How does the Singapore dollar exchange rate affect inflation?

Man using calculator and counting money

Direct Impact
Singapore imports goods and services from a variety of sources—vegetables from China, chicken from Malaysia, and construction equipment from the US, and so on. Many Singaporeans also travel, and what they spend overseas is counted as “imports” too! The goods and services imported from abroad are usually priced in foreign currencies.

Suppose that the prices of these foreign goods and services increase due to some shortage in supply among our trading partners. In Singapore dollar terms, these items would become more expensive for consumers and businesses, assuming that the various exchange rates do not change. When the Singapore dollar prices of many items across the economy increase rapidly, inflation rises.

However, if MAS tightens monetary policy, that is, it supports a strong S$NEER, the higher-priced imports will become cheaper in Singapore dollar terms for consumers and businesses in Singapore. In other words, strengthening the exchange rate can have a significant and direct impact on lowering inflation in Singapore.

Indirect Impact
At the same time, as the exchange rate strengthens, the prices of some imported goods in Singapore dollar terms may become even cheaper than items produced locally. Consumers here may switch to buying foreign imports instead of domestic products.

A stronger S$NEER also means that the Singapore dollar prices of our exports become more expensive to foreign buyers when converted into their currencies. They may then buy less from us, thereby reducing sales and revenues for Singapore exporters.

This decline in demand from locals and foreigners indirectly lowers inflation in Singapore. As Singapore businesses receive fewer orders, they would cut back on production. They may hire fewer workers or downsize to smaller factories and office spaces, leading to reduced incomes for domestic workers and firms. This reduction in overall demand “cools” the economy and reduces cost and price pressures.

While these indirect effects are also significant, they take a longer time to work through the economy.

These effects are reversed if the MAS eases monetary policy, that is, causes the S$NEER to appreciate more slowly, or even depreciate (weaken).

Exchange rate affects inflation Check out more in MAS Gallery Zone B: "How Does The Exchange Rate Affect Inflation"

Monetary policy affects the economy gradually

Monetary policy takes time to work through the economy and affect consumer prices. This is because price-setting by businesses involves many other considerations besides the exchange rate. These include demand conditions, competitive pressures, lengths of business contracts, as well as other input costs.

For instance, when MAS tightens monetary policy, the Singapore dollar strengthens. This will lower import costs for businesses in Singapore dollar terms. However, they may not make immediate changes to the prices they charge to consumers.

This could be because other business costs, such as electricity, warehouse and transportation services, or rental, may be fixed under an existing contract. Businesses might only be able to adjust their prices after their contracts expire and they can re-negotiate new contracts with revised prices. Companies may also need to consider how wage costs are changing. Therefore, it may take some time before the lower import costs due to the stronger Singapore dollar are passed on to consumers.

Businesses will also take time to assess how demand for their goods and services might change in response to MAS’ monetary policy tightening. A stronger Singapore dollar makes our exports more expensive to foreign buyers. For instance, tourists may not visit Singapore if our dollar is much stronger than their home currencies and costs of hotels and attractions priced in Singapore dollars become too expensive. Such changes in demand will eventually cause businesses to cut back on production, hiring, and investment. Over time, business costs in the Singapore economy should fall, causing businesses to adjust their prices.

In other words, the effects of a monetary policy move by MAS take time to gradually flow through the economy. Meanwhile, economic conditions in our trading partners and in Singapore are always changing. This means MAS needs to pay close attention to the factors driving growth and inflation in both the near and medium term when deciding on the setting for monetary policy.

In the next article, we will learn more about Singapore’s historical inflation experience.

To review how exchange rate-based monetary policy affects inflation, watch this video.