The Impossible Trinity

Case Study on Monetry Policy of Singapore

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Overview of the study

Monetary policy is a part of macroeconomic strategies wherein the monetary authority means central bank of the nation makes policies, rules and regulations to control the supply of money in the country. The target of this is to control high rate of inflation and interest so as to stabilize price & build trust in economy (Chen and, 2016). In Singapore, central Bank is responsible to make policies and regulations in regards to control the inflation rate by altering the interest rate or exchange rate. Its monetary policy covers several aspects i.e. control foreign exchange rate, open market operations, inflation rate and others. Monetary Authority of Singapore (MAS) aims at keeping appreciation rate of Singapore’s dollar effective exchange (S$NEER) rate at 0%. The authority also intervenes in keeping foreign exchange rate stabilized so as to prevent the possibility of excessive volatility in the exchange rate. The policy considers domestic rate of interest and monetary supply as an endogenous variables and therefore, money market operations are carried out in order to ensure sufficient liquid availability. Thus, its monetary policy is an inflation targeted strategy, in which, policy-makers make policies in order to control the inflation (Mohan, Patra and Kapur, 2013).

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Applying the international economics concept of impossible Trinity, it presents that it is impossible for every nation to have a fixed FOREX, free movement of capital and independent monetary policy. Here, free capital flow is regarded as monetary movement for trade & investment purpose, fixed FOREX rate indicates fixed exchange rate of one currency against the value of other currency and last one sovereign monetary policy is the process wherein central bank design policies so as to control the money supply in the nation (Cai and Pitsch, 2014). The trilemma is also called Unholy Trinity and became popular as Mundell-Fleming model examine the effectiveness of monetary policy of the country in an open economy with distinctive exchange rate (Schularick and Taylor, 2012). Considering it in Singapore’s open economy, the concept believes that it is impossible for the MSA to consider all of these three factors while designing the monetary policy therefore; there are three choices available to the policymakers presented below:

Being a major financial centre, Singapore’s MSA selected free mobility of the capital & targeted one monetary variable either exchange rate or other but not both. Unsurprisingly, exchange rate can be used as an effective tool in order to manage an open economy (Moin and Ahmed, 2012).

Impossible Trinity

Figure 1 Impossible Trinity
[Source: Stein, 2012]

Taylor has developed a rule that presents decisions on interest rate of Federal Open Market Committee (FOMC). It is based on altering either increasing or decreasing the interest rate, at which commercial banks can grant loans to each other, decided using following equation:

r = p + 0.5y + 0.5(p-2) +2
r= Interest rate
p – Inflation rate
y – Output gap (excess of potential GDP over actual output)

Referring Singapore, MAS follows inflation-targeting & exchange rate focused monetary policy with free flow of capital and domestic interest rate is determined through foreign interest rate comprising time-varying risk premium (Bruno and Shin, 2015). Thus, according to the rule, in order to control inflationary pressure, MAS needs to charge high rate of interest so as to control money supply or vice-versa. Lack of credibility of the statutory monetary authority has been recognized as a key reason behind avoiding & adopting Taylor’s rule, however, for an open-independent economy like Singapore there may be some other reasons (Galí, 2015). Evidencing from the empirical researches, implementation of Taylor rule in the closed economies like US and UK founded a significant impact on the economic performance. However, in the open economies, it is still a contrasting discussion. Therefore, the current research paper investigates that whether Taylor rule will be prove effective or not for the Singapore. It will make a counter-factual analysis to assess that whether the monetary policy framework would be more effective by using interest rate as an instrument instead of exchange rate.

Research aims and objectives

Aim: To critically evaluate the effectiveness of Taylor’s rule in Singapore’s open economy


Research question

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Q. Will Taylor Rule will be effective or not in designing monetary policy of Singapore?

Rationale of the study

Singapore’s exchange rate targeted monetary policy aims at managing the exchange rate with the focus on promoting price stability. The policy regime has three characteristics i.e. managing against currency basket of major trading partners, allowing exchange rate movement within policy band and reviewing policy with the underlying economic fundamentals (Sanders and Houghton, 2016). However, given an economic trilemma, Mundell prescribe that MAS can use any of two, but not all of 3 objectives (stated above) of monetary policy. However, Aizenman stated that all these follows linear relationship therefore, it make it essential for the policy makers to make a trade-off in selection two variables out of 3 set of objectives. An alternative available to the authority is that MAS can utilize interest rate as an instrument whereas exchange rate can be adjusted to market forces (Moreno, 2012). Thus the main question is that should Singapore adopts Taylor’s rule and float its currency? Thus, the paper investigated the characteristic of different policy choices and also examines the application of Taylor rule in monetary policy of Singapore.

Structure of the dissertation

The dissertation has followed structure outlined here below:

Introduction: This section briefly introduced the subject matter or overview of the research problem along with the aims and objectives. It also presents the potential contribution of the investigation and rationale why the current area needs to be investigated by the scholar.

Literature review: Literature review is a process wherein scholar critically evaluates the existing knowledge, methodological and theoretical contribution & substantive findings regarding the research topic. In this regards, researchers uses only the secondary material sources without conducting any original investigation or experimental work in the chosen field to gain conceptual knowledge in detail.
Conclusion: It will conclude the findings of the research in summary format to overcome the research issue investigated by the scholar.

Literature Review

1. Current monetary policy framework of Singapore and impossible trinity concept

In Singapore, Monetary Authority of Singapore (MAS) is the central bank who carries out central banking functions regarding monetary policy formulation & its successful implementation. The core focus of the monetary policy is to ensure price stability through managing trade-weighted rate of exchange. In this regards, it is targeted at maintaining rate under the policy band (Aziakpono, Kleimeier and Sander, 2012). Moreover, it also carries out money market operations in order to have sufficient quantum of liquidity for ensuring effective functionality of the banking system. MAS managed its exchange rate through following aspects:

Current statistical data reported that in Jan-Feb, 2017, Singapore’s core inflation excluding the cost of transport & accommodation has been averaged to 1.3% YOY which was 1.2% in the last quarter of preceding year 2016. Exceeding oil prices i.e. electricity, petrol and other is the main reason behind pickup in inflation. The economy is projected to continues to expand at the modest pace in the year 2017 and inflation rate has been forecasted to increase gradually mainly due to exceeding prices of oil (Monetary policy, 2017). On the other hand, demand-driven inflationary pressure is predicted to restrain and core inflation rate is supposed to retain at average rate slightly below 2%. MAS targeted at controlling inflationary pressure in the country through using exchange rate as an instrument. However, applying the Taylor rule, authority can use interest rate as an alternative means instead of current instrumental exchange rate.

Mundell’s Impossible Trinity

Figure 2 Mundell’s Impossible Trinity
[Source: Rey, 2015]

The above illustrated trilemma presented three sides, that are monetary independence, financial integration and stability in exchange rate to achieve the monetary policy targets, yet, it is impossible for the MAS to address all of these. In the study of Aizenman, Chinn and Ito (2013), it has been founded that targeting an exchange rate is considerably more effective in comparison to the interest rate as an instrument of macroeconomic fluctuations. However, on the other side, Taylor’s rule presented a mechanism that can be used by the MAS to reduce high rate of inflation by altering interest rate by targeting inflation and output gap. Although, it has been used over last two decades as a dual mandate in order to control price stability and boost economic sustainability, still, at the same time, the rule has several drawbacks and criticism.

2. Application of Taylor’s rule in the monetary policy

According to views of Gerstenberg and, (2015), Counterfactuals Simulation refers the flexibility in the rates so that it is very useful because of their flexible nature. When Singapore’s economy uses the counterfactual simulation it assumes the event or areas which are already in simulating in nature. It is a force which not only allows but also forces the brain to run the simulations in desired areas of Singapore. It is useful for the Singapore’s economy because it is flexible which means it can be simulating anything where it wants. It helps the economy to discover the hidden opportunities which may be assumed impossible by the country (Neely, 2015).

As per Bärgman and, (2015), Counterfactual simulations help the economy and allow finding out the actual figure which is real in nature. It is a concept which is related to human psychology and tendency to create possible alternative. It also includes all those things which could never happen in reality. According to He and, (2013), Counterfactual simulation helps the Singapore’s economy to identify the risk aversion, intention of behaviour. It also include the goal directed activity and collective action which is beneficial for the economy. By using the downward counterfactual simulation it could be worst result and people feel a sense of relief. On the other hand, upward counterfactual thinking, create negative thinking of people like disappointment which is related to the situation. As per the research in Singapore’s economy, there are various kinds of effects are contributions are investigated which make great impact in counterfactual simulation of the economy. As per the Hutchison, Sengupta and Singh (2012), the result showed that in a last past events people are more concerned and generated with downward counterfactual. They also examined that manipulating social distance; negative responses make wrong impact in the country's growth.

Recent research by Aizenman and Ito (2012), looked to determine the given power in the situation which affect the thought of counterfactual by which such views help to understanding the future performance. This research also determine that how manipulating the power given a chance to reflect differently by making effective personal control. According to Federico, Vegh and Vuletin (2014), counterfactual simulation includes various theories like Norm theory, rational imagination theory, functional theory and rational counterfactual. By using all these theories, it helps the Singapore’s economy to achieve their pre-determined target and achieve their growth. By using the norm theory, Singapore’s economy determines the different outcome with imaginative manner. On the other hand, functional theory is focus to check the perspectives of human and their activity by which people can avoid their past blunders. By using rational imaginative theory, people think alternative possible ways and rational counterfactual theory helps to maximize the attainment of the desired consequent. As per Pisani-Ferry (2012), norms and functional theory is taken by the Singapore’s economy so that it will be fruitful to the growth of the country. It also help to stabilise the monetary policy by accomplishing their pre-determine targets. As per the given by Taylor's view counterfactual simulation make moderate impact in their monetary policy which need more improvement so that country can achieve their desire target in future (Zagst, 2013).

A recent study conducted by Manogaran and Sek (2016), had investigated Taylor rule in context to ASEAN5 (Thailand, Singapore, Indonesia, Philippines and Malaysia) using NARDL (nonlinear augmented distributed lags model & Pooled Mean Group (PMG) method. The findings of the study presented that in the ASEAN countries, policy reacts asymmetrically to the exchange rates in the different time period such as short-term and long-term. Still, on the other side, policy may also react differently from the country to country. Evidencing from the results of the study, in Thailand, monetary policy framework is designed in such a manner to keep the exchange rate depreciated as policy shows decline in the interest rate with response to depreciated exchange rate in the long-run. Unlike this, the other four nations, Singapore, Indonesia, Philippines and Malaysia do not reflect any change with the increase or decline in exchange rate but response with the decrease or increase in long-run period. Referring Malaysia, the research founded out that there is fear floating exists because it reflects declined in the policy rate with the appreciated exchange rate therefore; central bank has to implement expansionary policy so as to boost & promote economic growth. In contrast, other three nations Indonesia, Singapore and Philippines had founded comfortable without any fear floating behaviour with the appreciating exchange rate behaviour by improving policy rates in order to derive benefits from the foreign flow of capital and assures appreciating exchange rate in future.

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Besides this, policy behaved differently in response to the output gap & inflation gap across distinctive countries. Countries with exceeding rate of inflation i.e. Thailand and Indonesia significantly react with the inflation gap in the long-run whereas Philippines and Malaysia shows high response with the output gap. It is because their actual output goes beyond the potential or targeted level. Therefore, central bank keeps down the rate to maintain their actual output in line with the targeted output to abstain high rate of inflation in long-run. Thus, the policy reacts asymmetrically hence consider Taylor’s rule as an augmented rule it is because, all the ASEAN5 reflected effective response with the volatile exchange rate by increasing or decreasing the policy rates. Majority of the countries monetary policy regime focuses on the inflation control still they are skeptical to allow fluctuations in the exchange rates due to the intervention of fear of floating.

However, on the critical note, Basilio (2013), argued that before using Taylor rule, interest rate sensitiveness of the economy must be checked. In Singapore, its extensive network of trade relationship with the rapid flow of capital with the liberal policy regime towards FDI stated that the economy is not very responsive with the fluctuating interest rate. In the counterfactual experiment, Taylor rule replaces the exchange rate rule, more specifically, when economy uses exchange rate then domestic rate of interest is determined to satisfy interest parity whereas when interest rate is managed then exchange rate is founded to do the same.

Study conducted by Chow, Lim and McNelis (2014), performed an Impulse Response Path analysis of output gap and inflation from the period ranging 1985 to 2009 under actual as well as counterfactual regime and the result determined that, with response to the productivity shock, under the exchange rate rule, inflation goes increase, however, it dropped down in Taylor rule. It is because; productivity shock maximizes the output gap. Since the Taylor’s interest rate rule respond to the output gaps by increasing the interest rate, inflation rate decline due to the productivity shocks. Similarly, inflation is also considered as more responsive to import-price inflation shock in Taylor rule comparatively to the exchange rate. Considering the nature of the shocks in the economy; impulse response analysis identified that one rule will be more beneficial over other one so as to stabilize the inflationary pressure. In case of dominant productivity shocks Taylor’s interest rate rule is considered as more effective, however, in case of dominant foreign price shocks, exchange rate rule is preferable.

The result of the study showed that welfare-maximizing rule of Taylor that is based on the lagged interest rate, output gap and inflation minimizes inflationary pressure in productivity shocks, however, exchange rate depreciation rule reduces the same in export price shocks (Jiménez and, 2014). Evidencing from the output generated, GDP volatility is founded more responsive to the export-pricing volatility (74%) in comparison to the productivity (4%) which suggests Singapore’s monetary authority to use exchange rate as an instrument for the monetary policy regime instead of Taylor’s rule. Besides this, in the stochastic simulation, the result showcase that under exchange rate rule, depreciation is less volatile & the interest rate is considered as more volatile in comparison to the interest-rate based rule. Evidencing from the outcome, optimal rule delivered zero output gap with low inflation coefficient (1.05) & larger smoothing coefficient (0.675) in comparison to the corresponding coefficient at 1.72 & 0.145 respectively.

On the critical note, De Brigard, Szpunar and Schacter (2013), pointed out that policy regime also needs to be examined on the basis of inflation persistence. Asian countries who had switched to inflation-targeting monetary policy focus with the application of Taylor rule declined inflation persistence. According to the results derived through simulation, the study stated that exchange rate persistent coefficient mean and median was recognized at the lower end of the actual distribution however the same under the Taylor rule were founded at the upper end. Thus, the finding clearly presented that monetary policy with the depreciating exchange rate policy had a comparative advantage over the Taylor rule regime so as to achieve lower inflationary persistence. The output of the study suggested that there is no reason for the MAS to fear floating the exchange-rate and using the rule of Taylor to manage their inflation rate. Thus, abandoning currently used exchange rate regime with the interest rate will indicates more exchange rate volatility and less fluctuation in the interest-rate.

However, on the other side, Drehmann and Gambacorta (2012), criticized the interest-rate focused rule of Taylor on the three pointed that are inclusion of exchange rate, its asymmetric form and foward V/s backward rule. In the first criticism, it is suggested to incorporate exchange rate in the Taylor rule especially in the emerging economies. Although these are small still very open in trade hence, these are sensitive to the volatile exchange rate movements and vulnerable to the external shocks, called fear floating behaviour. Such economies are reluctant to float their local currency value with the fluctuation in the exchange rate, hence, it is better for such countries to incorporate exchange rate in the rule to make monetary policy framework more effective.

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It is contradicted by Hofmann and Bogdanova (2012), arguing that monetary policy shouldn’t include a direct exchange rate because it may results in loss of credibility. The study opined that there is already an indirect effect of the monetary policy over output and inflation; therefore, there is no need for the countries to include it in the Taylor rule. Besides this, the rule follows an assumption of linear relationship however, criticisers disapproved the assumption by proving asymmetric (non-linear) relationship therefore, the rule cannot be considered as an effective method. Apart from this, it can be inferred that the rule only pay focus on the predetermined values of inflation & economic growth in order to formulate the monetary policy, still, the method provides an inadequate mechanism to predict the future status of the economy at a current level of inflation & output gap.


Based upon the analysis carried in the research, it can be concluded that every country’s monetary policy’s main focus is to control the rate of inflation through exchange rate control & interest rate movement. However, taking into account, the impossible trinity index which reveals that central bank can only use either of any two factors out of monetary independence, financial integration and stability in exchange rate in their monetary policy regime. In Singapore, Monetary authority uses exchange rate as an instrument for keeping control over the inflation rate so as to ensure price stability in the economy. It is because, being a major financial centre, Singapore’s MSA selected free mobility of the capital & targeted one monetary variable using exchange rate as a tool for inflation control. Thus, the alternative that is being available to the MAS is to use interest rate (Taylor rule) as a medium to minimize inflation. MAS allow free flow of capital under which interest rate is determined by the authority through foreign interest rate taking into consideration time-varying risk premium. According to the rule, if MAS needs to control inflationary pressure, then it needs to charge high rate of interest so as to control money supply or vice-versa.

The findings of various studies conducted earlier, it has been founded that monetary policy framework reacts distinctively to the output & inflation gaps. The research determined that in the exchange rate, inflation rate in an economy goes upward with response to the productivity shocks whereas the same goes decline in Taylor’s interest based rule. It demonstrates that with dominant productivity shocks Taylor’s interest rate rule is considered as more effective, however, in case of dominant foreign price shocks, exchange rate rule is preferable. Likewise, inflation significantly response to the import-price inflation shocks in comparison to the exchange rate. Besides this, it also has been evaluated that in the exchange rate based rule, depreciation is comparatively less volatile while interest rate shows high volatility or opposite under the interest-rate based monetary regime.

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However, on the other side, Taylor rule also has been contradicted on the basis of asymmetrical relationship means non-linear relationship. It also has been criticized on the basis of interest-rate rule of Taylor on the three pointed that are inclusion of exchange rate, its asymmetric form and forward V/s backward rule. Moreover, the findings also concluded that monetary policy regime response differently with the exchange rate movements in different time duration and in different economies. Focusing on Singapore, it is assessed that its economy has no floating fear with the Taylor rule. It is because, with the appreciating exchange rate behaviour, MAS will improve policy rates in order to derive benefits from the foreign flow of capital and assures appreciating exchange rate in future. Pointing out inflation persistence, the studies showed that monetary policy framework of the nation with the depreciating rate of exchange has certain advantage over interest rate based rule to control inflation rate. Thus, there is no reason for the Singapore’s open economy to fear floating the exchange-rate and using the rule of Taylor to manage their inflation rate. Abandoning currently used exchange rate regime with the interest rate will indicates more exchange rate volatility and less fluctuation in the interest-rate.

Thus, from the research, it becomes clear that it might be better for the Singapore to apply Taylor rule to control inflation in case of dominant productivity shocks. However, currently applied exchange rate is founded as a better choice for the monetary authority in case of dominant foreign price shocks.


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