fiscal policy lecture notes with supplementary notes

7/29/2019 Fiscal Policy Lecture Notes With Supplementary Notes

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Macroeconomic Policies

SAJC/2012/JC2/H1 and H2 1

3.2 HOW THE MACROECONOMY WORKS


Enduring Understandings

The students will understand that:

1) macroeconomic policies can help to solve macroeconomic problems inorder to achieve macroeconomic aims

2) a government could implement a policy mix to solve the macroeconomicproblems.

3) all policies, though could solve macroeconomic problems, do have itsdisadvantages/limitations.There are two types of disadvantages/limitations:(i) Desired extent of the change in macroeconomic indicator in order to

solve a macroeconomic problem could not be achieved.(i.e. The policy aims to increase NY in order to recover an economy outof a recession but the extent of the increase in NY is limited or smallerthan expected)

(ii) Conflict of aims may arise.

4) the effectiveness of macroeconomic policies to solve a macroeconomicproblem depends on the:a) ability of the policies to solve the root cause of the problemsb) characteristics and nature of economyc) mix of the policies to minimise the conflicts of aims.

Essential Questions

1) How do macroeconomic policies help an economy to achieve itsmacroeconomic aims?

2) Why do we need different macroeconomic policies?

3) How and why does a government implement a policy mix?

4) What makes a macroeconomic policy effective?


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Contents2 FISCAL POLICY ......................................................................................................... 5

2.1 Government Budget............................................................................................ 5Government expenditure ......................................................................................... 6Taxes........................................................................................................................... 6

2.2 Discretionary Fiscal Policy................................................................................. 72.3 The Disadvantages/Limitations of Fiscal Policy ............................................. 9

Limitation of Fiscal Policy: Conflicts of Macro/Micro Aims ................................. 9Limitation of Fiscal Policy: The desired extent of the change inmacroeconomic indicator in order to solve a macroeconomic problem couldnot be achieved. ...................................................................................................... 11Time lags .................................................................................................................. 11The accuracy of forecasting .................................................................................. 13Size of multiplier (H1 Economics need to have a broad understanding of howmultiplier could limit the extent of change an macroeconomic indicator)....... 13

2.4 Automatic Fiscal Stabilisers............................................................................. 15Effectiveness of Automatic Fiscal Stabilisers ..................................................... 16

2.5 Effects of Fiscal Policy on Aggregate Supply ............................................... 182.6 Effectiveness of Fiscal Policy .......................................................................... 182.7 Fiscal Policy in Singapore................................................................................ 18

Budget 2007: Reducing Direct Taxes, Raising the Goods and Services TaxRate ........................................................................................................................... 19Budget 2009: The Resilience Package ............................................................... 20

3 MONETARY POLICY .............................................................................................. 223.1 What is Money?................................................................................................. 223.2 Who conducts MP? .............................................................................................. 22

Reserve Requirements........................................................................................... 23Discount Rate .......................................................................................................... 23Reserve requirements ............................................................................................ 23Discount rate ............................................................................................................ 23Open-market operations ........................................................................................ 24

3.1 Expansionary Monetary Policy........................................................................ 25(A) Quantitative Measures ..................................................................................... 25(B) Qualitative Measures ....................................................................................... 27

3.2 Contractionary Monetary Policy ...................................................................... 28(A) Quantitative Measures ..................................................................................... 28(B) Qualitative Measures ....................................................................................... 29

3.3 The Effectiveness of Monetary Policy............................................................ 303.3.1 Pros of Monetary Policy ............................................................................... 303.3.2 Cons of Monetary Policy .............................................................................. 30Other problems of using MP are:.......................................................................... 30

3.4 Monetary Policy in Singapore........................................................................... 313.4.1 Openness to Trade Flows ............................................................................ 313.4.2 Openness to Capital Flows.......................................................................... 32


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Annex A ............................................................................................................................ 33Credit Creation and Destruction in the Economy ............................................... 34

4 EXCHANGE RATE POLICY................................................................................... 364.1 Adopting a Flexible Exchange Rate System ................................................ 374.2 Adopting a Fixed Exchange Rate System..................................................... 384.3 Adopting Managed Float Policy ..................................................................... 404.4 Exchange Rate Policy in Singapore ................................................................ 404.5 Possible policy conflicts.................................................................................... 46

5 PRICES AND INCOMES POLICIES .................................................................... 475.1 Incomes Policy to minimise cost-push inflation......................................... 47

6 SUPPLY-SIDE POLICIES...................................................................................... 486.1 Types of Supply-side measures ......................................................................... 49

6.1.1 Reducing Government Expenditure - Release More Resources ...... 49to the Private Sector ............................................................................................... 496.1.2 Reducing taxes to raise work incentive ................................................. 496.1.3 Reducing the Automatic Entitlement to Welfare Benefits: EncourageGreater Self-reliance............................................................................................... 506.1.4 Encouraging Competition through Policies of Deregulation andPrivatisation.............................................................................................................. 506.1.5 Adopt Exchange Controls to Influence the Movement of Capital ...... 516.1.6 Ease Business Costs in Difficult Times (Reduce Costs of Production)

516.1.7 Raise Productivity Levels......................................................................... 51


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Figure 1 Expansionary Fiscal Policy (AD-AS approach) ....................................... 7Figure 2 Expansionary Fiscal Policy (Y-AE approach) .......................................... 8Figure 3 Crowding Out Effect ...............................................................................11Figure 4 The Problem of Time Lags .....................................................................12Figure 5 Effects of Expansionary Monetary Policy (AD-AS approach).................26Figure 6 Effects of Expansionary Monetary Policy (Y-AE approach) .............Error!Bookmark not defined.Figure 7 Effects of Contractionary Monetary Policy (AD-AS approach) ...............29Figure 8 Effects of Contractionary Monetary Policy (Y-AE approach)............Error!Bookmark not defined.


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2 FISCAL POLICY

Readings:(i) John Sloman, 'Economics' 7th Edition, Pg 562-573(ii) Maunder, Economics Explained Revised 3rd Edition, Pg 486-497

Fiscal policy, is a demand side management policy, which involvesthe government changing the level of government expenditure (G)and/or tax receipts (T) so as to affect the level of aggregate demand(AD) in order to achieve macroeconomic stability. This refers toachieving macroeconomic objective of 1) increasing national incomeand hence strong economic growth (through increasing AD when ADis too low, cutting the horizontal portion of AS curve) 2) loweringunemployment and 3) lowering inflation (through decreasing AD whenAD is too high, cutting the vertical portion of AS curve).

Besides solving inflation or recession, fiscal policy can be used toachieve microeconomic aims of reducing income disparity through thetax system (see 2.7 Fiscal Policy in Singapore).

It is noteworthy to point out that fiscal policy has the ability toinfluence AS. In other words, fiscal policy has SS-side effects.

2.1 Government Budget

The government budget consists of two components:1. Government expenditure (G)12. Government revenue whose main source is from taxes (T)

A budget deficit implies G exceeding T whereas a budget surplusimplies T exceeding G.

1Government expenditure here refers to total government expenditure. Its impact can be

analysed using G on goods and services or as transfer payments through C and I. When there isan increase in the level of transfer payments, this shows up in Aggregate Demand as a change inthe level of household consumption, as it directly affects the ability of households to buy goodsand services.

Main aims of Fiscal Policy1. To increase national income and hence strong economic

growth2. To lower unemployment3. To lower inflation4. To reduce income inequality5. To influence aggregate supply


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Government expenditure

Government expenditure on public works (e.g. construction ofhighways, irrigation network, bridges, etc.) could be deliberatelyincreased.

The government can deliberately relax eligibility rules to enablemore people to qualify for transfer payments.

Reducing taxes and raising government expenditure are aimed atincreasing aggregate demand or aggregate expenditure to createincome and employment.

For Budget 2010, Singapores Expenditure on Education was 3.5%of GDP, while Defence was 4.1%, Health was 1.5%.

Taxes

The government could deliberately reduce personal income taxrate and/or indirect taxes to raise consumption. A reduction in

personal income tax rate will increase disposable income andhence encourage consumption, increasing aggregate demandindirectly.

If the tax cut is in favour of the lower income group, the multipliereffect will be greater. This is because the marginal propensity toconsume is higher for lower income group than for higher incomegroup. So the additional induced consumer spending on theincrease of an additional dollar of income is higher (smallerleakage) and, hence, the multiplier effect is greater.

A Brief Introduction to Taxes

A tax is a compulsory payment made to the government by various groups ofeconomic agents. There are two main types of taxes from which thegovernment collects its revenue. They are direct taxes (e.g. personal incometax, corporate income tax) and indirect taxes (e.g. excise tax (a sales tax onindividual products such as alcohol, tobacco, and gasoline), tariffs, Goods andServices Tax).

Taxes are considered as leakages out of the circular flow of income. In theanalysis of its effect, one needs to make a distinction between direct andindirect taxes. Direct taxes affect the households' and firms' disposable

income whereas indirect taxes do not.


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A lower corporate income tax increases the incentive to raiseinvestment in order to stimulate aggregate expenditure. (Corporateincome taxes reduce the after-tax income to the firms and, thus,limiting the funds available for investment.)

2.2 Discretionary Fiscal Policy

This refers to the deliberate changes in the level of governmentexpenditure and/or tax rates in order to change the level of AD or AEto affect national income through the multiplier effect. In other words,it is the discretionary fiscal policy which the government can use toregulate economic activities to tackle macroeconomic issues.

Discretionary fiscal policy can either be Expansionary orContractionary. For example, during a recession, government mayuse expansionary fiscal policy to increase the level of governmentexpenditure on infrastructure, public goods, healthcare, etc. toincrease aggregate demand and hence boost the level of economicactivities in the economy.

The government may also choose to lower taxes to stimulatespending and investment, thus boosting aggregate demand.

How would a government adopt expansionary fiscal policy to solve a

macroeconomic problem?

Figure 1 Expansionary Fiscal Policy (AD-AS approach)

AD

AS

AD

YY

Increase in government spendingand reduction in taxationcause AD to move to AD, andequilibrium income increases fromY to Y.

P

P

Real NY

General Price Level

Upwardpressureon prices

0


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Figure 2 Expansionary Fiscal Policy (Y-AE approach for H2 Economics only)

The government may experience a budget deficit when the economy isexperiencing a deflation, high unemployment or recession. This isbecause as the government adopts an expansionary fiscal policyinorder to recover the economy out of recession, there would be anincrease in G and/or a reduction of T, which results in a budget deficit.

Workings of Contractionary Fiscal PolicyDuring high inflation, government may use contractionary fiscal policyto decrease the level of government expenditure on infrastructure,

public goods, healthcare, etc. to decrease aggregate demand andhence dampen the level of economic activities in the economy.

The government may also choose to raise taxes to reduce spendingand investment, thus reducing aggregate demand (AD).

Due to the fall in AD, there would be a downward pressure on thegeneral price level. This is because as total spending in the economydecreases, the firms would cut down production which in turn causesthe producers to hire less factors of production or retrench workers.This would result in a surplus of factors of production which drives

the price of factor of production such as wages and hence cost ofproduction down. Since cost of production falls, the producers couldpass down the lower cost of production in terms of lower price. As aresult, if this applies to all firms in general, general price would fall,thus helping to address the problem of high inflation. (Do you knowhow to draw a AD-AS diagram to illustrate?)

The government may experience a budget surplus when the economyis experiencing a high inflation. This is because as the governmentadopts a contractionary fiscal policyin order to solve the problem of

AE =C + I + G + (X-M)

AE = C + I + G + (X-M)

Y = AE

Y* Y**Nominal NY

AE

Increase in governmentspending and reduction intaxation causes AE to move toAE, and equilibrium incomeincreases from Y* to Y**through the multiplier effect.

0


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high inflation, there would be an decrease in G and/or a increase of T,which results in a budget surplus.

2.3 The Disadvantages/Limitations of Fiscal Policy

There are two types of disadvantages/limitations that a governmentmight encounter as a government implement any policy:(i) Extent of solving the macroeconomic problem is limited.

(i.e. The policy aims to increase NY in order to recover aneconomy out of a recession but the extent of the increase in NY islimited)

(ii) Conflict of aims may arise.

What are the conflict of aims that might arise as a governmentimplements expansionary fiscal policy?

Limitation of Fiscal Policy: Conflicts of Macro/Micro Aims

a) Cost-push inflation:If the economy is overheating and inflation isrising, the government may raise taxes. A higher tax in the form ofhigher GST has to be passed on to the consumer in terms of higherprices. This in turn could lead to higher wage claims and, thus, cost-push inflation.

b) Welfare and distribution:The government may want to introducea cut in public expenditure in order to reduce inflation. A cut in welfarebenefits may have an impact on the people who depend on suchbenefits in addition to their meagre disposable income.

c) Disincentives to work: Progressive income taxes could be adisincentive to work, since tax rates get higher with higher incomeearned. That is, for every increase in income earned, a larger andlarger proportion of that increase in income gets taxed away, leavinga smaller and smaller proportion of disposable income.

Limitation of Fiscal Policy: The desired extent of the change inmacroeconomic indicator in order to solve a macroeconomicproblem could not be achieved.

d) Crowding-out effect: An expansionary fiscal policy that involvesincrease in government spending (G) leads to a rise in AD and NY.However, this rise in G may crowd out private investment spending (I)because of the resulting increase in the interest rate. The assumptionhere is that increase in government spending is funded by borrowing


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from the financial sector. Another such crowding out effect could bedue to resource constraints. With limited resources, increase ingovernment spending will mean that there is increased competitionfor scarce resources as well. This would usually push up the pricesof such resources, causing cost of production to rise. This highercost of production may cause investors to withdraw or halt theirinvestment in the economy.

For instance, when the government borrows money to finance itspurchases to boost aggregate demand, it will drive up interest rate. Itincreases the demand for money in the money market and thisincrease in the demand for money increases interest rate.

As a result of the higher interest rate, consumers may decide against

buying a car, a house or other interest sensitive goods, andbusinesses may cancel or scale back plans to expand or buy newcapital equipment. In short, the higher interest rate will choke offprivate spending on goods and services, and as a result, the impact ofthe increase in government purchases may be smaller than we firstexpected.

As a result, the increase in AD and NY will be limited by the fall in I.

Expansionary fiscal policy G Assuming that government needs to

borrow from banks to finance government spending amount of loanable

funds available for business investors would decrease interest rate

cost of borrowing business investment (G crowds out investment)

AD may not increase by the desired amount via the multiplier effect

NY might not increase by the desired amount and hence may not recover

from recession


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Figure 3 Crowding Out Effect

How come a government may not achieve desired extent of solvingthe problem (i.e extent of solving the macroeconomic problem islimited)?

Limitation of Fiscal Policy: The desired extent of the change inmacroeconomic indicator in order to solve a macroeconomic problemcould not be achieved.

Time lagsa) Recognition Lags: It takes time for policymakers to recognise theexistence of a boom or slump.

b) Implementation Lags: This is as a result of the time that it takes toput the desired policies into effect once economists and policymakersrecognise that the economy is in a slump or a boom. For example,time for analysis and problem of red tape.

c) Response Lags: The lags that occur because of the operation ofthe economy itself. Even after the government has formulated and

implemented a set of policies, the economy takes time to achieve theexpected outcome.

Overall, the timing of fiscal policy is crucial. Because of the significantlags before fiscal policy has its impact, the increase in aggregatedemand may occur at the wrong time. E.g., imagine the economy iscurrently suffering from low levels of output and high rates ofunemployment. In response, policymakers decide to increasegovernment purchases and implement a tax cut. But from the timewhen the policymakers recognise the problem to the time when thepolicies have a chance to work themselves through the economy,

AD

AS

AD

Real NYYY

Starting from AD, an expansionaryfiscal policy with no crowding out

effect shifts AD to AD and incomerises from Y to Y. However, withsome degree of crowding out, thesame policy will cause a fall in I,resulting in a shift of AD to AD and Yto Y instead.

General Price Level

P

P

0

AD

Y

P


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business and consumer confidence might have already improved thus,shifting the aggregate demand curve rightward increasing real outputand employment. By the time the fiscal policy runs its full course, theeconomy might end up experiencing the undesired effect of demand-pulled inflation!

Recession Expansionary fiscal policy G and tax which C and I

because of Recognition lag, Implementation lag or Response lag (please

explain the lags in yr answers) AD does not increase immediately, it

might increase after the economy recovers by itself more than necessary

increase in AD desired increase in AD may not achieved desired

increase in NY may not achieved (more than necessary increase NY will

increase DD pull inflation).

Real National Income

Figure 4 The Problem of Time Lags Time

From the illustration above, Path B shows the course of business cyclewithout government intervention. Ideally, with no time lags, thegovernment should intervene by contractionary policies at Stage 2 andexpansionary at Stage 4. This will result in the economys businesscycle following the course of Path C which ensures more stability.However, with time lags, contractionary fiscal policies at Stage 2 maynot come into effect until Stage 4, and expansionary policies at Stage4 may not come into effect until Stage 2. In this case, the resultingcourse of the business cycle may likely be Path A. Thus, a stabilising

Path A

Path B

Path C2 2

Stage 1 1 1

3 3

4 4


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policy using fiscal tools may make it even more destabilising becauseof time lags!

The accuracy of forecasting

Inaccurate forecasts can affect the governments decision to act swiftlyto address a problem of excess or deficient demand. For example, ifthe government inaccurately predicts the magnitude of an economicslowdown next year and over-exercises expansionary fiscal policy toboost the economy, it may cause the economy to expand more rapidlyand risk experiencing inflationary problems!

In addition, the government might also need to take into consideration

whether there are any other withdrawals (import, saving) or injections(export, investment) that are expected to take place before deciding onthe extent of contraction/expansion the fiscal policy tools should bring.While the government is pursuing an expansionary fiscal policy byincreasing G to generate higher AD and hence income andemployment, a fall in net exports may negate the effect. Similarly, acontractionary fiscal policy by reducing G will be offset by an increasein I (itself not entirely within the control of the government).

Size of multiplier (H1 Economics need to have a broad understandingof how multiplier could limit the extent of change an macroeconomic

indicator)

The overall impact of government spending or taxes will depend onthe size of its multiplier. Recall that the multiplier effect is: NY = k x AE

An increase in government spending of $1 million ( AE) willgenerate a higher level of national income ( NY) if the multiplier (k)is larger. Recall that

For example, if mpc = 0.5, k = 2 and mpc = 0.8, k = 5. This meansthat the larger the mpc, the larger the value of k. With an increase ingovernment spending of $1 million, a country with a larger multiplier(k = 5) will generate a larger increase in national income ($5 million)while one with a smaller multiplier (k = 2) will generate a smallerincrease in national income ($2 million).

The size of the multiplier is dependent on the size of the marginalpropensity to withdraw (mpw = mps + mpt + mpm). Various factorsaffect mps, mpt and mpm. For example, an open economy withhigher dependence on imports, such as Singapore will experience


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lower multiplier effect compared to one with less sources ofwithdrawals. With a given level of government spending, its multipliedincrease in national income will be lower as compared to other lessopen economies.

Recession Expansionary fiscal policy G and tax which C and I

AD via the multiplier effect NY

With a given amount of increase in AD, the desired amount of the increasein NY may not be achieved if the multiplier is too small.

What determines the size of multiplier?Higher the savings rate (Marginal Propensity to Save - MPS), import rate(MPM), and tax rate (MPT) multiplier will be very small

Qn: Given the above withdrawal rates (mpm, mpt, mps), what is theconsumption rate within the economy (i.e. mpc)

MPC = 1 (mpm+ mpc+mpt)

Formula of multplier:

Is Singapores multiplier small? Why?


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Limitation of Fiscal Policy: The desired extent of the change inmacroeconomic indicator in order to solve a macroeconomicproblem could not be achieved.

FactorType of tools that the government utilise whenimplementing fiscal policy

Fiscal Spending vs. TaxationHowever, a fall in T results in a smaller multiplier effect compared tothe same increase in G, because of the withdrawal effect of mps.

For instance, assuming mpc = 0.7, a $1m injection of governmentspending will generate $3.33m in income. Conversely, a tax cut of$1m will increase consumption by $0.7m, resulting in only $2.33mincrease in income.

While both may seem to be similar in effect, an increase in spendingis more effective in raising G than by reducing T as lower taxes toboost spending has to depend on the marginal propensity toconsume. Lower taxes boost disposable income, and the subsequentincrease in aggregate demand will be lower due to mpc (0.7) whereasgovernment spending that raises aggregate demand will be injectedin full.

Other limitations of tax cuts to boost national income: If tax cuts are temporary, consumers may not increase

spending. An increase in induced consumption through a tax cut depends

on the level of consumer confidence.

2.4 Automatic Fiscal Stabilisers

As the name suggests, automatic fiscal stabilisers stimulateaggregate demand automatically during periods of recession and

dampen aggregate demand during periods of expansion as opposedto deliberate government action that is used via discretionary fiscalpolicy. In other words, they refer to the built-in mechanisms that willautomatically stabilise the economy during recessions and booms.

E.g. of automatic fiscal stabilisers are:

For instance, based on the Year of Assessment 2012, a personearning $20,000 or below per year will pay a 0% tax rate. However,as the economy booms and his income increases above $20,000 peryear, his tax rate automatically increases to 2% as he moves up the


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income bracket. This increase in tax rate is progressive as a personmoves up the income brackets (a persons earnings above $320,000will be taxed at a rate of 20%)2.

As can be seen from the above example, when national income rises,a progressive income tax system (a kind of automatic fiscal stabiliser)will automatically raise the tax revenue for the government. On theother hand, governments spending on the unemployment benefits (akind of automatic fiscal stabiliser) will fall as more people areemployed during economic boom, and requires less governmentassistance. Both of these will act as a lower injection into the circularflow of income and help to dampen the increase in national incomewithout any deliberate action to increase tax rates and/or reducegovernment expenditure.

Conversely, when the economy is in recession, unemploymentincreases and tax revenues fall more, so disposable income does notfall as much as does real GDP. Thus, an income tax, cushionsdeclines in disposable income, in consumption, and in aggregatedemand.

Recession individuals would earn less income assuming

the automatic fiscal stabailiser such as progressive income tax

system and unemployment benefts in place and does not

change less income means less tax revenue would be

collected and more unemployment benefits needs to be

provided an individuals Yd would not decrease by much

during recession Consumption would not decrease by much

helps to stimultes Aggregate demand.

Effectiveness of Automatic Fiscal Stabilisers

1. Immediate impact of such measures

Automatic stabilisers have the advantage of acting instantly as soonas aggregate demand fluctuates. In contrast, it may take some timebefore discretionary changes in government taxes or expenditure canbe implemented, especially if information is not readily available forpolicymakers to finalise their policies.

2Ministry of Finance website, Personal Income Tax Rates

(http://app.mof.gov.sg/personal_income_tax_rates.aspx)


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2. Automatic stabilisers cannot prevent fluctuations they merelyreduce their magnitude

Unlike discretionary fiscal policy, automatic stabilisers merely reducethe severity of fluctuations, not eliminate them altogether. Forexample, as income rises, progressive taxes will help to moderate therise in income. However, the government can use discretionary fiscalpolicy to contract the economy and cause the income to changedirection (fall).

3. Fiscal dragFiscal drag is defined as the tendency of automatic fiscal stabilisers toreduce the recovery of an economy from recession. Automatic

stabilisers are useful in helping to reduce upward or downwardmovements in national income by controlling the expansion of theeconomy during a boom and help to boost the economy during arecession.

A fiscal drag can occur if the economy moves from a deep recessionand begins to recover. Instead of helping the recovery process,automatic stabilisers can instead slow down the recovery and act as adrag on the expansion.

Suppose that the government has adopted an expansionary fiscal

policy to help the economy to recover from recession by loweringtaxes. This boosts the economy and helps the economy recover viathe multiplier process. However, as the economy recovers andnational income increases, automatic stabilisers will dampen theincrease in consumption (by raising tax revenue or loweringgovernment spending). AD would therefore not rise as much as whenthere was no automatic stabiliser in place, thus dampening the effectof expansionary policy to help increase national income.

Therefore, there is a fiscal drag as the automatic stabiliser slowsdown the recovery when the government is trying to adopt

expansionary fiscal policy.

Expansionary Fiscal Policy G and T AD NY Individual earn more income assuming automatic fiscalstabilisers such as progressive income tax are in place


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4. Unemployment and income-related benefits

High unemployment benefits (given to alleviate the loss of incomedue to unemployment) may discourage workers to take up new jobs.Similarly, high income-related benefits may discourage people in verylow-paid jobs from seeking better ones, if the next job they take onoffers them very little more (or no better off) than before.

As Singapore government does not provide unemployment benefits,we do not suffer from the above problem as much as other countriessuch as the U.K. and Australia.

2.5 Effects of Fiscal Policy on Aggregate Supply

Fiscal policy can be used to influence aggregate supply. For example,the government can increase its expenditure on infrastructure(spending on roads and hospitals), merit goods (education andhealthcare), public goods (national defence) or give tax incentives forinvestment. All these government spending would increase theamount of capital goods and hence increase the productivity capacityof the economy. As a result, such expansionary fiscal policy will notonly increase AD (achieving actual growth) but also increase LRAS

(achieving potential growth). Therefore, the implementation of fiscalpolicy not only has the main intended effect of increasing AD but alsohas the side effect of increase LRAS (i.e. Fiscal policy has SS-sideeffects).

2.6 Effectiveness of Fiscal Policy

The effectiveness of macroeconomic policies to solve amacroeconomic problem depends on the:a) ability of the policies to solve the root cause of the problemsb) characteristics and nature of economy

c) mix of the policies to minimise the conflicts of aims.

2.7 Fiscal Policy in Singapore

As the open nature of Singapores economy results in much leakagesif fiscal policy is employed, fiscal policy mainly supports economicgrowth by promoting macroeconomic stability through fiscal prudence(living within our means) and by enhancing supply-side conditions.Fiscal Policy is directed mainly at promoting long-term economic


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growth by investing in infrastructure, education, research anddevelopment while taxing demerit goods like vehicle congestion andpollution).

The Singapore Government has adopted the following principles tomeet its objectives3:

1. The private sector is the engine of growth and thegovernments role is to provide a stable and conducivebusiness environment;

2. Tax and expenditure policies should be justified onmicroeconomic grounds and focus on supply-side issues;

3. The counter-cyclical role of fiscal policy is limited, due to highimport leakages.

With such prudent fiscal policy, Singapore enjoyed consistent budgetsurpluses that contributed to its high savings rate that allowed it toachieve one of the highest investment rates in the world.

Raising sufficient revenue while maintaining a competitive taxstructure and containing expenditure growth. Direct taxes (inparticular corporate taxes) should be lowered while indirect taxesshould be raised to make up for the shortfall. This will enhancebusiness competitiveness.

In addition, the Government is expected to balance the budget withinits 4-5 year term and can only draw on past reserves with theapproval of the President. This Constitutional framework protects pastreserves by enforcing financial prudence, while allowing theGovernment to draw on them in times of need.

Budget 2007: Reducing Direct Taxes, Raising the Goods and ServicesTax Rate4

In Budget 2007, the Singapore Government raised the GST rate from

5% to 7%. The rationale of this was to raise government revenue whilekeeping direct taxes competitive.

Corporate and Personal income taxes have been reduced worldwide.To attract more foreign investments, Singapore has to keep itsCorporate and Personal Income Taxes competitive. Corporate Taxwas lowered in Budget 2007 from 20% to 18% and in Budget 2009

3Monetary Authority of Singapore website, Macro Overview

(http://www.sgs.gov.sg/macro_overview/macrooverview_fiscal.html)4

Ministry of Finance website, Budget 2007(http://www.mof.gov.sg/budget_2007/budget_speech/downloads/FY2007_Budget_Statement.pdf)


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from 18% to 17%5. Personal Income Taxes has also been lowered. InBudget 2007, the top tier (annual income of more than $320,000) taxrate was lowered from 22% to 20%. This is to maximise the incentivesfor all Singaporeans to work hard and reap rewards of their effortswhile attracting and keeping both international and Singaporean talenthere.

Lower tax revenue from these sources will have to be replaced byother sources. By increasing the GST rate, it will broaden the tax baseand enable the government to implement its fiscal policies. GST ratewas increased in Budget 2007 from 5% to 7%.

Budget 2009: The Resilience Package

In 2009, together with the rest of the world, Singapore faced the mostsevere and widespread economic recession in the last 60 years.Singapore introduced the largest countercyclical Budget sinceIndependence (1965) to help us see through the downturn. It includesextraordinary measures such as Jobs Credit Scheme and SPUR(Skills Programme for Upgrading and Resilience)6, to prevent severeloss of jobs and to upgrade the skills of workers.

In addition, Singapores advantage in responding to the crisis is itsavailability of resources or its huge budget reserves accumulated over

the years from prudent fiscal policies. Prudence implies spendingwithin our means and building up reserves through accumulatingbudget surpluses during economic upturns.

Budget 2009 therefore introduced the measures that resulted in alarge budget deficit $2.9 billion for 2009. This is done in the hope ofreversing the decline in the economy by boosting our AggregateDemand (AD).

Figure 5 Singapore's Budget Position

2007 $7.6 billion

2008 $0.2 billion

2009 -$2.9 billion

2010 -$3.0 billion*

5Ministry of Finance website, Budget 2009

(http://www.mof.gov.sg/budget_2009/speech_toc/downloads/FY2009_Budget_Statement.pdf)6

Ministry of Finance website, Budget 2009(http://www.mof.gov.sg/budget_2009/speech_toc/downloads/FY2009_Key_Budget_Initiatives1.pdf)


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*budgeted (based on Budget 2010)


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3 MONETARY POLICYRecommended Readings:(i) John Sloman, 'Economics', 7th Edition, Pg 574-589(ii) Peter Maunder, Economics Explained, Revised 3rd Edition, Pg 486-497

Introduction:

Monetary Policy (MP) is a discretionary policy used to affect AD bychanging the money supply or the interest rate to support theachievement of a countrys key macroeconomic objectives.

Money supply is commonly defined as the quantity of money

available in the economy. Interest rate is the cost of borrowing money or the returns to

savings.

Monetary Policy also affects the volume and direction of credit, thequantity of money available for loan, in the banking system so as toachieve these objectives.(See Annex A Definitions of Money).

3.1 What is Money?

Economists define money as anything that is regularly used ineconomic transactions or exchanges. There are several majorfunctions of money, for example, as a medium of exchange or a storeof value (See Annex A Functions of Money).

3.2 Who conducts MP?

MP is formulated and implemented by a countrys monetaryauthorities. These are the central bank and government departments

dealing with monetary matters. In the U.S., the central bank is calledthe U.S. Federal Reserve (The Fed). In Singapore, the central bank iscalled the Monetary Authority of Singapore (MAS).

Note: Central Bank is NOT Commercial Banks. Commercial banksare financial intermediaries that are usually privately-owned andprofit-seeking businesses. They accept deposits from savers and giveout loans to borrowers. Examples of commercial banks in Singaporeare United Overseas Bank (UOB) and Development Bank ofSingapore (DBS).


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3.3 How is MP conducted?

A central bank controls the money supply in an economy through theuse of Quantitative and/or Qualitative tools or instruments. Such toolsare used in the credit creation process when money supply increasesor credit destruction when money supply decreases(See Annex A Credit Creation and Destruction).

Quantitative Tools Qualitative Tools

Reserve Requirements Interest Rate

Discount Rate Moral Suasion

Open-market Operations

Quantitative Tools:

Reserve requirements

Reserve requirements are regulations on the minimum amount thatbanks must hold against deposits. The minimum amount could be inthe form of a ratio, i.e. a percentage of deposits that banks must keepin reserves which cannot be loaned out. These deposits could bestored in the banks own vault or within the Central Bank. If theCentral Bank reduces the reserve requirement, banks can now loanout more money as compared to earlier resulting in an increase inmoney supply.

Note: This tool is rarely used because it can be disruptive to banksbusiness. If the Central Bank increases reserve requirements, bankssuddenly find themselves short on reserves, with no change indeposits. They will then have to curtail lending until they buildreserves to the new required level.

Discount rate

The discount rate is the interest rate on the loans that the CentralBank makes to commercial banks. Commercial banks may borrowfrom the central bank to meet reserve requirements in the event oftoo many loans being taken out or increased withdrawals of savingdeposits. When the Central Bank makes such a loan to commercialbanks, the banking system has more reserves than it otherwise wouldand this allows the banking system to create more money andincrease the money supply.

Thus, the Central Bank can change the money supply by changingthe discount rate increasing the discount rate will discourage


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commercial banks from borrowing from the Central Bank and lowerthe amount of reserves in the banking system. At times, the CentralBank may make such loans not to control money supply, but to helptroubled financial institutions and commercial banks.

Open-market operations

Open market operations refer to the buying and selling of governmentbonds. Anyone may buy and sell government bonds in the openmarket, including private individuals, businesses and commercialbanks. A bond is a certificate of indebtedness the buyer of a bondwill pay the seller (issuer) of the bond a sum of money. Upon thematurity of the bond, the seller will have to redeem the bond bypaying back the sum of money which the buyer had earliersurrendered plus interest.

To increase the money supply, the Central Bank will buy bonds fromthe public in the open market, thereby increasing the amount of localcurrency in circulation. To reduce the money supply, Central Bank willsell government bonds and the public pays for these bonds usingtheir own holdings of cash or bank deposits.

Therefore, Open-market operations change the quantity of money incirculation in the economy.

Note: The trading of government bonds by the Central Bank is also a

way for the government to borrow money from the public to finance itsdebts.

If the government wants to borrow money, would the Central Bankbuy or sell bonds?


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Qualitative Tools:Moral suasionCentral Bank or the government can use moral suasion to persuadeindividuals to increase or decrease savings and spending. Moralsuasion can also be used on commercial banks to encourage ordiscourage lending activities.

RegulationsCentral Bank can change the regulations relating to loans, hirepurchase and mortgages to influences borrowing and lending.

Interest RateSince interest rates are both returns to savings as well as costs ofborrowing, changing interest rates will affect consumers incentives to

save and firms incentive to borrow funds. Decreasing savings andincreasing borrowing will increase the money supply in the economywhich will encourage consumption and investment since individualsand firms have increased credit (money) to purchase consumer(consumption) or capital (investment) goods.

3.1 Expansionary Monetary Policy

A Central Bank usually implements an expansionary MP (also known

as monetary easing) during a recession or a period of sluggishgrowth. The main macroeconomic objectives of doing so are to:

1. stimulate economic growth;2. increase real national income; and3. reduce unemployment (mostly cyclical in nature).

A central bank can increase the money supply through bothquantitative and qualitative measures.

What can be implemented:

(A) Quantitative Measures (B) Qualitative Measures- Reduce reserve requirement- Reduce discount rate- Conduct open market operations

- Reduce interest rates directly- Moral suasion- Ease regulation

(A) Quantitative Measures

1. Central Bank can reduce the reserve requirement (e.g. thecash reserve requirement, liquidity ratio and special deposits)that commercial banks are required to keep as reserves withintheir own bank or with the central bank.


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2. Central Bank can reduce the discount rate which will

encourage commercial banks to borrow more from the CentralBank and increases the money supply.

3. Central Bank can also conduct open market operations bybuying government bonds or securities from banks or privateindividuals with cash. Banks with the extra cash (or excessliquidity) will be able to give out more loans which encouragesconsumption (C) and investments (I) thus increases AggregateDemand (AD) and real national Income (NY) will increase viathe multiplier process, as shown in Figure 6, Y to Y.

Banks might try to lend out the extra cash by lowering the

interest rates to encourage more borrowing which will increaseconsumption (C) and investments (I) as well.

Figure 6 Effects of Expansionary Monetary Policy (AD-AS approach)

Reducing interest rates reduces the opportunity cost of borrowing

funds for consumption and hence gives more incentives for the publicto borrow for hire purchase or home loan mortgages. It also reducesthe incentive to save. Both effects increase consumption (C).

Reducing interest rates also reduces the opportunity cost ofborrowing funds for business investment and increases the potentialrate of return on investments. Businessmen will have more incentiveto borrow for further investments (I).

Another way of viewing expansionary MP is that the central banksopen market purchase of government securities (or bonds) from

0

E

E

AS

General Price Level

Real NYY Y

PP

AD1

AD2


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banks increases banks money reserves and thus increasing theirability to give out loans (fuel credit creation or loan growth).

Therefore quantitative measures can influence (C) and (I) directly bychanging the money supply or indirectly by changing in the interestrate.

(B) Qualitative Measures

1. Besides influencing interest rates via money supply, Centralbanks can also reduce interest rates directly. This usuallyworks for large economies, but not for small and openeconomies like Singapore (refer to section on Singapores

monetary policy).2. Central Banks can persuade commercial banks to extend

more credit to companies (moral suasion).3. Central Bank can also ease regulations to make it easier for

banks to lend money for hire purchase or home loan mortgagepurposes.

Note: Both quantitative and qualitative measures can be used toinfluence the money supply which would influence consumption (C)and investments (I) thus changes Aggregate Demand (AD) and realnational Income (NY) will change via the multiplier process.


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3.2 Contractionary Monetary Policy

A central bank usually adopts a contractionary monetary policy (ormonetary tightening) when the economy is over-heating7 and whenthe objective is to reduce inflationary pressures.

What can be implemented:(A) Quantitative Measures (B) Qualitative Measures

- _______ reserve requirement- _______ discount rate- Conduct open market operations

- ________ interest rates directly- Moral suasion- __________ regulation

(A) Quantitative Measures

1. Central Bank can _______ the reserve requirement.

2. Central Bank can _______ the discount rate.

3. Central Bank can also conduct open market operations by_______ government bonds or securities from banks or privateindividuals with cash.

7Over-heating occurs when its productive capacity is unable to keep pace with growing aggregate

demand.


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Figure 7: Effects of Contractionary Monetary Policy (AD-AS approach)

(B) Qualitative Measures

1.

2.

3.

General Price Level

Real NY0


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3.3 The Effectiveness of Monetary Policy

3.3.1 Pros of Monetary Policy

If prudently and effectively managed, monetary policy can beeffective in influencing the overall money supply in an economy andinterest rates, thereby influencing consumption, investments,aggregate demand, economic growth and employment.

Monetary policy involves commercial banks which are the mainfinancial intermediaries in any economy. These banks subsequentlyinfluence consumption and investment decisions which exert large

impacts on the economy.

3.3.2 Cons of Monetary Policy

The effectiveness of using monetary policy as a macroeconomic tooldepends on the interest elasticity of demand for loans.

If the demand for loans is interest inelastic (an increase in interestrate will lead to less than proportionate decrease in the amount ofloans provided), the central bank needs to raise the interest ratessubstantially.

Reasons for interest inelasticity:

A rise in interest rates, particularly during recession, mayforce many firms into borrowing merely to survive;

Investment decision depends on many factors other thaninterest rates. These factors include political stability, marketconditions (if business outlook is positive, firms would notreduce borrowing by much even when interest goes up), etc.

Other problems of using MP are:

Imperfect market information in a dynamic financialenvironment to formulate a perfectly sound and effective MP there may be insufficient information as to the extent ofchange required to reach desired AD;


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Long and variable time lags from policy formulation,announcement, implementation to desired policy effects.Changes in MP can be mis-timed and worsen economicgrowth cycles;

MP may not be effectively and efficiently implemented in somecountries due to command and control problems, as in thefollowing case study on China.

Furthermore in the event of a contractionary MP, a high interest ratecould lead to the following problems:

Discourage investment in the long run, and hence long-termeconomic growth;

Add to the costs of production, to the costs of housepurchase and generally to the cost of living, thus leading tocost-push inflation;

Attract inflow of foreign capital, pushing up the exchangerates and reducing the export competitiveness. This maylead to an unfavourable current account.

Overall, MP should still be an indispensable tool of macroeconomicpolicy and is best complemented by other policies, such as fiscalpolicy and supply-side policies.

3.4 Monetary Policy in Singapore

The objective of Singapores monetary policy (MP) is to achievedomestic price stability as a basis for sustained economic growth.Singapore does not have an independent MP. Since 1981, its MP iscentred on the exchange rate. This is often referred to as our

exchange rate policy and hence we do not have an independentdomestic monetary policy. This is because Singapore has a smalleconomy which is open to trade and capital flows. This will bediscussed in detail in the next section, Exchange Rate Policy)

3.4.1 Openness to Trade Flows

In 2010, Singapores total trade (sum of export and import values ofgoods and services) with the rest of the world was about 3 times itsGDP. Domestic expenditures also have high import content. Exports


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have an estimated import content of 70%. The implication is thatdomestic prices in Singapore are largely determined by world pricesfor a given exchange rate. Hence, Singapore is a price taker on worldmarkets. Singapores interest rates tend to follow the world-widemovement in interest rates.

3.4.2 Openness to Capital Flows

Singapore has no control over capital inflows and outflows of foreigncurrency funds by residents and foreigners. It adopts a liberal policytowards foreign direct investments and allows for almost perfectcapital mobility. The implication is that MAS can either manage the

exchange rate or interest rate (money supply) but not both.

Exercising monetary independence will be neither effective nordesirable for Singapore. Imagine if the MAS were to target domesticinterest rates to be higher than world interest rates, then massiveinflows of hot money or short term capital will occur and this willexpand money supply in Singapore. Thus the contractionary MPpursued earlier would be ineffective.

Conversely, if the Singapore government pursues an expansionarymonetary policy by reducing interest rates. This will result in massive

outflows of hot money which will eventually lead to a fall in moneysupply. Hence expansionary monetary policy would be countered bythe fall in money supply due to the exodus of hot money, renderingthe policy ineffective.

These massive amounts of hot-money inflows to and outflows fromSingapore can create excessive short-term volatility in the exchangerate, which is disruptive for investors and businesses. Hence, anindependent MP is also not desirable.

Singapores conduct of monetary policy is centred on the exchange

rate, rather than controlling money supply or interest rates. Thechoice of the exchange rate as the main instrument of monetarypolicy must imply relinquishing control over domestic money supplyand interest rates.


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Annex A

Functions of Money

Money has 4 major functions. The first important function of money isto serve as a medium of exchange money can be used to buygoods and services. A seller will accept money for his goods becausehe knows the money he accepts can be used to buy other goods andservices. In the case of hyperinflation, money can no longer serve asa medium of exchange because prices of goods are so high that themoney used no longer has sufficient value (i.e. the internal value of acurrency) to serve as a medium of exchange.

A second function of money is that it serves as a standard of value,i.e. money is a standard by which we can measure the value ofdifferent goods. For example, a book and a pizza, two goods ofdifferent values, are measured using different amounts of money. Thedollar or currency is usually the common measurement of money insociety because there is a standard currency. It would be verydifficult to use cows as money because each cow is different andwould therefore indicate a different standard of value.

A third function of money is that it serves as a store of value.Therefore, people can use money to spend at a later time on goods

and services. Thus, money is a claim on future goods and services.

Lastly, money functions as a measure of debt, i.e. it records theamount of money to be paid in the future. This is only possiblebecause money can be a store of value.

Definitions of Money

Money supply is the quantity of money in the economy. However,there are different definitions of money supply because there arevarious forms of money that can serve the above 4 functions of

money.

M1 is the narrowest definition of money supply and consists of theforms of money which can readily serve as a medium of exchange.This refers to currency in circulation, as well as checkable deposits(deposits in a checking account that can be easily transferred quicklyfrom one party to another i.e. writing a cheque draws down on yourchecking account). The broader forms of money supply include M2,M3 and M4, in which these forms of money serve as a store of value.For example, M2 includes savings deposits on top of M1. M3 is themost commonly used measure of money supply in most economy. It


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includes M1, which serves primarily as a medium of exchange. Inother words, money supply in the economy can be easily andconveniently used to buy goods and services.

As such, by changing the money supply in the economy, it is possibleto affect the amount of goods and services people can buy usingavailable money. If people have less money, then they will buy orconsume less goods and services in the economy.

In addition, because money functions as a standard of value, thevalue of money in terms of how much goods and services it is worth(the internal value of currency) also determines how much goods andservices one can consume. If the value of money falls, the sameamount of money can no longer buy the same amount of goods and

services. In cases where money loses its value rapidly, it can thencease to become a medium of exchange.

Credit Creation and Destruction in the Economy

The quantity of money circulating in the economy can be changedthrough the processes of credit creation and destruction through thecommercial banking system.

A commercial bank is any bank that accepts checkable deposits.Commercial banks are privately-owned and profit-seeking

businesses. Credit creation occurs when banks make loans toindividuals and firms. The funds for these loans come from depositsin savings accounts made by individuals and firms in the commercialbank. If this process is repeated many times, the quantity of money inthe economy will be multiplied many times. Credit destruction occurs,when loans are paid back to the bank, decreasing the quantity ofmoney circulating in the economy.

Banks give individuals and firms incentives to deposit money assavings in banks by giving them a certain percentage of the amountdeposited the interest rate, in this case acting as a return on

savings. On the other hand, they charge individuals/firms for takingout loans in terms of a percentage of the amount loaned. In this case,the interest rate represents the cost to borrowing. Hence, to make aprofit, banks usually charge a higher interest rate for loans ascompared to the interest rate which accrues for savings accounts.The total profits earned are the interest rate differential multiplied bythe amount of money loaned out.


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As such, the bank would make the most profit if it could loan out allthe savings deposited. However, if that were the case, no individualor firm would deposit in the bank because they would not be able toretrieve their savings when they want to. As such, banks usually keepa portion of savings which are not loaned out, known as reserves.

As such, commercial banks have the ability to create credit orincrease the money supply and destroy credit, or reduce the moneysupply. However, this ability is regulated by the central bank throughregulations that central banks have over commercial banks. It isthrough this that the government can conduct monetary policy andadjust the quantity of money circulating in the economy.


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4 EXCHANGE RATE POLICY

Recommended Reading:

i) John Sloman, 6th Edition, Economics, Chapter 24.

The governments intervention in the foreign exchange market is tomanipulate the exchange rate in order to achieve its macroeconomicgoals.

Exchange rate policy impacts both the internal and externalequilibrium of the country. A change in the exchange rate can affectthe internal components of the economy such as an economysoutput, employment and income and general price levels. It may alsoaffect the external components of the economy - the balance ofpayments status.

Recall from Foreign Exchange: the 3 types of exchange rate systemsThere are three different types of exchange rate systems which agovernment can utilise/adopt:

Flexible or Freely Floating System where the exchange rate

is determined entirely by the market forces of demand andsupply in the foreign exchange market with no governmentintervention. Eg. Brazil adopted free floating exchange ratesystem from 1999 onwards.

Fixed Exchange Rate System where the government takesnecessary measures to maintain the exchange rate at anoptimal level. Eg. Chinas fixed exchange rate system

Managed Float Policy Exchange rates are allowed to floatwithin a stipulated band, with the government intervening from

time to time to prevent excessive exchange rate fluctuations.Eg. Singapores managed float exchange rate system since1981.

We are now going to focus on how exchange rate policy affects thebalance of payments (BOP) status.

How is a BOP disequilibrium rectified in the respective types ofexchange rate systems?


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Exchange rate systems chosen by a government have an impact onhow BOP disequilibrium is rectified.

4.1 Adopting a Flexible Exchange Rate System

4.1.1 How a Flexible Exchange Rate System solves BOPDisequilibrium

There is automatic adjustment to BOP disequilibrium because thesystem is self-regulating through the market forces of demand andsupply. Suppose a country is suffering from a BOP deficit, that is the

value of imports of goods and services and capital outflow is greaterthan the exports of goods and services and capital inflow.

This implies that the demand for the countrys currency will be lessthan the supply. This will cause the currency to depreciate in valueand this depreciation will make her exports relatively cheaper and herimports relatively more expensive. Value of imports is will fall andexport revenue will rise till BOP equilibrium is established.

What condition is necessary for a flexible exchange ratesystem to solve BOP disequilibrium?

Whether exchange rate adjustments can successfully correctbalance of payment disequilibrium depends on the price elasticity ofdemand for imports and exports and its price elasticity of supply ofexports and imports.

In the case where the demand for exports and imports are priceinelastic, a depreciation of the currency will lead to higher importexpenditure and lower export earnings. Thus, it may worsen thestatus of the balance of payments.

Why? If the PED for exports is less than one, a depreciation of the

currency will decrease the price of her exports. The increase inquantity demanded will be less than proportionate to the fall in price.Therefore the export earnings will fall.

If the PED for imports is less than one, a depreciation of the currencywill increase the price of imports in terms of domestic currency. Thefall in quantity demanded will be less than proportionate to theincrease in price. Therefore the import expenditure will rise.


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If the demand for imports and exports are price elastic, this will helpto correct the BOP deficit. This is the so-called automatic adjustmentof the flexible exchange rate system.The necessary condition for for a flexible exchange rate system to

solve BOP disequilibrium is stated below:

In general, the Marshall-Lerner Condition (PEDx + PEDm > 1) isrequired for a fall in exchange rate value to restore Balance of Tradeequilibrium.

What is the other benefit (advantage) of adopting flexible exchange rate

system?

The implication of adopting a flexible exchange rate system is that itis possible to pursue an independent domestic policy aimed atsecuring internal equilibrium.

The government can pursue internal policy objectives of reducinginflation, promoting economic growth and full employment whileleaving market forces to determine the exchange rate that wouldautomatically restore balance of payment equilibrium. For example,aBOP disequilibrium eg. BOP deficit can be corrected by depreciationwithout causing inflation.

So a country can make good use of domestic policies such asmonetary policy to achieve internal aims while any BOP disequilibriumcan be automatically corrected due to the flexible exchange rate system.

4.2 Adopting a Fixed Exchange Rate System

4.2.1 How a Fixed Exchange Rate System solves BOPDisequilibrium

BOP deficit (outflow > inflow) government needs to buy up excess

domestic currency in forex market in order to maintain the fixed

exchange rate contract MS in domestic country increase interest

rate in domestic country reduce C and I reduce AD reduce

general price level exports relatively cheaper, imports relatively

expensive assuming Marshall-Learner condition holds correct

BOT correct BOP assuming ceteris paribas


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Alternatively, the government may change the fixed exchange rate.See 4.2.2

4.2.2 Devaluation

Government may choose to devalue the currency, especially whenthe country is having persistent BOP deficit.

As the result of devaluation, imports will become relatively moreexpensive while exports become relatively cheaper. AssumingMarshall-Lerner condition holds, the balance of payment deficit canbe corrected.

(Note: In the event of a BOP surplus, the government can revalue thecurrency. As a result of revaluation, exports will become relativelymore expensive while imports become relatively cheaper.)

What problem (disadvantage) arises when a country adoptsfixed exchange rate system?

However, it is impossible to pursue an independent domestic policywith goals aimed at securing internal equilibrium policy conflict!

Monetary authorities have to pursue expansionary domestic policieswhen countries enjoy BOP surplus (due to BOT surplus and KFAsurplus as a result of net inflow of FDI) in order to maintain BOPequilibrium.

However, the economy is likely to be facing internal problems at thesame time it is experiencing BOP surplus.

This is because the increase in (X-M) and FDI lead to rise in AD,triggering demand-pull inflation, assuming economy is near or at Yf.

So there is a need to reduce inflation (internal problem). So thegovernment may wish to adopt a contractionary monetary policy.However, the necessity of maintaining external aims takesprecedence due to the country adopting a fixed exchange ratesystem (have obligation to maintain the peg/ fixed exchange rate).

So a policy conflict arises since expansionary not contractionarypolicy has to be adopted to maintain the external (BOP) equilibriumwhich will however worsen internal equilibrium!


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Why policy conflict?

BOP surplus (inflow > outflow) government needs to sell domestic

currency for foreign currencies in exchange in forex market in order

to maintain the fixed exchange rate increase MS in domestic

country decrease interest rate in domestic country increase C

and I increase AD increase general price level exports

relatively more expensive, imports relatively cheaper assuming

Marshall-Learner condition holds correct BOT correct BOP

assuming ceteris paribas.

However, the further rise in general price level worsen the situation of

inflation and hence this shows that pursuing fixed exchange rate

system makes a country lose control or freedom of using domestic

policies such as monetary policy to achieve internal aims or

objectives.

4.3 Adopting Managed Float Policy

The exchange rate is allowed to float freely within the band in themanaged float set by the government. Thus the external BOP willautomatically adjust to equilibrium as long as the rate is within the

band. If the rate falls/rises beyond the band, the governmentintervenes to bring the rate back within the band. This will minimisethe fluctuations and stabilise the economy.

4.4 Exchange Rate Policy in Singapore

Analyse whether there will be also be a policy conflict

when BOP deficit is experienced in a country with afixed exchange rate system.


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Compulsory Reading:

Economics Explorer #2 (www.mas.gov.sg)

Singapores monetary policy is centred on the exchange rate. WHY?

(A) Small size and opennessSingapore is a price taker. Changes in world prices directly impactdomestic prices. Exchange rate can influence overall demand andhence inflation.

(B) Openness to trade- Imports and exports amount to over 100% of GDP.

- High import content of final expenditure: 54 cents of every $1is spent on imports.

(C) Openness to capital flowsSmall differences between domestic and foreign interest rates canlead to large and quick movements of capital. This makes it difficultto control money supply. Domestic interest rates are largelydetermined by world interest rates. Thus, Singapore cannoteffectively control money supply and interest rates, unlike the U.S.The Monetary Authority of Singapore can however use exchange

rate to manage the economy more effectively.

4.4.1 Managed float system (Recall from Forex)

The MAS manages the S$ exchange rate against a trade-weightedbasket of currencies of Singapores major trading partners andcompetitors. The MAS maintains the trade weighted exchange ratewithin an undisclosed target band by intervening to prevent massivefluctuations of the exchange rate, consistent with the exchange ratepolicy and underlying economic fundamentals.

4.4.2 The transmission mechanism of monetary policy

The transmission mechanism refers to the channels through whichthe exchange rate policy of the MAS affects inflation and economicactivity in Singapore. Refer to Economics Explorer Series #2 fromMAS.

Keynesian Transmission mechanism


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See the diagram 1 below for Channel A: Impact of ER on importprices

Diagram 1

WeakerS$ ER

Each S$is worthless inUS$

Importedgds costmore whenconverted toS$

Domesticpr ofimportedgds rises

Pr of locally

produced gdsusingimportedinputs rises

Inflation

Trade-weightedS$ exchange Rate

DomesticDemand

Expectations/Confidence

TotalDemand

Interest Rate

Import Prices

INFLATION

A

ExternalDemand

B

Asset Prices

C

THE TRANSMISSION MECHANISM


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See the diagram 2 below for Channel B: Impact of ER on externaldemand

Diagram 2

Channel C: Impact of ER on Domestic Demand

(No diagram. See the explanation below)

Besides the main channels A and B, the exchange rate/monetarypolicy also impacts the economy through its influence on domesticdemand, e.g. via interest rate (Channel C).

Changes in the monetary policy also influences consumerconfidence, expectations about future course of the economy andasset prices, although their ultimate impact on domestic demand isdifficult to assess.

How does a change in exchange rate impact interest rate? The Central Bank can affect interest rate through its influence

on market expectations of future movement of the exchangerate. For example, if the market expects the S$ exchange rateto appreciate over time, this will result in huge inflow of foreigncurrency to purchase domestic currency. Increase in

domestic currency deposits by foreigners will increase moneysupply, hence driving down the interest rates.

How does interest rate affect the economy? Lower domestic interest rate Rise in C and I rise in AD

Evaluation of the extent to which interest rate change can affect theeconomy:

Weaker S$Exch Rate

More competitive Xin the SR

Higher X growth &over-heated

economy

Rise in wages &rentals

Surge inLabour costsInflation


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Interest inelastic investment: When business firms are

pessimistic about future economic activity, a decrease ininterest rates will do little, if anything to increase investment.Similarly if consumers are pessimistic about future economicactivity, little increase in C. So no or minimal increase in C andI will have negligible impact on AD.

Liquidity trap: Demand curve for money could becomehorizontal at some low interest rate. Any fall in interest rate willresult in no change in investment and, hence, aggregatedemand.

Next, we are going to examine the role exchange rate policy plays inreducing BOP deficit. We will also consider other policies that can beused to reduce BOP deficit.

Role of Exchange Rate Policy in Removing BOP Deficit

BOP DeficitExpenditure-Switching Policies Expenditure-reducing policiesExpenditure-switching policies aim toswitch expenditure from imports todomestically produced substitutes.

These policies aim to rectify thedeficit by reducing expenditure onimports.

Devaluation( Exchange rate policy)( Increase relative price of imports)

When a country devalues itscurrency, its exports becomerelatively cheaper in overseasmarkets and foreign imports becomerelatively more expensive whendenominated in domestic currency.This encourages people in the

country to switch from relatively moreexpensive imports to relativelycheaper import substitutes in thecountry. Export revenue would riseand import expenditure would fall.

DeflationThis is an expenditure-reducingpolicy which tries to cure thecurrent account deficit by reducingAD for goods and services so asto reduce the demand for imports.

Both monetary and fiscalmeasures can be used to deflatethe level of AD in the economy.When AD and NY falls, demandfor imports will also fall. Hence Mwill fall.


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Tariffs and import duties(Protectionist measures that increaseprice of imports that cause a switchfrom imports to similar domesticgoods and services)

Tariffs and imports duties aim todiscourage expenditure on importsand encourage expenditure ondomestic goods by increasing theprice of imports relative todomestically produced substitutes,leading to domestic consumersswitching to import substitutes. Thiscould however, provoke retaliation bythe countrys trading partners. (To beexamined further under InternationalTrade)

Direct Controls(Protectionist measuresthat reduce quantity ofimports)

Direct controls can be in the formof quotas and embargoes. Theformer aims to restrict the quantityof imports and the latter to preventexpenditure on imports so as toeliminate the deficit. Directcontrols can also be in the form ofexchange controls. Exchangecontrols are aimed at limiting theamount of foreign currency spenton imports. An added effect ofexchange control is that it can alsocheck the outflow of capital.

Is deflation a good measure to reduce the BOP deficit?

This may be an appropriate measure when the cause of theBOP deficit is recession abroad or when the local inflation rateis higher than foreign inflation rate.

However, deflation also causes reduction in real output which leads to rise inunemployment.

Question: Will deflation be effective to reduce current accountdeficit in Singapore?


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4.5 Possible policy conflictsi) Expansionary fiscal policy to create jobs and boost the economy

is this through increased government spending and/or reducedtax rates?

How is this government spending financed? Is it through increasing direct taxes such that there might

be disincentive to work and the implication on incomecreation and spending which may counter the effects of anexpansionary policy?

What about the external equilibrium i.e. the balance ofpayments of the country? What about the competitiveness

of its currency?

ii) Contractionary fiscal policy to reduce inflationary pressure maysee the government increasing tax and reducing governmentspending

But would this push cost of production up and therebyincreasing prices further?

Does this run contrary to the monetary policy of thecountry?

Does this conflict with the external equilibrium of thecountry?

iii) Contractionary monetary policy (to reduce the inflationarypressure in the economy) may require a fall in money supply soas to raise interest rates. However, this causes crowding outeffects as well.

Does this complement the fiscal policy and the externalequilibrium?

Does the increase in interest rates make exports moreexpensive?

iv) Expansionary monetary policy where MS is increased, interestrate falls in order to encourage more investments

How would this affect the external equilibrium and theexchange rate policy?

Is this in conflict with the fiscal policy of the country?


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5 PRICES AND INCOMES POLICIES

Recommended Reading:(i) Economics, Hoon Hian Teck et al, pp 293-295

A Prices and Incomes Policy is defined as an attempt by thegovernment to influence directly the setting of wages and prices.These policies attempt to act directly on prices and/or wages. Thegoals of these policies are to achieve low unemployment and stableprices.

5.1 Incomes Policy to minimise cost-push inflation

Incomes policy is an attempt by policy makers to moderate increasesin wages and prices either by persuasion or by legal rules.

If labour leaders can be persuaded or made by the force of law toreduce or moderate wage demands, and employers to cap ormoderate increases prices of their products, then this will help tolower inflationary expectations.

Singapore has an incomes policy which is one of the reasons why itgenerally has a low rate of inflation. One of these is a wage policy inthe form of guidelines put forward by the National Wages Council

(NWC). The NWC is a tripartite body consisting of representativesfrom labour unions, employers and the government. It enables thegovernment to play a mediating role between employers andemployees to monitor and guide the course of wages and prices inSingapore.

The NWC guidelines help to keep wage growth in tandem with labourproductivity growth. The incomes policy in Singapore goes one stepfurther to even implement wage cuts as in the case of the 1985-86recession. Then, the workers accepted a 15 percentage point cut(from 25% to 10%) in employers CPF contribution rate. When the

economy recovered, the unionised employees faith in the tripartitearrangement is maintained when employers contribution toemployees CPF is restored. Currently, for the bulk of the workforce,the employees contribution is 20% and employers is 14.5%.

Besides adjustments to CPF, NWC recently encouraged employersto introduce (besides bonus), a monthly variable component (MVC)above their employees fixed wage component. This component actsa variable cost to employers and can be cut in difficult businesstimes.


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6 SUPPLY-SIDE POLICIES

Recommended Readings:

(i) Economics, John Sloman, 6th

Edition, pp 413(ii) Economics, Roger Arnold, 6th Edition, pp 266-270

Supply-side policies are government policies designed to affectaggregate supply (AS) directly, specifically policies to reduce costs orraise productivity. They are also to minimise friction in markets and toimprove information flow. It seeks to achieve economic gains bylong-term measures designed to raise the rate of economic growthby shifting the long-run aggregate supply curve to the right ratherthan manipulating aggregate demand.

Important Note

However, supply-side policies often have demand-side effects just asdemand-side policies have supply-side effects. You should reflectthis in AD-AS diagrams and analysis.

For example, in 2002, the Singapore government set up theWorkforce Development Agency (WDA) to collaborate with variousindustries to re-train and re-skill workers displaced by structuralunemployment. The government expenditure on re-training (G) ourskilled workforce is an additional incentive for foreign investors tolocate their business in Singapore (I). Increase in both G & I led to anincrease AD. But the re-skilling also enhances the employability ofour workforce in new jobs and industries and can increase potentialoutput (AS) in the long run. Hence it is important for a government totake into account all effects when deciding on their economicstrategies.

The aims of these supply-side policies are to encourage and rewardindividual enterprise and initiative, and to reduce the role ofgovernment; to put more reliance on market forces & competition,and less on government intervention & regulation.


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6.1 Types of Supply-side measures

6.1.1 Reducing Government Expenditure - Release More Resources

to the Private Sector

A more efficient use of resources within the public sector and areduction in the size of the sector can allow private investment toincrease with no overall rise in aggregate demand. Thus the supply-side benefits of higher investment could be achieved without thedemand-side costs of higher inflation. In the UK, cash limits wereimposed on various government departments and local authorities toforce them to become more efficient.

Grants and subsidies were reduced. When subsidies were reduced,many nationalised industries would increase their prices since theirobjective is to maximise profits. However, these policies were notwithout problems. In some sectors, the effect was to cut servicesrather than increase efficiency. Since it was found much easier to cutlon

fiscal policy lecture notes with supplementary notes

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