Discuss the impact of falling domestic interest rates and rising labour productivity on the Singapore economy.

1) Explain causes of falling interest rates and rising labour productivity briefly

Falling interest rates:

Since the MAS targets Singapore’s exchange rate as their primary monetary policy tool, they give up control over the interest rate. Two things affect the interest rate in Singapore which has a very open economy with a well-developed financial system:

  • Interest rates in foreign countries
  • Expected appreciation or depreciation of the Singdollar

So, falling interest rates in Singapore could have been due to an expected appreciation of the Singdollar or falling interest rates in other countries (especially the US – interest rate in Sg closely tracks that in the US).

Rising labour productivity:

In light of declining labour productivity recorded in 2011 for the first time in two years, coupled with rising labour cost amid a tight labour market, there has been a renewed emphasis by the government on raising labour productivity for sustained growth. Hence, policies to upskill or train workers and to incentivize firms to invest in higher quality capital equipment, among others, might have resulted in rising labour productivity.

2) Discuss internal impact

Falling interest rates:

Stimulate growth and employment

– Raise AD by reducing cost of borrowing for consumers and firms (C and I increase) => stimulates spending.

– Can increase RNY and hence employment by increasing demand for labour if not at Yf already.

Increase inflationary pressures

– However, there is a potential risk of credit and asset bubbles, such as in the housing market.

– This asset price inflation can also spill over to general consumer price inflation.

– In light of stubborn inflation due to rising food, labour and fuel prices, falling interest rates might pose a threat to the Singapore economy in terms of increasing inflationary pressures if economy operating at close to Yf.

Evaluation of internal impact (with transition to rising labour productivity)

– However, housing prices determination might not center on domestic interest rates. Instead, housing prices might depend on local demand that moves with employment and wage growth, rather than speculative forces (risk of housing bubble forming not high).

– Hence overall, if the economy is not near or at full employment, the internal impact of falling interest rates can be beneficial for Singapore.

– However, if interest rates continue to fall without an increase in productive capacity of the economy, Singapore might suffer from inflationary pressures and overheat over time.

– Inflationary effect can be mitigated by rising labour productivity though.

Rising labour productivity:

Stimulate growth and employment

– Increase SRAS by reducing cost of production for firms and increase LRAS by increasing productive capacity of economy => reduces inflationary pressures in SR and LR, can stimulate growth too as move along AD to achieve higher RNY and also result in higher demand for labour with more production overall.

Reduce employment growth

– However, rising labour productivity might be associated with falling employment growth as firms might decide to reduce the number of workers employed if the output per worker goes up. Data from other countries suggests a correlation between rising labour productivity and falling job creation.

-That said, it might be possible for rising labour productivity and job growth to complement each other as the increase in value of output per worker could have come about through innovation in product development for better quality, more desirable and thus more valuable products and services, which can spur demand. This increased spending by consumers and increased export demand can lead to more production and hence higher employment.

– If there is innovation in production processes, firms could enjoy cost savings that enable consumers to benefit in the form of lower prices. Consumers might choose to spend the cost-savings on more goods and services, leading to higher output and employment.

– Finally, rising labour productivity will be a key factor in Singapore maintaining her competitive edge in attracting FDI, and if successful can lead to more jobs created by business ventures from overseas investors.

Evaluation of internal impact (with link to falling interest rates)

– Overall, it is likely that rising labour productivity can lead to strong economic performance if it is achieved through innovation. Whether the Singapore economy benefits from rising labour productivity might depend on whether demand can be sustained or even increased in the long run, perhaps through falling interest rates to boost C, I spending.

3) Discuss external impact

Worsen BOP

– Hot money could flow out of Singapore to places where interest rates are higher => capital account worsens

Improve BOP

– With downward pressure on currency due to outflow of hot money and rising labour productivity leading to cost savings for firms,  exports become more price competitive and AD will increase again => current account improves

– Rising labour productivity could attract FDI => capital account improves

Evaluation of overall external impact

– Overall impact on BOP depends on relative changes in current and capital accounts – likely to see improvement in BOP with combined effect as effects of rising labour productivity on efficiency and competitiveness more significant in affecting expectations of exchange rates (expected to appreciate – can attract hot money) and FDI

 4) Overall evaluation of impact?

If falling interest rates are not accompanied by rising labour productivity => economy might overheat as it moves closer to full employment level ( and assuming nothing else changes).

If rising labour productivity takes place but there is insufficient demand – economy could have too much slack, and unemployment might result. This can be addressed partly through falling interest rates.

When both happen, sustained growth is possible for the Singapore economy.

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