Nonlinear Adjustment and Exchange Rate Policy: Lessons from Singapore for other Small Open Economies

This paper uses a Smooth Transition Autoregressive (STAR) regression to estimate the adjustment speed of exchange rate in a small open economy, in which exchange rate policy plays an important role in facilitating macroeconomic adjustment and controlling inflation. The result of our estimation suggests that the adjustment speed in the selected economy (Singapore) is faster than estimates reported in the literature. The relatively fast adjustment speed and the other related successes in Singapore could make its system a role model for many other small open economies. In addition, we found evidence of the Harrold-Balassa-Samuelson (HBS) effect and our results support Lothian and Taylor’s (2008) argument that failure to include the effect in the estimation would lead to biased estimate in the adjustment speed. Thus, one should be cautious of the significant portion of past empirical studies that did not incorporate the HBS effect in their estimations. Future empirical studies should include the effect in the estimations and tests, or at least test for the absence of the effect before excluding it from the estimations. Finally, we found evidence that exchange rate policy is neutral in the longrun and non-neutral in the short-run in the selected economy. We then discussed the policy implications of this finding.