Much attention is paid to how central banks in large economies set monetary policy. Such economies are relatively closed and therefore not much affected by economic developments and disturbances abroad. But most central banks operate in Small Open Economies (SOEs) in which the exchange rate often plays a dominant role in determining economic outcomes. A sharp, unexpected exchange rate change can plunge the economy into recession or lead to a burst in inflation. Indeed, while flexible exchange rates are often thought of as shock absorbers, the experiences of SOEs is often that they function as shock generators.
Singapore’s “crawling peg”
Since 1981, Singapore has very successfully followed an intermediate policy strategy. Much like a fixed exchange rate regime, the strategy reduces the risk of damaging short-term fluctuations in the exchange rate. But like a floating exchange rate regime, it allows the Monetary Authority of Singapore (MAS) to gear policy to domestic considerations.
The crawling peg regime is focused on the Nominal Effective Exchange Rate (NEER) of the Singapore dollar as the intermediate target of monetary policy. The idea is that by steering the NEER, the MAS can achieve a desirable balance of inflation and economic activity in Singapore. While the MAS has good control of the exchange rate, it cannot precisely control it day-to-day. It therefore allows the exchange rate to move within a band around the target.
Since the objective of the MAS’s monetary policy is “to maintain price stability conducive to sustained growth of the economy,” the NEER has been allowed to appreciate gradually over time to limit inflation in Singapore. The average rate of appreciation of the NEER can be estimated by studying the time periods during which the desired rate of change of the NEER was positive. Doing so gives an estimate of the average rate of appreciation of about 1.5% per year.
