Michael Lohh MACROCONOMIC AIMS, PROBLEMS AND POLICIES Definitions needed for this topic 1. Equity: It refers to the equitable distribution of income whereby the economic growth results in widening the income gap. The government tries to redistribute income using taxes (e.g. progressive income tax, goods and services taxes). 2. Efficiency: It refers to goods and services being produced at a minimum cost so the consumer and firms can enjoy maximum benefits i.e. productive, allocative and dynamic efficiencies. 3. Economic growth: is a sustained increase in real national output of a country brought about by an increase in productive capacity in the economy. 4. Actual economic growth: is the annual percentage increase in the national output i.e. the rate of growth of the actual output. 5. Potential economic growth: is the speed at which the economy could grow annual percentage increase in the economy’s capacity to produce rate of growth of potential output. 6. Inflation: is a situation where there is a sustained and inordinate rise in general price level (GPL). 7. Deflation: is a sustained decrease in GPL. 8. Consumer price index: is a measurement of the market price of a basket of goods and services. 9. Unemployment: is the number of people of legal age who are willing and able to work but are unable to find suitable employment. 10. Voluntary unemployment: is the unemployment of those who do not want to work at the going wage rate. 11. Involuntary unemployment: is the unemployment of those who are willing and ready to work at the going wage rate but are unable to find jobs. 12. Underemployment (also called disguised unemployment): refers to the group who is apparently employed but are working below their productive capacity. 13. Full employment: is the level of employment sufficient to produce the economy’s potential output. Page 1 of 29
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Definitions needed for this topic
1. Equity: It refers to the equitable distribution of income whereby the economic growth results in widening the income gap. The government tries to redistribute income using taxes (e.g. progressive income tax, goods and services taxes).
2. Efficiency: It refers to goods and services being produced at a minimum cost so the consumer and firms can enjoy maximum benefits i.e. productive, allocative and dynamic efficiencies.
3. Economic growth: is a sustained increase in real national output of a country brought about by an increase in productive capacity in the economy.
4. Actual economic growth: is the annual percentage increase in the national output i.e. the rate of growth of the actual output.
5. Potential economic growth: is the speed at which the economy could grow annual percentage increase in the economy’s capacity to produce rate of growth of potential output.
6. Inflation: is a situation where there is a sustained and inordinate rise in general price level (GPL).
7. Deflation: is a sustained decrease in GPL.8. Consumer price index: is a measurement of the market price of a basket of goods
and services.9. Unemployment: is the number of people of legal age who are willing and able to
work but are unable to find suitable employment.10. Voluntary unemployment: is the unemployment of those who do not want to work
at the going wage rate.11. Involuntary unemployment: is the unemployment of those who are willing and ready
to work at the going wage rate but are unable to find jobs.12. Underemployment (also called disguised unemployment): refers to the group who is
apparently employed but are working below their productive capacity.13. Full employment: is the level of employment sufficient to produce the economy’s
potential output.14. Natural unemployment: is the employment rate where unemployment is frictional +
structural.15. Labour force participation rate: measures the percentage of working age population
who are members of the labour force.16. The balance of payment: is a summary statement of monetary value of all economic
transactions between the residents of the country with the rest of the world during a specific period of time, usually a year.
17. Fiscal policy: is the deliberate management of taxation and government expenditure designed to influence the level of economic activity i.e. budgetary policy.
18. Government expenditure: is the spending by the public sector.19. The monetary policy: involves the use of monetary policy tools by the Central Bank
to manipulate interest rate or money supply.20. The Central Bank: is an organisation of the government that undertakes all its major
financial operations.
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21. Money supply: is the quantity of money held by households and firms in the economy.
22. Liquidity preference: is the preference for holding money over other kinds of assets.23. Loanable funds: are funds available for borrowing and then used for investment.24. Foreign Exchange: is the trading of one’s country’s currency for another foreign
currency,25. Fixed exchange rate: is a rate fixed by the government to guarantee the official price
of currency in terms of other foreign currencies.26. Freely floating or flexible exchange rate: is a rate of exchange that is determined
freely by market forces of demand and supply in the FOREX market.27. Managed float exchange rate: happens when the government allows market forces
to determine exchange rate but will interfere to change it if beyond certain band.28. Appreciation: is an increase in the external value of a currency in terms of other
currencies in the FOREX market.29. Depreciation: is a reduction in the external value of a currency in terms of other
currencies in the FOREX market.30. Revaluation: is the increase in the official external value of a currency in terms of
other currency by deliberate government through the central bank authority.31. Devaluation: is the reduction in the official external value of a currency in terms of
other currency by deliberate government policy through the central bank authority.32. The Marshall-Lerner Condition: states that when the sum of price elasticities of
demand for imports and exports is greater than one, a depreciation or devaluation of exchange rate will lead to an improvement in the balance of trade.
Measurement: Economic growth is measured by percentage change in real GDP over time.
Causes of actual economic growth
1. Growth of any AD component Any increase of C+I+G+(X-M) will lead to AD increasing and hence national output
increasing if there is spare capacity in the economy. Thus, reflecting actual economic growth.
Causes of potential economic growth
1. Increase in quantity of factors of productiona. Labour: increase in legal working age or increase in working population size
(via foreign labour or baby boomers entering workforce) will increase labour force leading to increase in potential output thus increasing AS and potential EG.
b. Natural resources: the discovery of new sources of energy, minerals, land, etc. shows increase in potential output, and potential EG.
c. Capital stock: increasing the quantity of machinery and equipment will increase the potential output of the AS and the potential EG.
2. Increase in quality of factors of productiona. Labour: Better education or training, better knowledge and skills will increase
labour productivity .This will increase output per hour of work, increase potential output, AS and potential EG.
b. Land: better land fertility and better utilisation of land e.g. hills, mountains will increase the potential output, thus increasing AS and potential EG.
c. Capital stock: better technology and innovation with more efficient capital stock will increase potential output, AS and potential EG.
3. Improvement in the level of technologya. With R&D and innovation, the new technology will produce more output with
the same amount or less resources than before. This will increase potential output, AS and potential EG.
Benefits of Economic Growth1. Higher consumption
a. Economic growth higher national income higher consumer income higher purchasing power higher consumption
2. Lower unemploymenta. Actual economic growth increase real national output increase derived
demand for labour increase employment reduce cyclical unemployment.
b. Potential EG increase productivity reduce structural unemployment.3. Equitable redistribution of income
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a. Economic growth more tax collected progressive tax system government redistribute income from the rich to the poor through social welfare programmes.
4. Environmenta. Economic growth people more affluent less focused on private
consumption and more focused on living environment gain awareness of environmental degradation
Costs
1. Worsen income disparitya. Low skilled workers cannot keep up with technological advancements so they
are replaced by machines leading to unemployment or taking up lower paying jobs.
2. Environmenta. EG pollution more damage to the environment.b. EG depletion of non-renewable natural resources insufficient for the
future.
InflationMeasurements
1. Consumer price index (CPI): An indicator of inflation.2. Producer price Index (PPI): The index of wholesale prices measures prices at the
point of sale.3. GDP deflator: It measures changes in the economy’s average GPL.
i. Contractionary fiscal policyii. Contractionary monetary policy
iii. Appreciation of domestic currency5. Cost push inflation is caused by higher cost of production
a. Reasonsi. Wage-push: Due to powerful trade unions pushing for higher wages,
raising the cost of production and fall in SRAS may lead to wage-price spiral when the increase in wages is not due to increase in productivity.
ii. Imported price-push: With the inflation in foreign trading country, the increase in the cost of imported factors of production, the increase in the cost of imported factors of production e.g. raw materials, intermediate products and the fall in SRAS will result in imported inflation.
iii. Profit-push inflation: The monopoly charging higher prices due to the higher cost of production and the demand for goods and services provided by the monopoly is price inelastic. The increase in price leads to less than proportionate decrease in quantity demanded. The more price inelastic it is, the larger is the increase in price.
iv. Policies1. Appreciation Imported inflation2. Supply-side policies cost push inflation3. Direct controls cost-push inflation
Internal Effects of Inflation1. Investment
a. Mild demand-pull: The higher rate of returns leads to higher profit margin. Due to contractual agreement, SR cost of production does not rise thus stimulating investments.
b. Inflation leads to uncertainty and speculations.c. Inflation: The value of money falls, discouraging savings among households.
Less fund in the bank for investment decreases investment.2. Employment
a. Inflation decreases investment and net exports so there is a decrease in AD and fall in national income and output.
b. Producers cut back on production and reduce employment thus increasing unemployment.
3. Income redistributiona. Fixed income earners e.g. pension receivers with falling value of money and
fixed income, buys less goods and services.b. Variable income earners e.g. profit receivers; with goods and services
prices rising faster than costs profit income increases faster than the inflation rate.
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c. Creditor’s vs debtors: It benefits debtors at the expense of creditors. The value of money falls e.g. if GPL doubles, the debtors repays only half.
d. Savers: The value of money falls due to the inflation and nominal interest rates remain the same. Thus savings decline
External Effects of Inflation
1. Balance of paymenta. Inflation leads do domestic prices of goods and services becoming relatively
more expensive than trading rivals, resulting in an increase in imports i.e. (M) + decrease in exports (X) in domestic country thus decrease net exports (X-M) so BOT and BOP worsen.
Deflation
1. It usually occurs during recession Due to low C&I CPL lowera. Domestic goods and services seems relatively cheaper than foreign imports
net exports increaseb. Firms cut back on production further fall in AD.
Relationship between inflation and unemployment
1. The Philips curve shows trade-offs between inflation rate and unemployment rate. There is an inverse relationship between inflation rate and unemployment rate.
UnemploymentMeasurement: Labour force = Number of employed + number of unemployed.
Types of Unemployment1. Cyclical unemployment is associated with the business cycle usually during an
economic downturn.a. Reasons: Demand deficiency arises during recession where there is a fall in
national income and output. Fewer goods and services are demanded and hence produced. Producers cut back on production, reducing employment of workers so increasing in cyclical unemployment.
b. Policies:i. Expansionary fiscal policy
ii. Expansionary monetary policyiii. Depreciation of domestic currency.
2. Structural unemployment results from a change in the economy’s structure. IT occurs when the unemployed do not have necessary skills required for available jobs so leading to a mismatch of skills and job requirements.
a. Reasons: Change in consumer’s tastes and preferences or foreign competition declining demand AD falls in SR cyclical
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unemployment in LR Skills become obsolete structural unemployment.
b. Due to occupational immobility with new technology, e.g. automation in which machines replace labour or workers do not possess the necessary technological know-how leading to technological unemployment.
c. Due to geographical immobility where some regions experience full employment while others experience massive unemployment resulting in regional unemployment.
3. Seasonal unemployment results from seasonal or weather variations seasonal trades regular and predictable e.g. agriculture, tourism.
a. Reasonsi. Weather cycle e.g. four seasons, off-peak seasons (tourism).
ii. Traditions and customs festivals e.g. Christmas.b. Policies
i. Diversification of industriesii. Part-time work
Effects of unemployment1. Loss in output
a. Unemployment means production within PPC. There is under-utilisation of resources whereby actual output is lower than potential output results in output loss.
2. Loss of human capitala. Prolonged unemployment will result in erosion of skills and knowledge.
Moreover with competitions from fresh graduates lowers the changes of employment.
3. Loss in tax revenuea. Unemployment causes a loss in income. Thus, less income tax and GST are
collected. Government thus suffers from a loss in tax revenue. If the government provides welfare payment, it will be a strain on the government budget.
4. Social problemsa. Prolonged unemployment lowers the standard of living, low self-esteem and
demoralisation. Such social problems will lead to high crime, suicides and divorce rates.
Balance of payment
StructuresCurrent account consists of
1. Visible trade account or balance of trade in goods records imports and exports of goods i.e. X>M = surplus / M>X = deficit.
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2. Invisible trade account or balance of trade in services records trade in services between countries i.e. receipts > payment = surplus / payment > receipts = deficit.
3. Net income flows from abroad through the income of foreigners, rent, interest, dividends and profits received from or paid to the rest of the world.
4. Net current transfers or unilateral transfers are transfers of money to and from international organisations (e.g. UN), international transfers.
Capital account consists of
1. Capital transfers2. Debt forgiveness3. Acquisition4. Disposal of non-financial assets.
Financial account
1. It records cross-border movement of ownership of shares, property, bank deposits, loans, government securities, etc.
a. Direct investment involves the movement of real assets i.e. Net direct investments = direct investment into country by foreigners – direct investment abroad by residents of the country.
b. Portfolio investmenti. Short term investments e.g. Cross-border loans, inter-company debts
etc.ii. Money flows (hot money) made in response to take advantage of
differences in interest rates and exchange rate, and political uncertainty.
Net errors and omissions
1. This is to correct errors in statistics compiled balancing item.a. Positive receipts from abroad > payments to abroad.b. Negative payments to abroad > payments from abroad.
Official financing account: It contains surpluses and deficits of overall BOP.
1. Surpluses are used to repay loans or debts, buy gold or foreign currency.2. Deficits are financed by borrowing from IMF or foreign central banks.
Causes of Bop deficits1. Relative inflation rate:
a. Persistent higher inflation rate relative to trading partners: With domestic exports relatively more expensive and foreign imports relatively cheaper, the fall in quantity demanded for exports and rise in quantity demanded for foreign imports worsen BOT and BOP.
2. Relative incomes:
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a. Rise in national income relative to trade partners: The higher income and higher purchasing power increase the demand for imports more than that of exports thus worsening BOT and BOP.
3. Long term structural changesa. International trading patterns e.g. free trade agreement between countries,
protectionism.b. Due to changes in consumer tastes and preferences.c. Technological advancement more substitutes for domestic exports.d. Economic restructuring shifts from low-skilled industry to value-added,
knowledge-based industry.
Effects of BOP disequilibrium1. Effects of a persistent deficit
a. Depletion of official reserves draw from reservesb. Economic recession if caused by current account deficit imports >
exports fall in (X-M) fall in AD economy contract fall in national income and output, employment rates.
c. Devaluation of exchange rate lower investors’ confidence selling of currency capital outflow worsen financial account balance worsen Bop further.
2. Effects of a persistent surplusa. One country’s surplus is another country’s deficits so the country
experiencing deficit may impose protectionism.b. There is demand-pull inflation. Dutch disease effect is when appreciation of
exchange rate decreases export competitiveness. The economy contracts and increases unemployment.
Policies to reduce a BOP deficit1. Contractionary monetary policy higher interest rates relative to another country
investors and speculators make profit from differences in interest rates transfer money from foreign country with lower interest rates into local financial institutions (i.e. banks) short-term capital (hot money) inflow improvement in capital account improvement in BOP.
2. Depreciation of Devaluation of domestic currency central bank sells domestic currency price of exports cheaper in foreign currencies + price of imports more expensive in domestic currency consumers switch from foreign imports to domestic goods and services assume Marshall-Lerner condition improvement in BOT improvement in BOP.
3. Supply-side policy lower cost of production of domestic good and services prices of domestic goods and services relatively cheaper than foreign competitors Greater demand for domestic exports assume Marshall-Lerner condition improvement in BOT improvement in BOP.
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Policies to reduce BOP surplus1. Expansionary monetary policy lower interest rates relative to another country
investors and speculators aim to make profits from differences in interest rates transfer money out of a local financial institutes into foreign countries with higher interest rates short-term capital (hot money) outflow worsening capital account worsening BOP.
2. Appreciation of domestic currency central bank buys domestic currency price of exports more expensive in foreign currencies + price of imports cheaper in domestic currency consumers switch from domestic goods and services to foreign imports assume Marshall-Lerner condition worsens current account worsening BOP.
Note: Due to its lack of natural resources, Singapore’s exports are heavily made up of import content, appreciation leads to improvement in BOP appreciation of SGD price of exports more expensive in foreign currencies + price of imports cheaper in domestic currency since Singapore’s exports are heavily made up of import contents cheaper imports (raw materials) translates to cheaper cost of production of domestic goods and services (exports) price of Singapore’s exports do not increase as much in foreign currencies improvement in BOT improvement in BOP.
Fiscal Policy
Taxation1. Systems of taxes
a. Progressive tax system e.g. progressive income tax: The percentage of income tax paid increases as the income increases lading to redistricting the income from the poor.
b. Regressive tax system e.g. GST, Value-added Tax (VAT): The percentage of tax paid as a proportion of income decreases as the income increases, disadvantaging the poor.
c. Proportional tax system, e.g. corporate tax: The percentage of corporate tax paid remains unchanged as the profits increase.
2. Types of taxesa. Direct: When paid directly by individuals or institutions, the burden of tax
cannot be shifted e.g. income tax, corporate tax, property tax, road tax, etc.b. Indirect; Tax on goods and services burden of tax can be shifted from
producers to consumers i. Ad valorem tax tax on fixed percentage of the value of goods and
services.ii. Specific tax tax on fixed amount per unit of goods and services e.g.
GST, VAT, custom duties.3. Purpose of taxes
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a. Raise revenue to finance government expenditure for goods and services not provided efficiently by free market forces e.g. education, healthcare, military defence.
b. Redistribute income and wealth to reduce income inequality.c. Correct market failure to courage consumption or production of goods and
services deemed socially undesirable, e.g. alcohol, cigarettes.d. Promote economic growth to protect domestic or infant industries by
increasing net exports so as to improve BOP.e. Regulate expenditure reduce disposable income + post-tax profits (direct)
or reduce real value of income (indirect) reduce inflationary pressures + allocate resources more efficiently.
4. Effects of taxesa. Distribution of income
i. Direct progressive more equitableii. Indirect tax for lower income group regressive less equitable
but for higher income group progressive more equitableb. Labour supply
i. Income effect higher taxes afford less goods and services than before to increase income + afford more goods and services sacrifice leisure time one hour of work hours
ii. Substitution effect higher taxes one hour of work buys less goods and services than before one hour of leisure sacrifices in less goods and services work shorter hours.
c. Consumption level i. Direct tax reduce disposable income lower purchasing power -
lower C also depends on MPC and MPSii. Indirect tax demand for goods and services taxed is price elastic
quantity demand falls more than proportionately influence consumer C.
d. Savings reduce willingness and ability to save less funds for investments.
e. Investments high corporate tax decrease post-tax profits discourage investments.
f. Inflationi. Direct tax reduce disposable income + post tax-profits reduce
AD reduce inflationii. Indirect tax increase GPL of goods and services higher cost of
living unions call for higher wages wage-push inflation.
Government expenditure1. Types of government expenditure
a. Current or operating expenditure incurred in everyday routine work recurrent e.g. civil servant wages.
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b. Development or capital expenditure public investments development of economy and society e.g. building of schools, hospitals, infrastructure
2. Effects of government expenditurea. Resource allocation G change production patterns e.g. shift from low-
skill to knowledge-based industriesb. Income and wealth distribution G that benefits poor e.g. healthcare,
education, pensions, social welfare reduce income gap.c. Economic growth government expenditure on infrastructure, etc.
improves efficiencies increase national output + decrease unemployment increase national income.
d. Stabiliser affects level of economic activity by raising or reducing AD.
Tools1. Non-discretionary fiscal policy: Stabilises the economy by influencing AD without
government invention, also known as automatic stabilisers.a. Progressive tax system
i. Economic booms higher income more tax revenue contacts economy reduces inflationary pressures.
ii. Recession lower income less tax revenue tax revenue received falls faster than national income slower fall in C cushions impact of recession.
b. Unemployment benefits: During recession, employment rises. Unemployment benefits provide income to increase so cushion C, fall in AD.
2. Limitationa. The fiscal drag is the tendency of non-discretionary fiscal policy to reduce
recovery of economy from recession. This policy is not activated until destabilising changes take place so limits effectiveness.
3. Discretionary fiscal policya. Expansionary fiscal policy increases G and decreases T usually used in
recession/ to reduce cyclical unemployment.i. Increases G increased transfer payments increases disposable
income and C + increases public work projects AD increaseii. Decreases T increases post-tax profits + disposable income I + C
increase AD increase via multiplier effect economic growth increases demand for goods and service s greater incentive for producers to increase production employs more factors of production, e.g. labour decreases unemployment decreases cyclical unemployment.
b. Contractionary fiscal policy decreases G and increases T usually used to reduce inflation
i. Decreases G decreased transfer payments decreases disposable income and C + decreases public work projects AD decrease
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ii. Increases T decrease post-tax profits + disposable income I + C decrease AD decrease via multiplier effect multiplied decrease in national output and income decreases demand for goods and services lowers GPL lowers demand pull inflation.
4. Limitationsa. Crowding out effect If G financed by borrowing from financial institutions
e.g. banks the government compete with firms for funds less loanable funds for firms increases interest rate higher cost of borrowing discourages investments the government crowds out private spending.
b. Time lag policy may come into effect when the problem has been resolved could worsen economic problem
i. Recognition lag – time needed to recognise and diagnose economic problem i.e. recession, inflation.
ii. Administrative lag time needed for policies to be planned and approved.
iii. Operational lag time needed for policy to take effect and impact to be seen.
c. Suitability does not address the root cause of the problem e.g. to reduce demand-pull inflation uses contractionary policy result in higher unemployment and even recession.
d. Inflexibility difficult for government to change G in the short-run G tied to long-term contractual agreements cannot be halted without wasting resources.
e. If a country has a small multiplier size, it limits the effectiveness of its policy to raise national output and income and employment.
Uses1. Economic growth
a. Recession can be caused by the lack of AD. Thus, using expansionary fiscal policy actual economic growth also creates employment.
2. Inflationa. Demand-pull inflation is caused by the excess of AD. Thus, using
contractionary fiscal policy to reduce demand pull inflation.3. Unemployment
a. Cyclical unemployment is caused by the lack of AD> Thus, using expansionary fiscal policy to increase AD will reduce cyclical unemployment.
4. Income disparitya. Redistribute income from the rich to the poor through progressive income
tax and the provision of public, merit goods and essential services to the poor. Government can also provide transfer payments (e.g. welfare aid).
Singapore context
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1. Crowding-out effecta. This is irrelevant because Singapore has large foreign reserves and budget
surplus. Singapore government does not fund G by borrowing from financial institution.
2. Multiplier size Smalla. High MPM lack of natural resources + food for every dollar half
spent on imports.b. High MPS compulsory saving CPF up to 20% of income saved High
MPM + high MPS fiscal policy ineffective to stimulate growth.
Monetary Policy
Factors influencing interest rates1. Keynesian liquidity preference: Equilibrium interest rate is where the Keynesian
liquidity preference curve intersects money supply curve,a. The transaction purpose is for making daily payments for goods and services.b. The precautionary purpose is for unforeseen circumstances e.g. emergencies,
recessions, etc. savingsc. The speculative purpose is for investing in shares, bonds, etc.
2. Loanable funds theory: Equilibrium of interest rate is where demand and supply of loanable funds intersect.
a. Demand assumes that is derived from demand for capital investment quantity demanded depends on cost of borrowing e.g. high interest rate low expected rate of return on capital investment low demand for loanable funds.
b. Supply assumes it is determined by the savings level e.g. with a higher interest rate, there will be more savings and hence, more supply of loanable funds.
c. Limitation may be affected by other factors not only interest rates e.g. expectation of future interest rates of economic activities.
3. Crowding out effecta. Government budget deficit borrows from financial institution
competes with firms for loanable funds higher interest rates.4. Corporate tax
a. Change of corporate tax change of post-tax profits e.g. high post-tax profits greater demand for investment greater demand for loanable funds assumes ceteris paribus higher interest rates.
5. Expectation of changes in the exchange ratea. Speculation, e.g. expect appreciation hold on to currency until appreciated
vs expect depreciation hold on to liquid assets affect money supply affect interest rates.
6. Openness of economy
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a. If it is a very open economy, it will be very dependent on would demand and supply of money. The government influence over interest rate is limited so it is difficult to control liquidity.
Tools
Discretionary monetary policy1. Expansionary monetary policy usually used in recession or to reduce cyclical
unemployment increase money supply done by central bank to lower interest rate lower the cost of borrowing cheaper to borrow consumers increase consumption and firms encouraged to increase investment (higher expected rate of return on investments) C + I increase AD & AS increase via multiplier effect multiplied increase in national output and income higher economic growth employs more factors of production e.g. labour decreases unemployment.
2. Contractionary monetary policy usually used to reduce demand-pull inflation decreases money supply done by central bank to raise interest rate higher cost of borrowing more expensive to borrow consumers decrease consumption and firms discouraged to increase investment (lower expected rate of returns on investments ) C + I decrease AD & AS decrease via multiplier effect multiplied decrease in national output and income Decreases demand for goods and services lower GPL lower demand-pull inflation.
Limitations
1. Interest inelasticity of demand for C + I a. During recession pessimistic outlook fall in interest rate less than
proportionate increase in C + I limit effectiveness less effective than fiscal policy.
b. During boom optimistic outlook rise in interest rate less than proportionate decrease in C + I limits effectiveness.
2. The presence of multi-national corporations (MNCs) firms get funds from parent company raise in interest rate ineffective in discouraging investment contractionary monetary policy ineffective
3. The size of the multiplier effectiveness of policy to raise national output and income and employment dependent on the size of MPW (i.e. MPM + MPS + MPT)
Uses
1. Economic growtha. Recession is caused by the lack of AD use expansionary monetary policy
increases actual AD also creates employment.b. For sustainable economic growth prevents overheating of economy
needs to increase AS uses expansionary monetary policy2. Inflation
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a. Demand-pull inflation is caused by the excess of AD. Thus, use contractionary monetary policy.
3. Unemploymenta. Cyclical unemployment is caused by the lack of AD. Thus, use expansionary
monetary policy.
Singapore Context1. Openness of economy
a. It is very open to capital flows small changes in interest rate leads to large inflow or outflow of money supply difficult for the government to control money supply monetary policy ineffective.
Exchange rate policy
Tools
1. Appreciation and revaluation: the external currency value increases relative to another currency.
2. Depreciation and devaluation: the external currency value decreases relative to another currency.
Causes of changes
1. Changes in demand for exports and imports.a. Changes in demand for domestic export changes demand for domestic
currency.b. Changes in demand for foreign imports changes supply of domestic
currency.2. Change in capital flows:
a. Inflow affects the demand for domestic currency.b. Outflow affects the supply of domestic currency.
3. Changes in relative interest ratesa. The fall in relative interest rate in domestic country short-term capital (hot
money) outflow increases the supply of domestic currency domestic currency depreciates.
b. The rise in relative interest in domestic country short-term capital (hot money) inflow speculators and investors move money from country with lower interest rate into domestic country which has higher interest rate higher demand for domestic currency domestic currency appreciates.
4. Expectation of future exchange rate (speculations)a. Expect future exchange rate to fall/depreciate sells domestic currency to
b. Expect future exchange rate to rise/appreciate speculators buy domestic currency demand for domestic currency increases domestic currency appreciates.
5. Relative changes in price level (inflation rate)a. Domestic inflation rate higher relative to that of another foreign country’s
domestic exports more expensive in foreign currency + foreign imports cheaper in domestic currency demand for domestic currency falls + demand for foreign currency rises domestic currency depreciates.
b. Domestic inflation rate lower relative to that of foreign country’s domestic exports cheaper in foreign currency + foreign imports more expensive in domestic currency demand for domestic currency rises + demand for foreign currency falls domestic currency appreciates.
Internal effects
1. Income and employmenta. Appreciation assuming Marshall-Lerner condition holds
i. Price of exports in terms of foreign currencies increases quantity demanded for export decreases more than proportionately export revenue in domestic currency decreases.
ii. Price of imports in terms of domestic currency decreases quantity demanded for imports increases more than proportionately import expenditure in terms of domestic currency increases decrease in export revenue + increase in import expenditure (X-M) decreases AD decreases via multiplier effect multiplied decrease in national output and income decreases demand for goods and services producer cuts bac production employs less factors of production e.g. labour increases unemployment
b. Inflationi. Appreciation assuming Marshall-Lerner condition worsens
balance of trade AD decreases reduces demand-pull inflation at full employment.
External effects
1. Competitivenessa. Appreciation increases price of domestic exports in terms of foreign
currencies exports less competitive in international market.2. Balance of payment
a. Appreciation assuming Marshall-Lerner conditioni. Short-run BOP worsens
ii. Long run expectation of higher economic growth + rate of returns on investments attracts FDI improves BOP.
3. Terms of trade
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a. Appreciation decreases the price of imports in domestic currency TOT improves.
J-Curve effect: Demand for exports price inelastic time needed to find substitutes/ adjusts consumption patterns/ tied down by contractual agreements quantity demanded for exports less responsive to price changes Marshall-Lerner condition does not hold devaluation/ depreciation worsens BOP in short run improves in long run.
AD increase via multiplier effect multiplied increase in national output and income actual economic growth
b. Depreciation higher rate of returns on investments than before encourage investments increase in long-term investments AS increase potential economic growth.
c. Appreciation speculations inflow of short-term investments (hot money) AS increase potential economic growth.
2. Inflationa. Open to trade + imports raw materials susceptible to imported inflation
uses appreciation assuming Marshall-Lerner Condition holds prices of imports in terms of domestic currency decrease lower cost of production -> lower GPL reduce imported inflation.
AD increase via multiplier effect multiplied increases in national output and income increase in demand for goods and services greater incentive for producers to increase production employ more factors of production e.g. labour decrease in employment.
4. Balance of paymenta. Depreciation central bank sells domestic currency price of exports
cheaper in foreign currency + price of imports more expensive in domestic currency consumers switch from foreign imports to domestic goods and services assuming Marshall-Lerner Condition holds improve BOP.
Singapore Context
1. Central Banka. Monetary Authority of Singapore (MAS)
3. Occasions useda. Before 1997 Asian Financial Crisis economy operating close to full
employment appreciated Singapore dollar to reduce inflationary pressures and prevent economy from overheating.
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During the 1997 Asian Financial Crisis economy contract depreciated Singapore dollar to cushion impact of recession.
Supply-Side Policy (Singapore Context)
Education and training: The government invests in education and training increases productivity of labour force increases potential output AS increases potential economic growth low unemployment effective for structural unemployment.
1. Educationa. Singapore: Six years of compulsory education,b. Upgrading of schools e.g. indoors sport halls for all schools, computer labs.c. Building of more schools e.g. new government-funded universities.
2. Limitationa. Strain on government budget subsidies and cost of provisions
3. Training: The labour force is equipped with necessary skill sets for employments.a. Workforce Development Agencyb. Employment and Employability Institute (e2i)c. Skills training for Excellence Programmes (STEP)
4. Limitationsa. Strain on government budget subsidies and cost of provisionsb. Less educated and illiterate employees face extreme difficulties in learning
new skills.c. Firms are unwilling to send employees for training due to a loss in output and
need to find temporary replacement.
Research and Development (R&D) : The government provides funding or subsidies for R&D. This reduces the cost of production and increases AS which is effective for potential economic growth and cost-push inflation.
Limitations
1. Long term2. Success not guaranteed3. Large funding required.
Job fairs: Job fairs help to connect employers to potential employees which is effective for frictional unemployment.
1. Workforce Development Agency (WDA)2. Employment and Employability Institute (e2i)
Limitations
1. It is costly to organise (e.g. yearly job fairs at Suntec Convention Centre).2. It is cheaper to use the Internet. Singapore is an Internet-savvy country.
Direct Control: The government controls prices of goods and services, and wages which is effective for cost-push inflation
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Michael Lohh
1. Price ceilinga. It imposes maximum price of goods and services or wages until inflation is
reduced.b. Limitation
i. It takes immediate effectii. It is easy to enforce
iii. Once removed, prices or wages increase. This is ineffective as long-term measure.
iv. It leads to black market,v. It distorts market force.
2. Government guidelines: The government provides a signal for wage increases to ensure increase in wages are accompanied by increase in productivity in Singapore e.g. the National Wages Council recommends wage increases.
3. Trade unions: Trade union calls for wage increase may not be accompanied by increase in productivity leading to wage-price spiral and cost-push inflation.
Competition: The government imposes legislations and encourages competition which is effective for reducing inflation.
1. Privatisation: This increased competition leads to increase efficiency thus increasing consumer surplus and lowering price.
2. Limitation; Lower prices could be due to lower quality or lower wages.
