1. Why and how are the capital and current account tied together so closely?

In the balance of payment, current account and capital account are tied together by an accounting identity. Current account on one side and the capital and financial accounts on the other side should balance each other out due to the double entry of each transaction. [ current account + financial account + capital account + official reserve account = 0 ] For example, if a country has a positive capital and financial accounts, it will have a current account deficit - because the debit is more than the credit. It means that this country is borrowing and using other countries savings to meet its local investment and consumption demands. In contrast, if a country has a negative capital and financial accounts, it will have a current account surplus - because the credit is more than the debit. It means that this country is using its saving for investing. In Singapore, the government is heavily managed the countrys economy It promotes high levels of savings. Also, the Monetary Authority of Singapore focuses on accumulating foreign reserves. Consequently, Singapore became a net creditor to the rest of the world. It experience a large current account surplus and saving accumulation in excess of domestic investment demand which helped to produce a long-term real appreciation of the Singapore dollar. 2. What is a real exchange rate? What determines real exchange rates in the long-run? Real Exchange Rate = Nominal Exchange Rate - Inflation Its the ratio at which any countrys own currency is equivalent to other currencies in terms of purchasing power. It discounts inflation from the nominal interest rate. It also provides a better measurement of countries exchange rates. The Monetary Authority of Singapore focused mainly on inflation and didnt use exchange rate as a competitive tool. Therefore, Singaporean companies had to find its way in competing with foreign producers without having unemployment problem. The Singapores labor market was very tight and the economy operated at full employment. In general, the real exchange rate is determined in long run by Purchasing Power Parity, Net Foreign Asset, Productivity, Trade Trends, and Saving-Investment balance. (Appendix 3) Specifically, the real exchange rate of Singapore dollar was appreciating in the long run. The reasons for this long-term appreciation are: First: Singapores economic development and the transformation of the economy since the early 1980s; structural change in the economy, involving the evolution in economic activity from a predominantly low-skill, labor-intensive base towards greater capital and knowledge-intensive activity has meant a continuous shift in the basis of Singapore's competitiveness in international markets. Second: National thriftiness has led to large current account surpluses. Substantial public sector surpluses and the high private savings rate have led to persistent current account surpluses since the mid-80s. 3. How do exchange rates interact with trade balances and fiscal policies? Trade Balance: trade balance equals exports minus import. Therefore, everything that affects export and import affects trade balance. Exchange rate effects the price of goods and services

traded and therefore affecting the price of exports and imports. Higher export price than import one means a surplus in the trade balance and vice versa. Fiscal Policy: fiscal policy is the use of government expenditures and revenue collection (taxation) to influence the economy. Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment, and economic growth. If exchange rate depreciates the domestic goods become cheaper and this will increase the demand and lead to an increase in exports, reduction in economic growth and thus, achieve one of the government fiscal policies by the effect of exchange rate. Singapores rapid economic growth and industrialization played a key part in the sustained real appreciation of its currency prior to the Asian crisis. This appreciation came as result of persistent annual budget surpluses on the order of 12% of GDP. Economically this represented a withdrawal of funds from the domestic economy that created a need for obtaining capital from abroad to make up for shrinking liquidity. This in turn increased the value of the Singapore dollar creating deflationary pressure. 4. Evaluate the advantages and disadvantages of a fixed vs. floating exchange rate system given the structure of Singaporean economy? Referencing to the Singapore three main necessities and economic objectives. (Appendix 1) Advantages: the floating exchange rates system works as an automatic stabilizer for the value of the currency which helps in freeing the monetary and fiscal authorities to concentrate on internal objectives such as employment and economic growth. In the other hand, the fixed exchange rate would build credibility for the country and the central bank which promotes global trade and investment. Disadvantages: Floating Exchange rate would hurt the Singaporean government economic objectives (especially employment and industrialization) by losing control over inflation. IT also would lead to a very volatile SGD in the short run which has severe economic consequences. On the other hand, fixed exchange rate will not provide the flexibility the Singaporean authority would need in time of crises and shocks as it will be dependent on the pegged currencys exchange rate, interest rate, and economic conditions of that country. Therefore, fixing its exchange rate would not help the Singapore economy to be more off shore financial market. 5. Do you think a managed float remains consistent with the Singapores economic goals? The managed float regime of the Singapore dollar has been successful since 1981; and it is still consistent with the Singapores economic goals. This regime helped to maintain the purchasing power of the SGD and at the same time give the Monetary Authority of Singapore enough flexibility to deal with shocks in the global economy. The result is: Low inflation rate, Low interest rate, and Expectations for SGD to appreciate over time. To conclude, we dont recommend another exchange regime for Singapore at the present time. The free floating rate regime will bring increased volatility, higher inflation, and adverse investors decisions, while the fixed rate regime will change the actual value of currency as happened in Hong Kong. It is obvious that the current exchange rate system played an important role in success of Singapores economy because it built a stable currency that promotes international trade and investment.

Appendix

(1) Brief Background Singapore has a highly developed free-market economy that depends heavily on exports particularly in consumer electronics, information technology products, pharmaceuticals, and on a growing financial services sector. If the Monetary Authority of Singapore tries to raise or lower the interest rate or money supply, funds will immediately shift outside Singapore. Therefore, price stability is the basis for Singapores sustained economic growth. (Singapore dollars (SGD) per US dollar = 1.262). Singapore government three economic imperatives are: 1. Reduction of employment, 2. Promote industrialization, and 3. Become a globally competitive off-shore financial sector.

(2) The Impossible Trinity Singapore has free capital mobility and independent monetary policy, but doesnt have a purely fixed exchange rate.

Independant Monetary Policy

Purly Fixed Exchange Rate

Impossible Trinity

Free Capital Mobility

(3) Definitions

- Balance of Payments: statement of inflow and outflow payments for a particular country. - Current Account: broad measure of a countrys international trade in goods and services. - Capital Account: account reflecting changes in country ownership of long-term and shortterm financial assets. - Fixed Exchange Rate System: monetary system in which exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries. - Freely Floating Exchange Rate System: monetary system in which exchange rates are allowed to move due to market forces without intervention by country governments. - Fiscal Policy: government's revenue (taxation) and spending policy designed to (1) counter economic cycles in order to achieve lower unemployment, (2) achieve low or no inflation, and (3) achieve sustained but controllable economic growth. - Gross Domestic Product (GDP): the value of a country's overall output of goods and services (typically during one fiscal year) at market prices, excluding net income from abroad. - Net Foreign Asset (NFA): is the value of the assets that country owns abroad, minus the value of the domestic assets owned by foreigners. - Productivity: a measure of the efficiency of a person, machine, factory, system, etc., in converting inputs into useful outputs. It is a critical determinant of cost efficiency. - Purchasing Power Parity: theory suggesting that exchange rates will adjust over time to reflect the differential in inflation rates in two countries. - Saving-Investment balance: is a concept stating that the amount saved in an economy will be equal the amount invested. In other words, investment must be financed by some combination of private domestic savings, government savings (surplus), and foreign savings (foreign capital inflows). - Trade Balance: the international trading position of a country in merchandise, excluding invisible trade. If exports are greater than imports there is a surplus (or favorable balance of trade). - Trade Trends: the attempts to capture gains through the analysis of an asset's momentum in a particular direction.

(4) Advantages and Disadvantages of Exchange Rate Systems

Theoretical Advantages and Disadvantages of Fixed and Floating exchange rate systems. I. Floating Exchange Rate System Disadvantages Uncoordinated macrocosmic policies Higher volatility in output Discretionary, central banks are tempted to print more money which lead to inflation

Advantages Monetary policy independence Automatic stabilization Flexible exchange rates may also prevent speculation in some cases II. Fixed Exchange Rate System

Advantages Creditability and discipline (it force CB to not print so much money which makes it anti- inflationary) Higher trade and investment due to lower uncertainty and lower transactions costs Fixed regimes can absorb monetary shocks coming from large countries

Disadvantages Loss of independent monetary policy

Speculative attacks No automatic adjustment and higher cost of adjustment if there is misalignment in the exchange rate