Macroeconomic Goals & Policies

Question 1

A change in AD affects the following goals:

Answer 1

1) Actual growth
2) Demand-pull inflation
3) Cyclical unemployment

Question 2

A change in (X-M) affects the following goals:

Answer 2

1) Actual growth
2) Demand-pull inflation
3) Cyclical unemployment
4) Balance of Payments (current account)

Question 3

A change in FDI affects the following goals:

Answer 3

1) Actual growth and potential growth
2) Demand-pull inflation
3) Cyclical unemployment
4) Balance of Payments (capital/financial account)

Question 4

The main difference between FDI and domestic investment is that:

Answer 4

Domestic investment is affected by the level of domestic interest rates, while FDI is independent of local interest rates (do not confuse FDI with hot money flows).

Question 5

The main difference between FDI and hot money flows is that:

Answer 5

FDI is long-term, while hot money is short-term. Consequently, FDI contributes towards actual and potential growth in an economy while hot money has no material impact on an economy’s growth prospects.

Note: Hot money flows may even be disruptive for an economy through generating asset-price inflation, and causing wide swings in the exchange rate (which destabilises trade). However, hot money inflows may increase domestic money supply and lower interest rates, which can lead to growth in AD.

Question 6

Explain how a rise in interest rates affects (X-M) in an economy.

Answer 6

When interest rates rise

Hot money flows in

Demand for country’s currency rises

Exchange rate appreciates

Assuming MLC holds, (X-M) falls.

Question 7

Explain how a fall in interest rates affects (X-M) in an economy.

Answer 7

When interest rates fall

Hot money flows out

Supply of country’s currency rises in forex market

Exchange rate depreciates

Assuming MLC holds, (X-M) rises.

Question 8

Is MLC relevant when considering the effect of higher inflation rates on a country’s net exports?

Answer 8

No, because import prices are unchanged. Hence, only PEDx is relevant.

Question 9

Define economic growth

Answer 9

It is the increase in an economy’s real GDP. For economic growth to be sustainable in the long run, there must be a combination of actual growth (increase in AD) and potential growth (increase in AS)

Question 10

What is unemployment?

Answer 10

It is a situation where people who are willing and able to work cannot find jobs. There are 3 main types of unemployment - cyclical, structural and frictional.

Question 11

What is inflation?

Answer 11

It is a sustained increase in the general price level which could be due to demand-pull factors or cost-push factors.

Question 12

What is the balance of payments?

Answer 12

It is a record of transactions between a country and the rest of the world over a period of time , and consists of the current account, financial (or capital account in some school notes) account and the official financing account

Question 13

What are the 4 key economic indicators?

Answer 13

1) To achieve sustainable economic growth
2) To keep unemployment low
3) To maintain price stability
4) To maintain a healthy balance of payments

Question 14

What are the drivers of actual growth?

Answer 14

Mainly ICE, ICE, PIQ

Consumption which depends on disposable income of consumers, the availability and cost of credit, and the expectations of price levels and the economic outlook

Government’s goals and budget

Level of investments, which is affected by interest rates, corporate tax, expectation of the economy

Net exports, which is affected by the price competitiveness of exports, the income levels of trading partners and the quality competitiveness of exports.

Note that stating the components of AD is not enough. The factors affecting each component must be highlighted in your essay.

Do also note that a fall in cost-push inflation can also trigger actual growth.

Question 15

What are the drivers of potential growth?

Answer 15

Quantity and quality of FOP such as:

Land (land reclamation)
Labour (inducting foreign workers or sending workers for skills upgrading courses
Capital (government spending on infrastructure or attracting foreign investors)
Technology/entrepreneurship

Question 16

What is cyclical unemployment?

Answer 16

It is a situation where AD in the economy is low and there is not enough demand in the economy to create enough jobs (derived demand for labour is low). This usually occurs during a recession.

Question 17

What is structural unemployment?

Answer 17

It is a situation where there is a mismatch of worker skills and job requirements. It usually occurs when an economy is restructuring and some workers may find their skills irrelevant.

Question 18

What is frictional unemployment?

Answer 18

It is a situation where there is imperfect information flows between employers and job seekers. It is usually temporary in nature.

Question 19

What are the drivers of cyclical unemployment?

Answer 19

Mainly ICE, ICE, PIQ

1) Consumption which depends on disposable income of consumers, the availability and cost of credit, and the expectations of price levels and the economic outlook
2) Government’s goals and budget
3) Level of investments, which is affected by interest rates, corporate tax, expectation of the economy
4) Net exports, which is affected by the price competitiveness of exports, the income levels of trading partners and the quality competitiveness of exports.

Note that stating the components of AD is not enough. The factors affecting each component must be highlighted in your essay, together with AD/AS diagram.

Question 20

What is demand pull inflation?

Answer 20

It is inflation that results when AD rises as the economy approaches full-employment. This occurs as the growth in an economy’s productive capacity is unable to keep up with the increase in AD.

Question 21

What is cost-push inflation?

Answer 21

It is inflation that occurs due to an increase in the cost of production, independent of AD.

Question 22

What are the drivers of demand-pull inflation?

Answer 22

Mainly ICE, ICE, PIQ

1) Consumption which depends on disposable income of consumers, the availability and cost of credit, and the expectations of price levels and the economic outlook
2) Government’s goals and budget
3) Level of investments, which is affected by interest rates, corporate tax, expectation of the economy
4) Net exports, which is affected by the price competitiveness of exports, the income levels of trading partners and the quality competitiveness of exports.

Note that stating the components of AD is not enough. The factors affecting each component must be highlighted in your essay, together with AD/AS diagram. Remember to highlight that the economy is approaching full employment too.

Question 23

What are the drivers of cost-push inflation?

Answer 23

1) Wage push inflation, which may be triggered due to high trade union power demanding better pay without a commensurate increase in productivity(less relevant in SG context) and expectations of inflation which results in workers negotiating for higher wages to protect their purchasing power (wage-price spiral).
2) Import-push inflation that is triggered by exchange rate depreciation or global supply shocks that lead to an increase in the price of imported goods and raw materials.
3) Tax-push inflation that occurs due to a rise in taxes such as GST
4) Profit-push inflation that occurs as firms with extensive market power may raise prices to increase profits.

Question 24

What does the current account consist of?

Answer 24

1) Net exports (balance of trade)
2) Income flows
3) Transfer payments

Question 25

What does the financial (or capital) account consist of?

Answer 25

1) Hot money (short-term), which is affected by interest rate changes and expected changes in interest rates.
2) Direct or portfolio investments (long-term), which are affected by the expectations of the economic outlook. Direct investments (FDI) is also affected by operating costs such as the level of corporate tax, the level of infrastructural development in the economy, the ease of doing business as well as confidence in the economy’s growth prospects.

Question 26

When a question asks for the importance of the 4 macro goals, the answer should contain:

Answer 26

An explanation of the consequences of achieving/not-achieving the goals (refer to national income

Question 27

Why is economic growth important?

Answer 27

1) Raises material standard of living as household purchasing power increases
2) Leads to a fall in cyclical unemployment as the derived demand for labour to produce goods and services rises
3) Higher income, sales and corporate tax revenue for the government , which can be deployed towards spending on social amenities or capital goods.
4) Improves business confidence. Higher investment levels further generate potential growth in the economy. FDI inflows also improve the capital/financial account and contributes towards a country’s foreign reserves.
5) Further fuels economic growth with high consumption and investment activities

Students can turn these points around to discuss the costs of a recession.

Question 28

1-on-3: How can the impacts of high growth feed into the causes of unemployment?

Answer 28

The rise in consumption spending and investment expenditure leads to a multiplied increase in national output, leading to an increase in demand for labour to produce goods and services, hence leading to a fall in cyclical unemployment.

Question 29

1-on-3: How can the impacts of high growth feed into the causes of inflation?

Answer 29

1) If the increase in consumption spending and investment expenditure occurs while the economy is approaching full employment, demand-pull inflation may occur.
2) However, higher investments into capital goods may lead to potential growth in the long run, which alleviates inflationary pressures.

Question 30

1-on-3: How can the impacts of high growth affect the BOP?

Answer 30

1) Higher income results in higher import-spending which worsens the BOP through the current account.
2) However, inward FDI due to rising confidence improves the BOP though the capital account.

Question 31

Why are high unemployment rates undesirable for an economy?

Answer 31

1) High unemployment is usually associated with low consumption and investment spending, which further lowers the economic growth prospects of the country.
2) Unemployment also suggests that the country is not using its resources efficiently, and any potential gains that these resources could have brought about (e.g. increase in amount of goods produced for export which increases the country’s foreign earnings) are lost.
3) Aside from the fall in tax revenue, there is also greater strain on government resources to provide unemployment benefits. Such payments carry opportunity costs, as the funds could be directed into infrastructural projects to increase the economy’s growth performance.

Students can turn these points around to discuss the benefits of low unemployment.

Question 32

1-on-3: How do the consequences of high unemployment affect economic growth?

Answer 32

1) The fall in consumption spending and investment expenditure leads to a multiplied decrease in national output, hence actual growth and potential growth falls (assuming the investment expenditure were originally directed into capital goods)
2) If workers are unemployed for a long period of time, workers may lose their skills and motivation to work, which leads to further loss of potential growth.
3) If employment is prolonged, countries may face a brain drain as workers may seek jobs elsewhere, leading to a loss in productive capacity.

Question 33

1-on-3: How do the consequences of high unemployment affect inflation?

Answer 33

1) The fall in AD leads to a fall in demand-pull inflation within the economy.
2) The fall in potential growth may stunt the growth of the country’s productive capacity, and hence it may be more susceptible to inflationary pressures in the future.

Question 34

1-on-3: How do the consequences of high unemployment affect the balance of payments?

Answer 34

1) The fall in consumer income results in lower-import spending, which improves the BOP through the current account.
2) A fall in investor confidence due to high unemployment may lead to an outflow of FDI, which worsens the capital account.

Question 35

Why are high inflation rates undesirable for an economy?

Answer 35

1) A rise in a country’s inflation rate relative to other countries will lead to its exports becoming less price competitive. Assuming PEDx>1, quantity demanded falls more than proportionately, leading to a fall in export revenue.
2) Domestic consumers may switch from domestic goods towards imported substitutes as they may be cheaper. This leads to a rise in import expenditure, resulting in a fall in domestic consumption and hence AD. BOP worsens.
3) High inflation deters investment since price instability makes it harder for investors to predict future streams of cost and revenue.
4) Shoe leather and menu costs will be incurred, suggesting resources are not efficiently utilized.
5) Inflation distorts the price signal and there may be inefficient allocation of resources.

Students can flip these points around to discuss the benefits of prce stability.

Question 36

1-on-3: How do the consequences of inflation affect economic growth?

Answer 36

1) The fall in net exports, consumption and investment expenditure leads to a multiplied decrease in national output. Hence, actual growth falls.
2) The fall in investment expenditure may lead to fall in potential growth (assuming the investment expenditure was originally directed into capital goods)

Question 37

1-on-3: How do the consequences of inflation affect unemployment?

Answer 37

1) The fall in net exports, consumption and investment expenditure leads to a multiplied decrease in national output. Since the demand for labour is derived from the demand for the goods and services that hired labour is used to produce, cyclical unemployment will increase.

Question 38

1-on-3: How do the consequences of inflation affect the balance of payments?

Answer 38

1) The fall in net exports and FDI worsens the BOP through the current and capital accounts respectively.

Question 39

Why is an unhealthy BOP (deficit or surplus) undesirable for an economy?

Answer 39

1) A deteriorating current account that stems from a worsening balance of trade reduces AD and national income through the multiplier process.
2) A worsening of the capital account due to outflow of FDI has negative implications for potential growth in the long-run
3) A deterioration in the capital account due to an outflow of hot money leads to a decrease in the supply of loanable funds, which raises interest rates and decreases AD.
4) A persistent BOP deficit accompanied by high levels of external debt reduces investor confidence in the economy
5) A persistent current account deficit may reflect underlying lack of competitiveness of exports (relating to price and quality)
6) A persistent BOP deficit may lead to a depreciation of the currency due to decreased demand for exports, which leads to the threat of imported inflation.

Question 40

1-on-3: How can a BOP deficit affect economic growth?

Answer 40

1) The fall in net exports (deficit on current account) leads to a multiplied decrease in national output, hence actual growth falls
2) Potential growth falls as well due to a drop in FDI (deficit on capital/financial account), assuming the investment expenditure were originally directed into capital goods.

Question 41

1-on-3: How can a BOP deficit affect unemployment?

Answer 41

1) Since there is a fall in national output, the demand for labour to produce goods and services falls, leading to a rise in cyclical unemployment.

Question 42

1-on-3: How can a BOP deficit affect inflation?

Answer 42

1) The fall in AD leads to a fall in demand-pull inflation.
2) The fall in potential growth may cause the economy to be more susceptible to inflation in the future.
3) Depreciation of the currency generates imported inflation.

Question 43

How is the 1-on-3 exercise (where the consequences of a macro problem feed into the causes of other macro problems) useful in essays?

Answer 43

1) It is useful in assessing the impact of an event on the economy to ensure that all 4 goals are discussed in detail (using the DICE approach). This is especially the case if the event only has a direct link to one macro problem. Using the 1-on-3 exercise helps us extend the discussion to other macro goals.
2) Assessing the priority of macro-economic goals (using the CFCE approach), specifically to consider how the failure to achieve one goal can thwart other macro goals.

Question 44

What should we take note of when explaining the priority of goals and what framework can we use?

Answer 44

1) It is insufficient to justify that a certain goal should be prioritized above the others because of the consequences of failing to achieve it. Every goal has consequences of not achieving it, hence every goal is equally important. However, this is still an important content paragraph.
2) We should go on to explain how the failure to achieve a particular goal (e.g. inflation) can frustrate the other macroeconomic goals (using the 1 on 3 exercise)
3) We should also note how there are certain trade-offs between goals which prevents us from achieving all 4 goals at the same time.
4) Overall, which goal to be prioritized depends on the state (mostly) and nature (lesser extent) of the economy and would differ for all economies
5) The approach can be summarized into the CFCE framework, which stands for Consequences of goals, Frustration of other goals, Conflicts with other macroeconomic objectives, and Evaluation

Question 45

When assessing the impact of an event on the economy, what framework should we use?

Answer 45

Since we are evaluating the consequences on an economy, we should look at how ALL 4 goals are affected, hence the DICE framework should be used.

1) Direct impact of the event
2) Indirect impacts (use the 1 on 3 exercise to see how other goals are affected, if the first step does not cover all 4 goals)
3) Counteracting measures taken to mitigate the impacts
4) Evaluation based on the nature and state of the economy

Question 46

Crossing the barriers (in relation to macro policies) means that…

Answer 46

Students need to be aware of how demand-management policies can have supply-side effects, and vice-versa.

Question 47

How does fiscal policy work in influencing AD and AS?

Answer 47

AD

• A change in G affects AD directly
• A change in personal income tax affects consumption, while a change in corporate tax affects investment

AS

• A rise in G on infrastructural development contributes to potential growth and hence shifts LRAS outwards.
• A cut in corporate taxes boosts investments, which if directed to capital goods shifts LRAS outwards.
• A fall in personal income taxes increases the drive and incentive to work, leading to an outwards shift of LRAS due to the higher productivity of labour

Question 48

To choose or run a budget deficit (surplus) is the same as running:

Answer 48

An expansionary (contractionary) fiscal policy

Question 49

Fiscal tightening is the same as:

Answer 49

Running a contractionary fiscal policy

Question 50

Fiscal consolidation means:

Answer 50

Increasing T and reducing G to reduce the government budget deficit or outstanding debt.

Question 51

Pump priming means

Answer 51

To raise G and reduce T to stimulate and economy, usually during a recession.

Question 52

A hard landing means

Answer 52

An economy is tipped into recession after a period of rapid growth. This is usually due to tightening of monetary policy in an attempt to rein in inflation.

Question 53

How does interest-rate policy work in influencing AD and AS?

Answer 53

Change in the money supply to influence interest rates which then affects consumption and investment

AD

• A change in interest rates affects consumption (affects both borrowers and savers through the cost of credit and opp cost of consumption) and investment (through the expected profitability of investments)
• In economies open to capital flows, a change in interest rates can also influence exchange rates (through hot money outflows) and hence impact external demand in the form of net export earnings. (e.g. lower interest rates lead to a depreciation of the currency through hot money outflows. Assuming MLC holds, net exports will rise)

(Take note that the cost and availability of credit are two separate issues. When there is a rise in the money supply, there is a greater availability of credit, which stimulates C and I directly)

AS
- A rise in investments on capital goods increases potential growth

Question 54

How does exchange-rate policy work?

Answer 54

A change in the external value of a country’s currency to influence the level of external demand

AD
- A change in exchange rates affects (X-M), which affects AD. If imports become relatively more expensive due to depreciation of the currency, the demand for domestic substitutes may also rise, which raises AD through consumption.
SRAS
- An appreciation of the exchange rate reduces imported inflation (cost-push inflation) and raises SRAS.

Question 55

How do supply-side policies work?

Answer 55

Long-run: The use of market-based or interventionistic policies to boost the productive capacity of an economy.

Short-run: Policies targeting a reduction in the cost of production.

AD

• R & D can boost research quality, which increases the demand for a country’s exports. Hence, AD rises due to an increase in (X-M)
• Having a well-educated and skilled labour force (where workers constantly upgrade their skiils to remain relevant) makes the economy an attractive destination for foreign investors. Hence AD rises due to an increase in FDI and domestic investment.
• Short run supply side policies e.g. maintaining competitive wages or tax levels lowers the cost of production and stimulates actual growth (downward movement along the AD curve)

AS
- Supply side policies generate potential growth through increasing the quantity and quality of a country’s factor of production.

Make sure you revise the difference between interventionistic and supply-side policies.

Question 56

How does the A3 exercise work?

Answer 56

To evaluate whether a certain policy is useful in tackling the various macroeconomic problems.

1) Break down the macro-economic problems into their root cause
2) For every policy, circle the factors where the policy can exert an effect
3) Where areas are not circled, the policy cannot effectively target these areas and other policies may be needed as complementary policies.
4) Factors not circled could represent specific limitations of the chosen policy.
5) Recall generic limitations e.g. size of k, time lag.

Question 57

Summarise the effectiveness of fiscal policy in boosting economic growth

Answer 57

Pros:
1) Fiscal policy can directly increase AD through government spending.

2) A decrease in personal income tax increases consumption, while a decrease in corporate tax increases investment, further boosting actual growth.
3) Fiscal policy in the form of infrastructural spending can boost potential growth

Cons:
1) The ability to engage in fiscal spending depends on the state of the government budget. If the government needs to borrow to finance its spending, crowding out may occur

2) The effectiveness of tax cuts depends on expectations of the economic outlook.
3) Fiscal policy is not able to stimulate external demand which renders it less effective for small and open countries like Singapore
4) The effectiveness of fiscal policy in boosting economic growth depends on the size of the multiplier
5) Time lags associated with the use of fiscal policy and recognition, administrative and operational lag

Question 58

Evaluate the effectiveness of interest-rate policy in boosting economic growth

Answer 58

Pros
1) Interest policy can boost actual growth by stimulating consumption and investment through a cut in interest rates.

2) A cut in interest rates will lead to outflow of hot money, hence a depreciation of the exchange rate and stimulate external demand through boosting price competitiveness of exports.
3) Interest-rate policy can boost potential growth by encouraging investments into capital goods.

Cons

1) The effectiveness of interest rate cuts depends on expectations of the economic outlook.
2) Interest rates cannot affect net exports and hence external demand for countries which are not open to capital (hot money) flows or where exchange rates are tightly controlled.
3) The effectiveness of monetary policy in increasing national income depends on the size of the multiplier.
4) If an economy is near the liquidity trap (i.e. interest rates cannot be further lowered), interest-rate policy is not feasible.

Question 59

Evaluate the effectiveness of exchange-rate policy in boosting economic growth

Answer 59

Pros
1) A depreciation of exchange rates can stimulate external demand by boosting price-competitiveness of exports and is especially useful for export-driven economies such as Singapore.

Cons
1) However, a weak currency may lead to cost-push inflation, which partially offsets the gain in export price-competitiveness from a weaker currency.

2) The Marshall Lerner’s condition must hold before a depreciation of the currency will lead to an increase in net exports. MLC may not hold in the short run due to the presence of import contracts.
3) No direct impact on potential growth.
4) Less effective in boosting domestic demand.
5) Size of multiplier may limit effectiveness of policy.

Question 60

Evaluate the effectiveness of supply side policies in boosting economic growth

Answer 60

Pros
1) Supply-side policies can promote potential growth by boosting quality and quantity of factor of production

2) Research and development efforts can boost export quality, which increases the demand for a country’s exports. Hence, actual growth rises through a rise in net exports
3) Having a well-trained workforce and a skilled labour force makes a country a more attractive destination for investors, hence boosting the level of investments, which raises actual growth as well.

Cons
1) Effects can only be seen in the long-term

2) Success of training programmes depend on receptiveness of workforce.

Question 61

Evaluate the effectiveness of fiscal policy in reducing unemployment.

Answer 61

Refer to points under how fiscal policy boosts economic growth

• Fiscal policy has no direct impact on structural and frictional unemployment

Question 62

Evaluate the effectiveness of interest rate policy in reducing unemployment.

Answer 62

Refer to points under how interest-rate policy boosts economic growth

• Interest-rate policy has no direct impact on structural and frictional unemployment

Question 63

Evaluate the effectiveness of exchange rate policy in reducing unemployment.

Answer 63

Refer to points under how exchange-rate policy boosts economic growth

• Exchange-rate policy has no direct impact on structural and frictional unemployment

Question 64

Evaluate the effectiveness of supply side policies in reducing unemployment.

Answer 64

Refer to points under how supply side policies boosts economic growth

• Supply-side policies can tackle structural and frictional unemployment through re-training or career fairs

Question 65

Evaluate the effectiveness of fiscal policy in alleviating inflation

Answer 65

Pros

1) Fiscal policy can reduce demand-pull inflation through a direct cut in G
2) A rise in taxes can cut consumption and investment spending, reducing demand pull inflation
3) By directing funds into infrastructure, potential growth can occur in the long-term which lowers demand-inflation in the future (although demand-pull inflation worsens in the short-run).

Cons

1) Due to the inflexibility of government spending, it may not be straightforward to cut G (especially spending on merit goods e.g. the building of hospitals to provide healthcare)
2) The effectiveness of tax hikes depends on expectations of the economic outlook
3) Fiscal policy is unable to influence external demand and is less effective in small and open countries such as Singapore.
4) Fiscal policy has no direct impact on cost-push inflation

Note that the budget is not a concern here, since contractionary policies are used.

Question 66

Evaluate the effectiveness of interest-rate policy in alleviating inflation

Answer 66

Pros
1) Interest-rate policy can reduce demand pull inflation by reducing C and I through a rise in interest rates.

2) A rise in interest rates can lead to an appreciation of the exchange rate (through the inflow of hot money) and reduce external demand, provided MLC holds.
3) The effectiveness of interest-rate hikes in alleviating inflation depends on the expectations of economic outlook.

Cons
1) Interest-rate policy has no direct impact on cost-push inflation

2) Interest rate hikes cannot affect net exports in economies which are not open to hot money flows (such as China)

Question 67

Evaluate the effectiveness of exchange-rate policy in alleviating inflation.

Answer 67

Pros
1) An appreciation of the exchange rate can reduce imported inflation directly (a form of cost-push inflation) – MLC not needed.

2) It can also reduce demand pull inflation by lowering the price-competitiveness of the country’s exports – MLC must hold.

Cons
1) However, a stronger currency can lower net exports which lead to trade-offs with the goals of growth and low unemployment.

Question 68

Evaluate the effectiveness of supply side policy in alleviating inflation.

Answer 68

Pros

1) Supply-side policies can promote potential growth which raises the country’s productive capacity and reduces demand-pull inflationary pressures
2) R and D can lead to import substitutes which lowers the vulnerability of a country to imported inflation
3) Raising labour productivity, assuming unchanged wages means that each worker is more efficient which lowers the per-unit cost of production and reduces wage-push inflation

Cons

1) Effects can only be seen in the long-run
2) Receptiveness of workers to being retrained may be in doubt.

Question 69

Evaluate the effectiveness of fiscal policy in rectifying an imbalance of payments

Answer 69

Pros

1) The use of a contractionary fiscal policy can tackle a current account deficit by reducing national income and hence import spending.
2) A contractionary fiscal policy can reduce demand-pull inflation and boost export price-competitiveness, hence improving the current account
3) Lower corporate taxes help to attract foreign investments due to lower operating costs

Cons
1) There is a trade-off with other macroeconomic goals, since a contractionary fiscal policy can lead to lower growth and higher unemployment

Question 70

Evaluate the effectiveness of interest-rate policy in rectifying an imbalance of payments

Answer 70

Pros

Refer to first 2 points above to evaluate how interest-rate policy can rectify a current account deficit.(Evaluate the effectiveness of fiscal policy in rectifying an imbalance of payments)

Cons

1) While higher interest rates can lead to hot money inflows which improve the capital, this is not a viable solution in the long run given the volatile nature of hot money.
2) There is a trade-off with other macroeconomic goals since a contractionary policy can lead to lower growth and cyclical unemployment

Question 71

Evaluate the effectiveness of exchange rate policy in rectifying an imbalance of payments

Answer 71

Pros
1) A deprecation of the exchange rate can improve the current account through raising net exports, provided the MLC condition holds

Cons
1) A weaker currency can lead to imported inflation which partially offsets the gain in export price-competitiveness from a weaker currency

Question 72

Evaluate the effectiveness of supply side policy in rectifying an imbalance of payments

Answer 72

Pros

1) R and D can improve the quality-competitiveness of exports
2) Having a well-trained workforce and skilled labour force makes the country a more attractive destination for foreign investors hence improving the capital account

Cons
1) Effects can only be seen in the long-run

Question 73

What essay framework can we use when assessing the effectiveness of a policy in rectifying a macroeconomic problem?

Answer 73

The GPLS framework

Goal (context is important in determining root cause of problem)

Policy

Limitations of policy (context is important in determining specific limitations)

Supporting policies

Question 74

What is the framework for assessing conflicts between macroeconomic goals?

Answer 74

1) Policy trigger
2) Explain conflict
3) Evaluate likelihood of conflict.

Question 75

Apply TEE to analyzing the conflict between growth and demand-pull inflation.

Answer 75

Trigger: expansionary fiscal policy, interest-rate policy and exchange-rate policy.

Explanation (with fiscal policy as example): The use of an expansionary fiscal policy results in an increase in GPL as the increase in AD brings the economy closer to full employment level. Supply constraints experienced in the economy results in higher strain on limited resources, leading to an increase in COP which is then passed on to consumers. Additionally, the competition for the limited goods and services produced also results in an increase in GPL.

Evaluation: If the country is experiencing severe recession, the likelihood of conflict is low. The trade-off may be temporary if the government employs fiscal policy with a supply-side slant (e.g. infrastructure and capital goods) which increases potential growth.

Question 76

Apply TEE to analyzing the conflict between growth and external stability.

Answer 76

Trigger: expansionary fiscal policy and interest-rate policy

Explanation: Expansionary fiscal policy leads to a higher level of national income and purchasing power, which stimulates higher consumption of goods and services, including on imports, hence leading to a deterioration of current account. This is especially the case for import-reliant countries like Singapore.

Evaluation: This should not be a huge concern as higher import spending leads to higher material SOL. However, if the country is facing a persistent BOP deficit, any further deterioration of the current account may lead to a larger deficit which will deplete the country’s foreign reserves.

Question 77

Apply TEE to analyzing the conflict between growth (or external stability) and imported inflation.

Answer 77

Trigger: Depreciation of the exchange-rate

Explanation: Small and open countries may depreciate the country’s currency to boost net exports to bolster growth or improve BOP. Assuming the MLC holds, net exports will rise, leading to higher growth. The BOP improves through the current account. However the depreciation of the currency results in imported inflation.

Evaluation: The conflict is less likely in economies which are resource-rich and less independent on imports.

Question 78

Apply TEE to analyzing the conflict between sustained growth and employment.

Answer 78

Trigger: supply-side policy.

Explanation: Some economies may need to restructure their economies to develop new areas of comparative advantage. This may lead to a mismatch of skills, hence leading to structural unemployment.

Evaluation: The trade-off with structural unemployment can be minimized if forward-looking policies are put in place to accompany the restructuring process.

Question 79

Name the specific drivers of economic growth in Singapore

Answer 79

Actual growth (export-driven): Since Singapore has a small domestic market, the impact of a change in C or I on aggregate demand is relatively small. Hence, actual growth is largely driven by (X-M). Equivalently, the threat to Singapore’s economic growth is mostly likely to emerge from an external recession, which leads to falling net exports for Singapore.

Potential growth: Given that Singapore is a small economy, resource endowment is poor. Hence, Singapore has to focus on promoting potential growth to increase the country’s productive capacity.

Question 80

Name the specific drivers of inflation in Singapore

Answer 80

Cost-push inflation (import-reliant): Given that Singapore is a small economy which is resource-scarce, it has to rely on other countries for imported raw materials and finished products. Hence, it is vulnerable to price changes in other countries, which may trigger imported inflation. For example, a supply shock arising from instability in the Middle East can lead to an increase in the global price of oil, which leads to a substantial increase in the cost of production in Singapore.

Demand-pull inflation (export-driven): In view of the small size of Singapore’s domestic economy, demand-pull inflationary pressures are likely to arise from a spike in net exports instead of domestic sources. This is because net exports constitute a significant component of AD.

Question 81

Name the RECENT causes of inflation in Singapore.

Answer 81

QE measures in US and Europe have led to an inflow of hot money to Singapore. This has pushed up prices of assets in Singapore. – housing is a component in the CPI basket
Wage-push inflation: To reduce reliance on foreign workers, the government has raised the foreign worker levy, which contributes toward some degree of wage-push inflation.
Higher COE prices feeding into higher transport prices – transport is a component in the CPI basket

Question 82

Name the specific drivers of unemployment in Singapore

Answer 82

Cyclical unemployment (export-driven): Since Singapore has a small domestic market, Singapore is more vulnerable to demand-deficient unemployment arising from a fall in external demand.

Structural unemployment: Being a small economy with few natural resources, Singapore has to continually restructure her economy to produce goods and services which are increasingly capital-intensive. This is to differentiate Singapore’s comparative advantage from other countries. The restructuring of the economy has contributed to structural unemployment in Singapore due to the resultant mismatch of skills.

Frictional unemployment is not a major concern as job fairs and portals are frequently set up to ensure information flows from potential employers to potential employees and vice versa.

Question 83

Is fiscal policy useful in the Singapore context?

Answer 83

Since Singapore’s domestic economy is small and mainly driven by exports, fiscal policy is not the main demand-management tool. However, it may be used as a short term tool to boost AD during a severe recession.

Singapore focuses on fiscal prudence and does not actively engage in pump-priming activities. However, the government spends on infrastructure that will contribute to both actual and potential growth. Income and corporate tax rates are kept low to attract talent and foreign investors.

Fiscal policy can be used as a tool to tackle inequity (through a progressive tax system), externalities (taxing demerit goods) and missing markets.

Question 84

Is the interest-rate policy useful in the Singapore context?

Answer 84

Since we are an open economy which is open to capital flows, any change in interest rates would lead to hot money flows which has a disruptive impact on the economy. Specifically, there would be wide-changes in Singapore’s exchange rates, which is disruptive to our trade, since our trading partners would be less confident about the stability of Singapore’s currency.

Additionally, the flow of hot money due to a change in interest rates will lead to a change in Singapore’s money supply, negating the effects of the monetary policy.

Hence, Singapore does NOT adopt the interest-rate policy.

Question 85

Is the exchange-rate policy useful in the Singapore context?

Answer 85

Singapore maintains a modest and gradual appreciation of the currency to keep out imported inflation since we are very reliant on imported raw-materials. However, assuming the MLC condition holds, this would have a contractionary effect on our economy. During recessionary periods, the bank may adopt a zero-appreciation stand or depreciate the exchange rate slightly to boost net exports.

Question 86

Are supply-side policies useful in the Singapore context?

Answer 86

Singapore focuses on the use of supply-side policies to boost potential growth such as providing skills-upgrading programmes (interventionistic) and maintaining a business-friendly climate to attract investments. (Market-based)

Supply-side policies are also used to reduce structural unemployment in Singapore through boosting labour productivity. (Eg SPUR and CET) Grants are also given to employers to encourage their employees to attend such courses. At the same time, compensation is paid to employers for the loss of man-hours.

Question 87

When are we not able to use fiscal policy?

Answer 87

When the government debt is unsustainable and borrowing of funds to further stimulate the economy is impossible

Question 88

When are we not able to use the indirect mechanism of monetary policy (interest-rates)?

Answer 88

When nominal interest-rates are near zero and they cannot be further lowered.

Question 89

How do austerity measures work?

Answer 89

Taxes are increased and government expenditure is reduced in the hope of reducing government debt. In the long run, austerity measures reduce the risk of government default which improves investor confidence. The rise in investment activities contributes towards a rise in corporate tax revenue which improves the budget.

Question 90

What are the limitations of austerity measures? (GRIT)

Answer 90

Cutting G lowers growth and results in higher unemployment. Through automatic stabilizers, income revenue falls while government spending on transfers increases, hence increasing the debt in the short term.

The country’s credit Rating may worsen in the short term, which leads to higher borrowing costs. Hence the burden of interest repayments rises

Inflexibility of public spending means that cutting G is not so straightforward.

Higher income Tax drives out high-income earners while higher corporate taxes discourage foreign investors. Hence overall tax revenue may fall.

Question 91

How do austerity measures affect Singapore?

Answer 91

Impacts: Austerity results in a contractionary impact on EU countries, hence purchasing power falls which results in a fall in demand for Singapore exports. The fall in exports leads to lower growth, higher cyclical unemployment and a worsening BOP. Higher taxes may lead to foreign investors gravitating towards Singapore. The rise on FDI has a positive impact on growth, employment and on the BOP. Imported inflation will fall in Singapore as there is lower global demand for resources against European recession. In the long run, the economic prospects in European countries may improve and Singapore’s exports and growth will grow.

Counteracting measures: Given the contractionary impacts of austerity measures on SG’s economy in the short term, expansionary measures such as a slight depreciation of the Sing dollar or an increase in G can be used.

Evaluation: The fall in net exports will have a significant impact on growth. Singapore is likely to be already facing slow growth since austerity usually occurs against a backdrop of a slowing EU economy. Hence, Singapore’s economy will further worsen in the short term.

Question 92

What is quantitative easing?

Answer 92

QE taps on the direct mechanism of monetary policy when increasing money supply cannot further lower nominal interest rates. This is done through the bank buying long-term bonds, effectively handing out cheap money. This encourages banks to make more consumer loans and allows companies to have access to capital for investment purposes.

With greater availability of credit, consumption spending rises. Firms may also invest in new capital goods. Hence, AD rises through C and I.

When C and I spending on assets such as stocks and property rises, owners of these assets feel richer, compelling them to consume more through the wealth effect.

Some money pumped into the economy may flow overseas as hot money. This outflow results in a depreciation of the home currency, which stimulates exports earnings.

If the above effects led to inflation in the economy, real interest rates become negative since real interest rates = nominal interest rates (near 0) – inflation rate. Negative real I returns on savings is a disincentive to save and spurs further spending.

Question 93

What are the limitations of QE?

Answer 93

QE may not be effective if expectations are poor.

Question 94

What is the impact of QE on Singapore?

Answer 94

Impacts: QE in the US may lead to an outflow of hot money into SG, which leads to appreciation of the SGD, worsening price-competitiveness. This threatens actual growth, employment and the country’s BOP position. Demand-pull inflation pressures may fall. Since Singapore’s interest rates are tied to US rates, maintaining low rates in the US also leads to low borrowing costs in SG. This stimulates consumption which may lead to asset-price inflation. Hot money inflows into SG can also aggravate asset-price inflation.

Counteracting measures: Contractionary fiscal policy targeting the property sector can help to lower asset-price inflation.

Evaluation: The change in net exports would have a significant impact on our economy. Since Singapore is likely to be facing slow growth (QE takes place during recession), the rise in net exports due to QE will be welcomed.

Question 95

What is the role of productivity in driving a country’s economic performance?

Answer 95

Higher productivity generates potential growth (LRAS shifts right).

Assuming wages are unchanged, higher productivity results in lower wage-push inflation (LRAS shifts right).

Hence, exports become more price-competitive and net exports rise, assuming PEDx>1. Actual growth results (movement along AD curve).

Investor confidence may improve. Rise in domestic investments and FDI shifts AD to the right and further bolsters growth.

Question 96

How can a country’s competitiveness be measured?

Answer 96

The global competitiveness of an economy can be considered from three perspectives – (i) export price and quality competitiveness; (ii) the country’s attractiveness as a foreign direct investment (FDI) destination; and (iii) its labour competitiveness.

Refer to Youtube video under www.thateconstutor.com for more details.

Question 97

What is the rebalancing act which China is trying to perform?

Answer 97

Shift reliance from external drivers of growth towards domestic C and I. This entails raising C (through tax cuts) and increasing the size of China’s multiplier (through lowering mpm, mps and mpt).

Refer to Youtube video under www.thateconstutor.com for more details.