DETERMINATION OF OPTIMAL CURRENCY BASKET FOR THE SINGAPORE ECONOMY

Abstract

Given that Singapore operates a managed float regime by relating the Singapore dollar to a trade-weighted basket of currencies, the determination of the optimal weights for the currency basket are examined in this paper. The weights are computed under the assumption that the objective of the policymaker is to minimise the variability of domestic output. A basic trade model is employed for the analysis. In order to reflect the importance of the service sector in Singapore, this paper incorporates the service sector into the basic trade model.

With the introduction of euro on 1 January 1999, this paper includes euro into the currency basket and looks at the weights assigned to euro. In addition, with the possibility of the world economy reducing to three major trading blocs, this paper examines its implications on the optimal weights for the currency basket. That is, to formulate a currency basket which consists of only the US dollar, the yen and the euro.

Using the formulas derived from the analysis, the optimal weights are shown to be a function of the trade shares and the variances and covariances of exchange rates and relative prices. The result seems to indicate an over-dependency of the currency basket on the US dollar. As for the currency basket that consists of only the three major currencies, there is a shift of importance from the US dollar to yen. The weight for the euro has also increased significantly.