographs
on Singapore’s exchange rate policy and on monetary policy operations in
February 2001 and January 2003 respectively. MAS also organised a formal
macroeconometric modeling conference in February 2000 to launch the
Monetary Model of Singapore (MMS), and in the process help to enhance the
public’s understanding of the economic model used by MAS.
How has greater transparency enhanced monetary policy?
MAS’ move towards greater transparency in monetary policy has been received
positively by the media, market and wider public. In promoting understanding
of the thinking behind the policy stance, it has helped to align the views of the
market with those of the policymakers, thus reducing the need for otherwise
heavy interventions by MAS to achieve the desired exchange rate outcome.
Greater disclosure and clarity of monetary policy, backed by a long history of
credibility, have helped to support and enhance the effectiveness of MAS’
management of the S$ exchange rate. It has also provided greater information
to help affect price and wage settings and business decisions, particularly in the
recent period of increased volatility in the economic environment. In addition,
increased transparency has enhanced MAS’ reputation and image, and fostered
the discipline and commitment to meeting its objectives. As greater
transparency leads to more open debate and criticism, MAS would need to be
able defend its policy objectives and decisions. The resulting competition of
ideas and more open dialogue would invariably lead to better and more
informed policymaking
Constraints of Monetary Policy
While it can ensure price stability for sustainable economic growth, monetary
policy per se cannot affect the long-term growth capacity of the economy. In
the long run, the growth of an economy is determined by supply-side factors
such as technological progress, capital accumulation, and the size and quality of
the labour force. Some government policies may be able to influence these
supply-side factors, but monetary policy generally cannot do so directly. By
providing a sound and stable macroeconomic environment, however,
monetary policy can ensure the smooth and efficient functioning of the
economy, thereby sustaining its growth.
Apart from monetary policy, there are a number of other forces affecting
output and prices in the economy. For example, the government's actions on
its tax and expenditure programmes, i.e. fiscal policy, can have a significant
impact on the economy as well as influence people's behaviour and
expectations.
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Fiscal policy can either constrain or abet central banks in their efforts to ensure
low and stable inflation. It is well known that in the post-war years, many
newly independent countries launched ambitious social programmes without
sufficient tax revenues to pay for them. Often, governments resorted to
borrowing and printing money to overcome their revenue shortfalls, leading to
high indebtedness and inflation.
Monetary Policy does not Work Alone
It is important to appreciate that monetary policy does not work
alone in Singapore. In addition to having the appropriate monetary
policy stance and framework, the effectiveness of the system also
depends on several other key factors. Most importantly, the
appropriate macroeconomic policy mix, which requires the efficient
co-ordination of monetary and fiscal policies, is essential in
achieving sustained economic growth over the medium term.
Other important factors include, an effective legal and judicial
system, an efficient and robust financial sector and an enterprising
and sound corporate sector.
Supporting factors of
monetary policy
Prudent
fiscal
policy
Deep and
efficient
financial
markets
Sound
corporate
sector
Effective
legal and
judicial
system
Other forces affecting demand or supply can be difficult to predict and can
affect the economy in unforeseen ways. This is particularly so for a small open
economy like Singapore.
On the demand side, these include external shocks such as the Asian financial
crisis, which saw a slump in external demand for Singapore's goods and
services. On the supply side, these include the oil shocks of the early 1970s
and 1980s, and natural disasters such as floods or droughts, which raise costs
and affect production. As these shocks affect output and prices, monetary
policy can attempt to counter their adverse effects on the economy, although it
cannot offset them completely.
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Monetary Policy… an Art or a Science?
There are a number of limiting factors that make the practice of
monetary policy more an art rather than a science.
Limitations of Monetary Policy
First, despite the best effort of the national account statisticians,
the central bank does not have up-to-the-minute, reliable
information about the state of the economy. Economic data are
limited because of lags in their publication as it takes time to
capture the myriad transactions in the economy. Besides, some
sectors of the economy are difficult to quantify and national
account statisticians have to make do with estimates.
Second, the central bank, or anyone for that matter, does not have
perfect knowledge of how the economy works: its multitude of
linkages, causes and effects.
Third, monetary policy affects the economy with long and variable
lags. The extent of the monetary policy impact can also be
uncertain as the structure of the economy changes over time.
How MAS deals with these limitations
For these reasons, MAS relies on a host of economic indicators as
guides to its monetary or exchange rate policy. These include
monetary indicators such as the trade-weighted exchange rate,
interest rate and money supply, and economic variables such as
labour market conditions, inflation and GDP growth.
Because of the lags in monetary policy, MAS formulates and
conducts monetary policy in a forward-looking manner. This is
accomplished by simulating and evaluating the impact of monetary
policy over the medium term using macro-econometric models of
the economy.
As no model can fully capture the workings of the economy, MAS
is not wedded to any single model and, instead, relies on several
models and tools to inform on its policy. Uncertainty and the lessthan-perfect knowledge of the economy also call for some degree
of humility and vigilance in the conduct of monetary policy, as well
as regular reviews of policy as new information becomes available.
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Conducting Monetary Policy amidst Uncertainty
The global economy has been increasingly subjected to more
frequent shocks. These include economic and financial as well as
shocks of a geopolitical and idiosyncratic nature, such as terrorist
attacks and medical pandemics. The sudden and unanticipated
nature of such shocks makes it impossible for policymakers to
predict accurately the occurrence of such events, and thus poses a
significant challenge to monetary policymakers. Nevertheless, it is
important for monetary policy to be formulated taking into account
the risks associated with such negative shocks, especially given the
severe consequences of these shocks.
As such, policymakers need to identify and understand the sources
of risks and uncertainty facing the economy at the present point in
time, and to quantify such risks if possible. They then need to
make reasonable assumptions about the economic impact and
assign probabilities to the occurrence of these shocks. An
assessment of the various possible outcomes under alternative
choices for monetary policy must then be made. Finally,
policymakers will have to arrive at a judgment and decision about
the optimal monetary policy action that maximises the central
bank’s likelihood of achieving price stability and sustainable
economic growth over time.
Indeed, Alan Greenspan, Chairman of the Federal Reserve Board
of Governors, has explicitly recognised the role of uncertainty in
the conduct of monetary policy. He mentioned that “uncertainty is
not just an important feature of the monetary policy landscape; it is
the defining characteristic… As a consequence, the conduct of
monetary policy in the US at its core involves crucial elements of
risk management, a process that requires an understanding of the
many sources of risk and uncertainty that policymakers face and
quantifying of those risks when possible.” 1 He highlighted further
that “a central bank needs to consider not only the most likely
future path for the economy but also the distribution of possible
outcomes around that path. The decision-makers then need to
reach a judgment about the probabilities, costs, and benefits of the
various possible outcomes under alternative choices for policy.” 2
1
Greenspan, Alan (2003) “Monetary Policy under Uncertainty” at a symposium
sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 29
August.
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2
Greenspan, Alan (2004) “Testimony of Chairman Alan Greenspan” at a nomination
hearing before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate,
15 June.
economics
explorer series
The Economics Explorer Series aims to provide an accessible
introduction to a broad selection of economic issues,
ranging from monetary policy to trade to inflation. It is for
anyone interested in taking a closer look at the economic
issues affecting Singapore.
#1 The Monetary Authority of Singapore
#2 Monetary Policy and the Economy
#3 Inflation
All issues of the Economics Explorer Series can be downloaded
from the MAS website at www.mas.gov.sg.
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