Lower interest rates and more money raise spending; a stronger currency lowers import prices and helps control inflation.
Interest rate: a cut makes borrowing cheaper and saving less rewarding. Households borrow and spend more, and firms invest more. Total demand rises, helping growth and employment. A rise does the opposite and helps to control inflation.
Money supply: increasing the money supply, for example by making it easier for banks to lend, raises spending. Reducing it lowers spending and inflation.
Foreign exchange rate: if the currency rises in value, imports become cheaper and exports dearer for foreign buyers. Cheaper imports lower the prices of many goods, which reduces inflation. If the currency falls, exports become cheaper and more competitive, helping growth and jobs.
Singapore's central bank, MAS, uses the exchange rate as its main tool, because Singapore imports most of what it consumes. Monetary policy can work fairly quickly, but its effects are uncertain. If confidence is low, people may not borrow even at low rates.
- Lower interest rates
- Raise borrowing, spending, growth and jobs.
- Higher interest rates
- Reduce spending and inflation.
- Stronger currency
- Cheaper imports, lower inflation; dearer exports.
- Singapore
- MAS uses the exchange rate as its main monetary tool.
Worked example: Singapore fighting inflation with the exchange rate
Suppose prices of imported food and fuel are rising fast.
- MAS lets the Singapore dollar rise in value against other currencies.
- Imports priced in foreign currency cost fewer Singapore dollars, so their prices in Singapore rise more slowly.
- Because Singapore imports most of its food and fuel, this slows inflation.
- Trade-off: Singapore's exports become dearer for foreign buyers, which may slow growth.
Watch out for this
Raising interest rates is a way to boost economic growth.
Higher interest rates reduce borrowing and spending, so they slow growth. They are used to reduce inflation. Lower rates are used to boost growth.
Check your understanding
A central bank wants to reduce unemployment during a recession. What should it do?
- Cut interest rates
- Raise interest rates
- Make the currency rise in value