Pa ado, E ic
Wo king Pape
An exchange a e policy ule
IDB Wo king Pape Se ies, No. IDB-WP-1482
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Sugges ed Ci a ion: Pa ado, E ic (2023) : An exchange a e policy ule, IDB Wo king Pape Se ies, No.
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A
n Exchange Ra e Policy Rule
E ic Pa ado
IDB WORKING PAPER SERIES Nº IDB-WP-1482
Decembe 2023
Depa men o Resea ch and Chie Economis
In e -Ame ican De elopmen Bank
Decembe 2023
A
n Exchange Ra e Policy Rule
E ic Pa ado
In e -Ame ican De elopmen Bank
Ca aloging-in-Publica ion da a p o ided by he
In e -Ame ican De elopmen Bank
Felipe He e a Lib a y
Pa ado, E ic.
A
n exchange a e policy ule / E ic Pa ado.
p. cm. — (IDB Wo king Pape Se ies ; 1482)
Includes bibliog aphical e e ences.
1. Fo eign exchange a es-Singapo e. 2. In la ion (Finance)-Singapo e. 3. Mone a y
policy-Singapo e. I. In e -Ame ican De elopmen Bank. Depa men o Resea ch and
Chie Economis . II. Ti le. III. Se ies.
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Abs ac
This pape in oduces a no el mone a y policy amewo k whe e he exchange
a e becomes he cen al ins umen . Using Singapo e as a case s udy, i
explo es he Mone a y Au ho i y's adop ion o he exchange a e as he
p ima y ool since 1981, di e ging om con en ional app oaches cen e ed on
in e es a es o mone a y agg ega es. The es ima ed exchange a e eac ion
unc ion aligns well wi h ac ual de ia ions, suppo ing he hypo hesis ha
Singapo e’s o wa d-looking policy ule e ec i ely esponds o in la ion and
ou pu ola ili y, especially du ing economic c ises. This amewo k o e s a
p omising al e na i e o coun ies wi h open economies and challenges in
implemen ing adi ional in e es a e ins umen s.
JEL classi ica ions: E31, E52, E58, F41
Keywo ds: exchange a e, in la ion, mone a y policy ules, Singapo e

2
1. In oduc ion
Inc easing globaliza ion and g owing in e na ional capi al lows ha e p esen ed signi ican
challenges in implemen ing e ec i e mone a y policy and selec ing app op ia e policy
ins umen s. These challenges a e pa icula ly p onounced o small, open economies ha s i e
o con ol in la ion despi e cons an o eign shocks. Singapo e, ecognizing hese challenges,
adop ed a mone a y policy amewo k cen e ed on managing he exchange a e, wi h he p ima y
objec i e o p omo ing p ice s abili y as he ounda ion o sus ainable economic g ow h.
Consequen ly, adi ional app oaches such as he Taylo ule (Taylo , 1993) o he McCallum ule
(McCallum, 1988), which use in e es a es o mone a y agg ega es, espec i ely, as policy
ins umen s, a e inadequa e o cha ac e izing Singapo e’s mone a y policy.
In his pape , I build upon Pa ado (2004) by in oducing a no el policy ule ha places he
exchange a e a he co e o he mone a y policy oolki . Focusing on Singapo e as a case s udy, I
es ablish and e alua e a new eac ion unc ion o explo e how changes in he ade-weigh ed
nominal exchange a e espond o de ia ions in in la ion and ou pu de ia ions om hei
espec i e a ge s. The es ima ed eac ion unc ion e eals a o wa d-looking app oach aimed a
achie ing s abili y in bo h in la ion and ou pu . The s ong his o ical alignmen indica es ha his
no el eac ion unc ion could se e as a aluable benchma k o cha ac e izing mone a y policy in
Singapo e.
Since 1981, he Mone a y Au ho i y o Singapo e (MAS) has ac i ely managed he
Singapo e dolla ’s exchange a e agains a ade-weigh ed baske o cu encies ep esen ing
Singapo e’s majo ading pa ne s. The composi ion o his baske is pe iodically e ised o
accommoda e changes in ade pa e ns, al hough speci ic de ails ega ding he index and a ge -
band bounda ies emain undisclosed. The MAS guides he exchange a e o app ecia e o
dep ecia e h ough di ec sales o pu chases o he U.S. dolla in he o eign exchange ma ke ,1
p ima ily in luenced by he s eng h o weakness o expec ed in la iona y p essu es. In essence,
he mone a y policy pu sued by he MAS ollows an uncon en ional in la ion a ge ing egime.2
As he MAS s a es, “The p ima y objec i e has been o p omo e p ice s abili y as a sound
basis o sus ainable economic g ow h. The exchange a e ep esen s an ideal in e media e a ge
o mone a y policy in he con ex o he small and open Singapo e economy. I is ela i ely
1 Changes in in e na ional ese es G ange -cause changes in he exchange a e.
2 See Pa ado (2004) and McCallum (2014) o u he de ails on mone a y policy in Singapo e.
3
con ollable h ough di ec in e en ions in he o eign exchange ma ke s and bea s a s able and
p edic able ela ionship wi h he p ice s abili y as he inal a ge o policy o e he medium- e m.”3
The pape is o ganized as ollows. Sec ion 2 p o ides a summa y o Singapo e’s
mone a y/exchange a e policy amewo k, and i s ope a ion du ing he pas ou decades. Sec ion
3 speci ies and es ima es a policy eac ion unc ion o Singapo e. In addi ion, i p o ides
obus ness checks o es he s abili y o he exchange a e policy ule’s coe icien s. Sec ion 4
summa izes he esul s and de i es implica ions o mone a y policy.
2. Backg ound o Singapo e’s Mone a y F amewo k
Singapo e's exchange- a e-cen e ed mone a y policy amewo k has helped achie e a ack eco d
o low in la ion wi h p olonged economic g ow h (see Figu e 1). Taking ad an age o Singapo e's
high sa ing a e, p uden iscal policy,4,5 and subs an ial o eign ese es, mone a y policy has
o se in la ion p essu es by guiding he exchange a e along an app ecia ing pa h. A i s sigh , a
s able a e o in la ion has been associa ed wi h an app ecia ing exchange a e. Fo ins ance, in he
ea ly 1980s a combina ion o oil p ice shocks and high capi al lows in ensi ied in la ion p essu es
in he economy. Howe e , by app ecia ing he ade-weigh ed exchange a e index (TWI) by 30
pe cen du ing 1981-1985 (a e aging abou 5 pe cen pe yea ), in la iona y p essu es we e
con ained.6
In 1985, Singapo e su e ed i s i s ecession, caused la gely by he de e io a ion in expo
compe i i eness, a cyclical down u n in elec onics, and he collapse o he cons uc ion boom. To
egain compe i i eness, a eal dep ecia ion was implemen ed h ough a educ ion in business cos s
om a cu in employe pension con ibu ions, and a dep ecia ion o he nominal exchange a e.
The TWI dep ecia ed only by abou 16 pe cen du ing he 1985-1988 pe iod e en hough i
dep ecia ed sha ply agains he Japanese yen and Ge man ma k du ing he pe iod o U.S. dolla
s eng h ollowing he Plaza Acco d. A e he economy eco e ed om he 1985 ecession, ea
o enewed in la ion p omp ed he MAS o allow he TWI o app ecia e om 1988 h ough 1997.
3 Mone a y Au ho i y o Singapo e (2012).
4 Con inued iscal su pluses since 1980, excep o 1987 and 2001/02, has eleased he MAS o he need o inance he
go e nmen , allowing i o ocus on i s p ima ily esponsibili y o main aining p ice s abili y.
5 Nadal De Simone (2000) inds ha in abou 70 pe cen o he iscal yea s be ween 1967 and 1995, he ac ual policy
mix in Singapo e was a con ac iona y iscal policy accompanied by a con ac iona y mone a y policy.
6 In la ion in Singapo e ended a ound 6 pe cen annually in he pe iod 1981-82, which con as s wi h he OECD
a e age o nea ly 11 pe cen .
4
This policy ac ion limi ed in la iona y p essu es and p ecluded an o e hea ed economy du ing he
i s hal o he 1990s, when eal GDP g ow h a e aged almos 8 pe cen each yea .
Wi h he onse o he Asian c isis, he economy was bu e ed by a s eng hening o he
Singapo e dolla in e ec i e e ms, owing o he sha p dep ecia ion o he egional cu encies.
Al hough he Singapo e dolla weakened agains he U.S. dolla , i s eng hened signi ican ly
agains he Indonesian upiah, Thai bah , and Malaysian inggi . As in la ion eased and eal GDP
g ow h s alled, MAS ended i s decade-long end app ecia ion o he TWI, by easing policy and
guiding he exchange a e o luc ua e wi hin a ze o-app ecia ion exchange a e band. The MAS
also conduc ed mone a y ope a ions o ensu e adequa e liquidi y in he money ma ke , allowing
domes ic in e es a es o decline.
Figu e 1. E olu ion o CPI, TWI, and IIP
A. CPI s TWI B. IIP s TWI
In ea ly 2000, agains he backd op o a a o able ex e nal en i onmen and a s ong
ebound in he Singapo e economy, mone a y policy was igh ened by inducing a g adual
app ecia ion o he Singapo e dolla on a ade-weigh ed basis. MAS announced in Janua y 2001
ha i would main ain his policy s ance o limi in la ion p essu es, bu economic condi ions
subsequen ly de e io a ed by mo e han expec ed. Agains he backd op o a weak ex e nal
economic en i onmen , a p o ac ed global elec onics down u n, and subsiding in la iona y
5
p essu es, he MAS eased he policy s ance o a neu al se ing in July 2001, wi h a policy band
cen e ed on a ze o pe cen app ecia ion o he exchange a e.
Du ing he global c isis o 2008, Singapo e’s economy expe ienced a widesp ead decline,
sh inking by 16.4 pe cen in he ou h qua e o 2008 on a seasonally adjus ed annualized basis
compa ed o he p e ious qua e . This down u n was d i en by a signi ican d op in global
demand, leading o a apid slowdown in sec o s linked o ade, including manu ac u ing,
wholesale ade, and anspo a ion se ices. Addi ionally, he inancial sec o aced se e e
challenges due o ins abili y in in e na ional inancial ma ke s. As a esul , he MAS shi ed i s
policy s ance o ze o app ecia ion in Ap il o 2009 and e u ned o modes app ecia ion in Oc obe
o 2010, when he economy ebounded conside ably, and in la ion ose o le els abo e 3 pe cen .
The ou b eak o he COVID-19 pandemic hi he global economy, including Singapo e.
Mos sec o s we e a ec ed by he c isis, especially ou ism, a ia ion, e ail, and cons uc ion. Tha
yea , Singapo e’s economy ell 3.9 pe cen , and in la ion was 0 pe cen , wi h de la ion o 9
consecu i e mon hs. MAS op ed o a ze o-app ecia ion mone a y policy, and he TWI ell nea ly
3 pe cen in 2020.
Du ing 2021 and 2022, Singapo e’s economy eco e ed, la gely due o he easing o some
COVID-19 es ic ions, obus iscal s imuli, and mone a y policy easing. This eco e y also
b ough wi h i demand p essu es, which combined wi h pe sis en global supply chain dis up ions
and he onse o he wa in Uk aine, con ibu ed o a subs an ial ise in in la ion. P ice inc eases
peaked in Augus o 2022, eaching 7.4 pe cen . In esponse o hese in la iona y p essu es, he
Mone a y Au ho i y o Singapo e (MAS) igh ened mone a y policy by e-cen e ing he mid-poin
o he Singapo e dolla nominal e ec i e exchange a e policy band and sligh ly inc easing he
a e o app ecia ion o he policy band.
Wi h his backg ound, he nex sec ions analyze he de e minan s o in la ion as a basis o
speci ying a policy eac ion unc ion ha could ep oduce hese his o ical shi s in he policy
s ance. The impac o he di ec e ec s o he exchange a e on in la ion and i s indi ec e ec s
h ough ou pu changes will shed ligh on he ansmission channels o mone a y policy. The
es ima ed eac ion unc ion would be used o gauge how changes in economic undamen als
in luence changes in he mone a y policy s ance, as e lec ed in he changes in he TWI.
12
Figu e 4. Be a and Gamma wi h Di e en Time Ho izons
Expec ed in la ion = 9
(1) All coe icien s a e s a is ically signi ican a he 95 pe cen le el.
(2) The se o ins umen s includes 1 o 12 lags o CPI in la ion, he indus ial p oduc ion gap, he TWI, he Wo ld
Commodi y Index, and he nominal ede al unds a e. Con empo aneous CPI in la ion and TWI a e also included as
ins umen s.
Sou ce: Au ho ’s es ima es.
3.3.2 Selec ion o Ins umen s and Lags
The se o ins umen s in his s udy encompasses all he a iables wi hin he MAS’s in o ma ion
se when changes in he exchange a e— he policy a iable—occu . A simila app oach is
discussed by Fa e o (2000), who no es ha a ec o should inco po a e all he a iables a ailable
o he cen al bank when making decisions on in e es a es. Fu he mo e, o e alua e whe he he
simple speci ica ion o he mone a y policy ule o e looks signi ican a iables ha a e pa o he
cen al bank’s ule, he s anda d s a is ical analysis employs he J- es o assess he alidi y o
o e iden i ying es ic ions.
Rega ding he inclusion o lags, Cla ida, Galí, and Ge le (2000) a gue ha he ins umen s
used should be based on he in o ma ion se a ailable when de e mining he in e es a e. They
inco po a e ou lags o in la ion, he ou pu gap, he ede al unds a e, he sho -long sp ead, and
commodi y p ice in la ion in es ima ing he Fede al Rese e’s policy eac ion unc ion.
Simila ly, Capu o and He e a (2017) use lagged alues o coun y-speci ic ou pu ,
in la ion de ia ions, he policy a e, exchange a e changes, and con empo aneous and lagged
0.0
0.5
1.0
1.5
2.0
2.5
3.0
2015 2016 2017 2018 2019 2020 2021 2022
Coe icien
Sample's uppe ange
Be a Gamma

13
alues o common a iables such as he ed unds a e and he pe cen age change in oil p ices o
each coun y. Addi ionally, con empo aneous in la ion is included as an ins umen .
4. Conclusion
The es ima ion esul s om he eac ion unc ion analysis p o ide compelling e idence ha
con olling in la ion has been he p ima y ocus o mone a y policy in Singapo e. This suppo s
he hypo hesis ha he mone a y policy amewo k in Singapo e can be cha ac e ized by a o wa d-
looking policy ule ha aims o s abilize expec ed in la ion and main ain ou pu a i s po en ial
le el. No ably, he es ima ed eac ion unc ion implici ly includes an in la ion a ge ing
componen , as a gued by Cla ida, Galí, and Ge le (1998, 1999), highligh ing i s signi icance in
ensu ing e ec i e mone a y policy making.
Fu he mo e, he coe icien s associa ed wi h CPI in la ion and ou pu e eal ha mone a y
policy in Singapo e assigns conside able impo ance o main aining low and s able in la ion.
Impo an ly, he es ima ions demons a e s abili y ac oss samples, sugges ing he indings a e
obus . When c ises such as he 2008-9 inancial c isis and he COVID-19 pandemic a e
conside ed, he coe icien associa ed wi h expec ed in la ion is la ge . This implies ha he policy
esponse is mo e p onounced du ing economic down u ns, unde lining he adap i e na u e o
mone a y policy in add essing ecessions.
Gi en he s ong his o ical i o he es ima ed eac ion unc ion, his app oach p esen s a
p omising al e na i e o coun ies wi h high openness o capi al ma ke s ha ace challenges in
managing mone a y policy e ec i ely using adi ional ins umen s such as in e es a es o
mone a y agg ega es. In ac , ecen esea ch building upon his amewo k sugges s ha when a
small and open economy has a ade openness le el abo e 40 pe cen o GDP, a mone a y policy
amewo k cen e ed on an exchange a e ins umen is mo e e icien in s abilizing p ices han he
adi ional in e es a e app oach (He esi and Pa ado, 2023).
14
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