macro nov 2012

Macro Question 1

The Monetary Authority of Singapore will continue with the policy of a modest and gradual appreciation of the S$ foreign exchange rate to ensure medium-term price stability.

(MAS Policy Statement, 14 October 2010)

(a) Explain how exchange rates are determined in Singapore. [10] (b) How far do you agree with the proposition that an appreciating Singapore dollar

will lead to price stability? [15]

(a) Introduction:

‐ Define exchange rate – exchange rate is the value of one’s currency in terms of another currency.

‐ Context of Singapore: Singapore dollar is managed against a trade-weighted basket of currencies of our major trading partners and competitors. The trade weighted Singapore dollar is allowed to float within an undisclosed band. The band allows short term, temporary movements in response to crisis; as buffer to external shocks.

Body: Explain Singapore’s managed float regime in exchange rate determination

‐ Explain how free forces of demand and supply of S$ affect the S$ exchange rate. o Explain factors affecting demand and supply of S$ Any 2 ideas (1 each for

current account and capital account – show changes both in the demand and supply of S$)

Current account – relative inflation rates, changes in income levels of trading partners Eg. Increase in the demand of Singapore’s goods and services by foreigners increase the DD for S$ Appreciation of the S$.

Capital account – inflow-outflow of FDI/Hot money flows E.g. Fall in interest rates in other countries Relative interest rates rise in Singapore Fall in hot money outflow Fall in DD for foreign currency Fall in the SS of S$ in the foreign exchange market Appreciation of S$

‐ Explain how MAS manages exchange rate within target band

o When S$ appreciates beyond the target band set by MAS, the central bank will increase the supply of S$ in the foreign exchange market by increasing the demand for foreign currency, and selling S$. Increase in SS of S$ will decrease in external value of S$ in the foreign exchange market.

o When the $$ depreciates below the target band set by MAS, the central bank will increase the DD for S$ in the foreign exchange market by selling foreign currency (foreign reserves). Increase in DD will lead to an appreciation of the S$ within the band.

‐ Illustrate the effects diagrammatically. ‐ Explain the market mechanism how a change in DD/SS will affect the external

value of S$.

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© RI 2011 [Turn Over

Conclusion:

‐ The interaction of demand and supply for Singapore currency in the foreign exchange market determines the external value of S$.

- The change (appreciation / depreciation) of S$ can be due to a change in DD or SS or a combination of DD and SS changes.

(b) Introduction:

- Explain what is meant by price stability low and stable inflation rate - Appreciating Singapore dollars rise in the external value of the S$ against her

trading partners and competitors.

Body: Thesis: An appreciating Singapore dollar can lead to price stability

- Explain how an appreciating S$ will dampen demand-pull inflation Illustrate a case

of demand-pull inflation diagrammatically (AD0 to AD1 P0 to P1).

Appreciation of S$ rise in Px in terms of foreign currency fall in quantity demanded for exports

Appreciation of S$ fall in Pm in terms of domestic currency rise in quantity demand for imports

Assuming the Marshall-Lerner condition holds, where PEDx + PEDm > 1 Net exports falls AD falls (AD1 to AD2) dampening demand-pull inflation (P1 to P2).

‐ Explain how an appreciating S$ will dampen cost-push inflation Illustrate a case of

cost-push inflation (AS0 to AS1 P0 to P1). Appreciation of S$ makes imports cheaper in S$ this will dampen the price of

imported factors of production fall in cost of producing of goods increase AS (AS1 to AS2) dampen cost-push inflation in Singapore (P1 to P2).

This is especially important for Singapore, as she relies heavily on the imports

- Illustrate the effects diagrammatically.

Anti-thesis: An appreciating Singapore dollar may not lead to price stability

- Explain limitations of appreciating the S$ to manage inflation

GPL

Real NY

AS0

AD0

Y0 Y2 Y1

P2

P1

P0

0 AD2

AD1

GPL

Real NY

AS1

AS2

AS0

AD0

Y0 Y2 Y1

P2

P1

P0

0

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Marshall-Lerner condition may not hold in the very short-run appreciation of the S$ will lead to an increase in NX worsen demand-pull inflation.

Does not tackle the root cause of inflation Domestic inflation: caused by structural rigidities, rise in wages/rent,

housing, COE, etc. Appreciation may not be effective in reducing inflationary pressure.

Modest and gradual appreciation will limited the extent to which price stability can be achieved.

Appreciation of S$ will reduce short run export price-competitiveness. In the short run, there is a trade-off between policy objectives – price stability & economic growth, employment level in the export-oriented industries.

Extent to which strong S$ can manage inflation is limited as the extent to which the S$ can appreciate is limited due to the tradeoff.

Limits the extent to which a stronger S$ will mitigate external factors causing inflation.

Overall Evaluation & Conclusion:

- Judgement: A strong S$ will lead to price-stability to the extent that it can dampen demand-pull inflation and imported inflation.

- Seems to be effective given Singapore’s low and stable inflation rate. (in recent years, inflation is high due to domestic factors)

- The extent to which it will lead to price stability depends on: The root cause of inflation: will be effective if due to imported inflation and

rising DDx. M-L condition Short run vs long run effects

- Other evaluative comments: LR: need other policies e.g. SS-side policies to achieve price stability over

the long term. Costs of appreciating S$ may be high in the SR limiting the extent to

which S$ can appreciate.

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Question 2

To help Singapore achieve sustainable economic growth, the government has been reducing income taxes and corporate taxes over the years. It also increased its reliance on indirect taxes - raising the rate of Goods and Services Tax (GST) from 5% to 7% in 2007.

Discuss whether the changing tax structure will improve current and future living standards in Singapore. [25]

Candidates are expected to examine how the change in tax structure may affect actual growth and potential growth, equity given the regressive nature of GST and as the income tax system gets less

progressive non-material indicators such as pollution and stress level tax revenue and tax base, and how that may impact on government ability to spend in areas

to improve livings standards, and and how these points above may have an effect on current and future living standards

Suggested Outline:

Introduction: - Living standard refers to the material and non-material welfare of each citizen in the country. - Increase in current material SOL arises largely from a rise in actual growth and possible

increases in future SOL arises from the increase in AS due to raised productive capacity. - Rationale for increased reliance on indirect taxes: It is a trend amongst DCs to rely more on indirect taxes especially with a rapidly ageing

population that reduces the revenue from income taxes. For Singapore, income taxes are less progressive (being capped at 20% at the highest tier

and at 15% for foreign workers) than most other developed countries as the government wants to prevent brain drain and attract foreign talent. Corporate taxes were reduced to 17% with the objective of attracting FDI and encouraging entrepreneurship. The loss in tax revenue thus has to be compensated by an increase in GST.

Thus, the under-lying objectives are more to affect AS than AD, though the effect on AD cannot be ignored.

Body: Explain impact of changing tax structure on standard of living

Thesis: SOL may rise

Anti-thesis: SOL may not rise/or may not rise that significantly

A. Effect on Actual Economic Growth

1. Effect of fall in direct taxes:

households’ disposable income rises firms’ post-tax profits rise,

entrepreneurship is encouraged and increased influx of FDI

as a result, AE rises - through multiplier process – real GDP increases

link to impact on material SOL – increases ability to consume more goods

1. Effect of fall in direct taxes:

rising AD can cause over-heating, thus causing real GDP to rise by less

more importantly, it may worsen inequity since the % rise nominal wages of the lower income group may be rise less than that of inflation rate , causing their real wages to fall

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and services

Note that there must be at least an explicit recognition that real GDP per head, instead of GDP, is the measure of material SOL

Example:

Thus real GDP per head may rise, assuming popn size relatively stable

In line with government’s long-term plan to increase the population size, a more conducive income tax can attract more foreigners to set up home in Singapore, thus population size may also rise in the LR – link to effect on real GDP per head

effect depends on size of k

C as small % of GDP due to small domestic market

unpredictable effects of taxes

2. Effect of rise in GST

With rise in GST which falls on firms: AS decreases (upward shift in horizontal

segment of AS curve) Ceteris paribus, this may lead to cost-push

inflation and a fall in real GDP

Synthesis

evaluate the relative impact on SOL due to rise in GST vs fall in direct taxes effect of rise in AE possibly greater than fall in AS – since the last GST increase was in

2007 while income taxes and corporate taxes have been reduced more significantly – with income taxes capped at 20% and corporate taxes reduced to 17%.

Over LT, increased population size due to more immigrants may increase C as % of GDP, and could reduce Singapore’s dependence on X?

B. Effect on Future Living Standards

Future SOL may rise due to potential growth and possible future realized growth

effect of reduced income taxes: may increase incentive to work increase in quality and quantity of

labour as Singapore retains and attracts foreign talent

increased I (on plants and machines) due to lowered corporate taxes

the above effects serve to raise productive capacity and thus AS, with a positive impact on future SOL full employment frontier shifted

outwards, thus allowing for further increases in AD

reduces inflationary pressures brought about by increases in AD

Whether SOL rises depends on the extent to which the corporate tax cut can attract FDI - theoretically, one can look at MEI which

itself is affected by business prospects - applied to the Singapore context, we face

competition from the region in terms of attracting FDI

also issue of whether investment can be labour-displacing

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Synthesis:

That the effect on AS may be more pronounced than the effects on AD, given Singapore’s small k and small domestic market

C. Effect on Equity

The change in tax structure may worsen inequity

regressive nature of GST worsens inequity as it takes a larger % of the poor’s income

furthermore, GST is broad-based and necessities are not exempted since demand is price inelastic, again

more adverse impact on the lower-income group as their purchasing power is reduced

compounded by the fact that Singapore’s income tax is relatively less progressive, and cuts in tax rates are more likely to benefit those at the higher income brackets

Evaluation: that inequity can be reduced as government has in place transfer payments to help the needy such as Workfare Supplement Bonus, GST and utilities rebates etc.

D. Effect on Tax Base and Tax Revenue

GST widens tax base and may be more conducive for government efforts in sustaining living standards ageing population reduces size of

labour force and may reduce direct income tax revenue

a switch to reliance on indirect tax allows government to sustain its tax revenue to finance spending in areas to increase living standards

While there may be may be a temporary fall in direct tax revenue due to the tax cuts, this could be more than offset by the rise in revenue as real national income rises

E. Effect on Non-Material Welfare

1. Stress level

income effect: preference for leisure since disposable income has increased

substitution effect: reduced income taxes may increase incentive to work. Longer working hours may reduce quality of life

increased stressed level due to competition for jobs with influx of foreign labour

strain on infrastructure eg. public transport and amenities with more foreign labour

Synthesis:

Recent studies have shown that Singaporeans have over-taken the Japanese and Koreans in terms of the number of working hours. This could be due to factors like competition for jobs which in itself may be a result of the change in tax structure.

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The impact on environment may not be adverse

type of investment Singapore attracts are more the technology-intensive types and service-oriented eg. biotechnology, biomedical, pharmaceutical and integrated resorts

if there is an increase in manufacturing investment which is still vital to any economy including Singapore’s, there may be more negative externalities generated due to pollution

or how increased growth and spending power leads to increased car usage and more pollution

Conclusion & Overall Evaluation:

- Recognize that sustainable growth and resultant impact on SOL may not be brought about by a changing tax structure alone

- Whether SOL rises for everyone still depends on government efforts to trickle ‘fruits of masses’ down to the masses eg. through subsidies in education and healthcare

- Looking forward: how impact can be affected if GST rises further and some brief suggestion on how system can be tweaked – eg. exempting necessities from GST

Question 3 Many advanced countries like USA and UK have been adversely affected by the recent financial crisis and increasing competition from emerging economies such as China and India. (a) Explain the causes of unemployment in these advanced countries in recent years. [8] (b) Discuss whether a change in interest rates is the best policy to reduce unemployment in these countries. [17]

(a) Introduction: - Define unemployment and identify types of unemployment.

Body: ‐ Explain how the recent financial crisis in US and UK caused a recession by causing

an autonomous fall in Aggregate Demand and rise in unemployment: Banking crisis:

credit crunch banks unwilling to lend money high risk of default => difficult for firms to get bank loans I falls

negative wealth effect – fall in value of assets (financial and physical) => feel poorer fall in C

Aggravated by bleak economic outlook C falls, I falls. ‐ Use of AD-AS framework to explain how this leads to cyclical unemployment. If

diagrams are used, they must be integrated into the explanation. ‐ C, I and X – components of AD => AD falls – fall in national income / output fall in

demand for labour (derived demand) demand-deficient /cyclical employment in these economies.

‐ Explain how increasing competition from caused unemployment.

Increasing competition from emerging economies – loss of comparative advantage:

Greater competition in the global market – exports of emerging economies – more competitive given lower cost of production due to cheaper inputs

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(relatively more abundant supply) fall in labour-intensive X, increase in M => C of domestically produced goods and services falls AD falls…

Collapse of labour-intensive import-substituting industries in the US and UK as consumers switched to cheaper imports from China and India.

Emerging economies – China & India – huge domestic market => proximity to such markets is an important consideration and response to changing market conditions => Possible exodus of foreign direct investment from advanced economies as firms relocate to take advantage of the cheaper resources too I falls.

Influx of foreign workers (cheaper source of labour) in advanced economies – increase in unemployment in advanced economies.

Outsourcing of jobs to China and India – give examples of jobs that are outsourced e.g IT-related jobs to India…

Advanced economies in the face of such competition – need to restructure – shift in production – mismatch of skills => structural unemployment.

(b) Introduction:

‐ Identify expansionary monetary policy: to reduce unemployment in these countries expand money supply reduce interest rates

‐ Define scope of analysis: Reduce cyclical unemployment and structural unemployment.

Body: Thesis: Interest rate policy is the best policy to solve unemployment ‐ Explain how the policy works to solve unemployment

o Explain the transmission mechanism of fall in interest rate o Explain how a fall in interest rate can help to boost employment through job

creation Interest rate = price of loans. Fall in interest rate => cheaper loans increase in investment, ceteris

paribus – explain with reference to MEI function. Increase in volume of investment job creation income generation increase in demand for goods and services i.e multiplier effect)

Fall in interest rate => lower returns on savings / lower opportunity cost of consumption increase in household expenditure, ceteris paribus increase in demand for goods and services job creation boosting employment.

Fall in interest rate => lower reward for saving => save less, consume more => C increases.

o Is it the best policy to reduce unemployment? If firms and households respond to the fall in the interest rate because of

good business outlook. Extent of job creation depends on the size of the multiplier.

Possible evaluation: what is the possible size of multiplier in USA & UK and therefore its impact on job creation.

External effect: outflow of “hot” money depreciation of country’s currency which results in exports being cheaper in terms of foreign currency, ceteris paribus. This can counter, to some extent, the initial loss of X competitiveness to the emerging economies.

Possible evaluation: is this a long term solution to the unemployment problem? How dependent are these advanced economies on imported inputs from the emerging economies?

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Anti-thesis: Interest rate policy is the not the best policy to solve unemployment ‐ Explain limitations of the policy:

o For policy to be effective, firms and households to increase investment and consumption. However,

MEI inelastic – less than proportionate increase in I when interest rate falls. Therefore, is less effective. I – more dependent on “animal spirit”.

Is there already a liquidity trap? If yes, then fall in interest rate is ineffective and thus not the best policy.

FDIs – not affected by changes in interest rate – alternative sources of funds

More importantly, demand-management tool and does not solve structural unemployment.

Effect on I and C is uncertain. Much depends on the economic outlook e.g if pessimistic – lower interest rate may not induce firms to increase

‐ Identify and explain alternative policies that are better than interest rate policy to solve unemployment

o To counter the element of uncertainty in impact, government may want to resort

to expansionary fiscal policy. E.g Fiscal stimulus – increasing G on public works projects boost

demand increase in production and income fall in cyclical unemployment. Better than interest rate policy? Analysis of merits and demerits.

Merit: G increases – amount injected into the circular flow can be controlled by the government i.e first round of increase = the amount that by which G is increased…k works its way through to bring about an increase in income that is a multiple of this increase in G.

Demerit: crowding out. It’s another demand-management tool that can help to solve only cyclical unemployment. Therefore government needs to implement supply-side policies too to solve structural unemployment.

Recognise that reduction in personal and corporate income taxes which is aimed at increasing C and I, like a fall in interest rate, does not yield a predictable outcome.

o Supply-side policies (beware; not all are appropriate and thus students must be discriminating in choice of supply-side policies) – to solve structural unemployment – Analysis of merits and demerits of supply-side policy to solve structural unemployment brought about by competition from China and India.

Education and training – new skills, higher productivity lower unit cost -- enable them to compete with the cheaper labour from China and India to some extent.

Need to re-structure from industry from which US and UK had lost comparative advantage to new sunrise industry.

Note: If R&D is used as a point in your answer, it must be linked to the search for a new niche area, to regain comparative advantage (in context of preamble), to compete with China and India. At the same time, candidates must recognise that 1) R&D, when in progress, does not generate many jobs given its very specialized nature. 2) R&D requires a longer time to yield results than demand-

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management policies but it is necessary if USA and UK want to solve structural unemployment.

Conclusion & Overall Evaluation: ‐ While a fall in interest rate can reduce only demand-deficient unemployment it is still

a necessary but insufficient policy that is needed to solve the current unemployment problems in the US and UK. If the root cause of structural unemployment is to be dealt with, then interest rate is not the best policy and it has to be supplemented by other policies esp supply-side policy .

‐ Qn to ask: Is there really a “best” policy? … Question 4

The relative importance of the components of circular flow of income for a small, resource scarce and open economy, such as Singapore, is likely to be different from a large and developing economy, such as China, with vast reserves of cheap labour and a government committed to opening up its economy to rapid economic growth.

a. Explain this statement. [10]

b. Discuss the likely economic impact on both developed and other developing economies of the integration of an economy like China into the world economy. [15]

Suggested Content Ideas

Part (a)

Introduction

Explain what is meant by the circular flow of income, with explicit reference to injections (I, G and X) and withdrawals (S,T and M) within the 4 sector circular flow. Diagram to be used to illustrate.

Identify and explain the various components within the 4 sector circular flow of income.

Body

Explain the differences in the size of various components of the circular flow of income for a small, open economy like Singapore and a large country like China.

For consumption C, it is obvious that C would likely take up a significantly smaller proportion of GDP for Singapore as compared to China: o it has a significantly smaller domestic market compared to China. o at a higher level of development and hence lower marginal propensity to consume. o higher propensity to save due to various savings scheme and virtue of thrift Any changes in C would be relatively more significant in changing the GDP for China as compared to Singapore, thus accounting for its relative importance to China.

For export revenue (X) and import expenditure (M), it is likely that X and M individually take up a very large and significant proportion of GDP (more than 100% of GDP) as compared to China: o it has a small domestic market hence higher reliance on the external market to generate

income and growth through export of its goods and services (export oriented). Large external market also allows firms to produce on a large scale so as to enjoy IEOS.

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o it is resource scarce hence need to import practically everything from raw materials / intermediate goods for her industries to basic necessities / consumer durables for her consumers.

Any changes in X and M would be relatively more significant in changing the GDP for Singapore. In comparison China, that proportion might be of lesser importance (although not insignificant). This importance to Singapore was also seen in the 2009 economic crisis where Singapore went into a recession as a result of her major trading partners’ fall in demand for her exports.

For government expenditure G, one can expect the size of G to be a relatively larger component of GDP for China as compared to that of Singapore: o the government “committed to opening up its economy to rapid growth”. This implies that the

Chinese government would most probably be increasing its expenditure on improving physical as well as telecommunications infrastructure etc

o still a welfare state to a large extent, hence needs to take care of the needs of its large population

o largely no handouts by Singapore government, believes in meritocracy and most key industries have been deregulated over time (utilities, power and gas, public transport, telecommunications)

Conclusion

Due to the different unique characteristics of China and Singapore, the relative importance of each component that makes up the circular flow of income is vastly different. In addition, active government intervention through its policies has also brought about differences in these components.

Part (b)

Introduction

Identify that the increasing integration of China with its vast resources, into the world economy is a result of globalization.

Define globalization - increasing integration of global economies, facilitating higher volumes of cross border transactions in terms of goods and services, capital flows as well as exchange of knowledge, skills and ideas.

Recognise that the rise of China and its integration into the world economy will bring about both positive and negative effects to developed as well as other developing countries across the world.

Body Impact of China’s integration on developed countries eg, US, UK, Singapore

China with its vast supplies of relatively low-skilled labour, results in China having a comparative advantage in labour-intensive and low-tech intensive production (eg. manufacturing). Hence the integration of China leads to an erosion of CA among developed countries such as USA, EU and even Singapore in labour-intensive and low-tech production.

This results in developed countries experiencing a fall in X revenue of their manufactured goods, leading to a fall in their AD ceteris paribus. Firms in these industries will shut down as profitability declines and they are unable to compete with low-cost production from China, giving rise to structural unemployment.

In addition to a fall in export revenue (X), developed countries may see a rise in import expenditure (M) of relatively Chinese manufactured products as their own consumers switch to the cheaper import substitutes. The rise in M leads to a fall in AD. (However, this may work out to be advantageous for consumers in developed countries as they get to consume cheaper goods, enjoy greater variety raising consumer satisfaction and welfare).

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The structural unemployment is magnified when labour-intensive industries in the developed countries outsource or offshore their production processes to China in order to take advantage of the relatively lower costs of production. With such outsourcing/offshoring, there will be a likely fall in investments within the developed countries, also leading to a fall in AD.

The outflow of investment worsens the capital/financial account, while the loss of X and a rise in M from China will lead to a worsening of the BOT and hence current account. Together, this results in a worsening of the BOP position of the developed countries and hence a possible depreciation of their exchange rates.

Although there is a fall in X from labour-intensive, goods from developed countries due to increased competition from China, there may also be a higher level of X from capital intensive, knowledge intensive goods (e.g. capital equipment, machinery and consultancy services) exported by developed countries to China to aid in China’s economic growth. Hence the overall impact on X of developed countries will depend on the relative magnitudes of the changes in X

o If the loss in X > gains in X, there will an overall fall in AD among the developed countries, leading to lower production levels, higher unemployment levels and adverse effects on the actual growth for developed countries.

The loss of jobs in the labour-intensive sectors coupled with the growth of the exporting capital-

intensive sectors may result in greater levels of income disparities within the developed countries. While the integration of China into the world economy brings about many threats to the developed

world, countries also benefit from the influx of cheaper Chinese goods, as these help to reduce inflationary pressures at home. Besides, with more competition from the Chinese manufacturers, domestic producers in developed countries will be forced to engage in more efficient methods of production thereby cutting costs and raising the quality of their products through R&D etc. This further reduces inflationary pressures at home and also increases consumer welfare.

Countries like Singapore would be likely to benefit from an increase in FDIs from other developed countries such as US or EU, despite the increasing competition from China. This is because Singapore possesses the necessary infrastructure that facilitates the setting up of their bases/headquarters, allowing these foreign investors to monitor their production processes in China.

By taking advantage of lower COP in China, this may help to generate cost savings for foreign firms in China and hence boost their X competitiveness in the long run. The repatriation of profits from will also allow developed countries to experience an improvement in their current account. This would have the effect of improving their BOP as well as appreciating the exchange rates for developed countries.

The inflow of skilled talent from China into the developed countries as a result of globalization will also benefit the developed countries as there would be greater transfer of skills, knowledge and the enhanced synergy would help raise productivity levels within the developed countries, hence contributing to potential growth of the developed countries.

Impact of China’s integration on other developing countries eg. India, Vietnam

Other developing countries that possess the same factor endowments as China (eg. vast supplies of relatively low-skilled labour) will face greater competition in terms of X of labour-intensive products and may therefore be adversely affected by the integration of China into the world economy. The fall in X will then result in a fall in AD in these countries.

Due to China’s pursuit of economic growth, she may have courted FDIs with more incentives, leading to an FDI diversion away from these developing countries into China instead. The loss of FDIs will thus also lead to a fall in AD in these developing countries affecting actual and potential growth as well as employment.

China’s rapid economic growth and industrialization would also have resulted in a heightened demand for global commodities such as oil, leading to the bidding up of prices of such global commodities and hence imported inflation for countries that require these imported raw materials.

However, while the integration of China into the world economy may create largely negative effects on developing countries, competition from China also forces labour-intensive industries in

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these countries to be more productively efficient and this would, in the long run, be beneficial to the developing countries.

Conclusion: The integration of China into the world economy creates both positive and negative effects on

other economies. Therefore, it is important for governments across the world to leverage on the growth of China while at the same time, implement policies to mitigate the negative effects.

Q5. RJC 2009 Prelims

“Singapore's network of Free Trade Agreements (FTAs) has expanded to cover 13 regional and bilateral FTAs with 23 trading partners, including countries such as the US, China, India and Japan. FTAs have been instrumental in helping Singapore-based businesses strengthen cross-border trade by eliminating or reducing import tariff rates and easing investment rules.” Source: http://www.fta.gov.sg

Discuss the extent to which Singapore’s network of FTAs will help to achieve her macroeconomic objectives. [25]

Suggested answer scheme

Introduction

- Definitions Singapore’s key macroeconomic indicators

Sustained economic growth Low & stable inflation Low unemployment rates or full employment Balanced BOP in LR & stable exchange rates

FTA An agreement between countries to facilitate cross-national boundary movement of Goods & services Capital Labour

Body

- movement of goods & services achieved through the reduction or elimination of tariff and non-tariff barriers due to

reduction/elimination of tariffs, Singapore’s exports are cheaper in member countries. This will lead to an increase in Qx, and hence X increases actual growth

↑X →↑AD→ more than proportionate ↑NY due to multiplier process reduces unemployment in export sector, moves economy closer to Yf improves current account due to increases in X revenue S$ appreciates and/or accumulation of foreign reserves Due to FTA, COP falls due to greater availability of cheaper imported raw materials,

leading to increase in SRAS hence moderating cost-push inflation. However,

Dd-pull inflation may occur if economy is operating at intermediate or classical range with greater reliance on X for NY growth, economy may experience volatile NY growth

which is tied to economic performance of other countries due to reduction/elimination of tariffs, Pm falls and Qm increases hence M expenditure

increases if PEDm > 1 This increase in M may increase unemployment in import substitution sectors, hence

cause demand deficient and structural unemployment

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If M exp increases more than X rev, current account worsens. Effects on economy is dependent on changes in (X-M), which is influenced by terms of

trade, price elasticity of demand for X and M, competitiveness of Singapore’s export industry, competitiveness of Singapore’s import substitution industry, absence of protectionist tariffs even before signing of FTA

- movement of capital achieved through lowering non tariff barriers such as ownership restrictions and

eliminating restrictions on movement of funds increase in FDI into Singapore increases economic growth as ↑I → ↑AD & ↑AS →

sustained economic growth importation of technology → ↑AS

However, while unemployment is reduced, it may cause demand-pull inflation in SR. Also, it may cause wage-push inflation due to increase in demand for labour

improves capital account → appreciation of S$ and/or accumulation of reserves may create ‘Dutch disease’ due to appreciation of S$

in longer term, worsening of current account due to repatriation of profits reliance of FDI for economic growth may lead to physical crowding-out, possible

financial crowding-out if funds are raised in Singapore

- Growth of industries which Singapore has CA (i.e. growth of knowledge and technology industries)

enhances Singapore’s economic growth However, the highly specialised structure makes Singapore more susceptible to industry-specific shocks.

- increase in FDI out of Singapore (into foreign countries) may increase structural unemployment outsourcing of labour intensive industries causes structural unemployment worsens capital account in the short run in longer term, BOT, current account may improve due to repatriation of profits

- improves competitiveness and profitability of Singapore firms by tapping on cheaper land and labour factors of production, GNP may increase despite fall in GDP Effects on economy depends on Net FDI into the country which is influenced by

o ease of setting up operations and doing business in Singapore o corporate taxation framework / incentives framework o quality of infrastructure and availability of supporting industries

Type of FDI into Singapore and Type of FDI out of Singapore o ‘upgrading’ of Singapore’s economic structure if investments are in knowledge

and technology intensive industries o re-allocates human capital for more productive uses (in LR) if labour intensive

processes are outsourced

- Policies to support FDI policy o training of skilled labour for knowledge and technology industries o retraining of workers in labour intensive industries for deployment in service industries

- Movement of labour movement of labour into Singapore to augment Singapore’s labour pool

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influx of lower skilled workers reduces wage-push inflation, maintains COP and competitiveness. However, depressing wages of lower skilled local workers → worsening inequity

influx of highly-skilled workers increases productivity allows the development of knowledge and technology intensive industries movement of labour out of Singapore reduces Singapore labour pool. if these are

highly skilled workers Loss of human capital → ↓ AS → compromises economic growth Effects on economy depends on

- ability to control the inflow of lower-skilled workers - Work permits & Employment pass system - ability to attract foreign and local talent - Personal income tax structure - Quality of living in Singapore

Conclusion

- The network of FTA presents opportunities and threats to the Singapore economy - The extent to which Singapore benefits from the FTA network (in terms of achieving the

macroeconomic objectives) depends on competitiveness of the local economy its ability to attract the right type and sufficient amount of FDI its ability to retain local talent and attract foreign talent ability to mitigate negative effects such as structural unemployment and rising inequity

Question 6

Our prospects have never been better. The key reason is globalisation. Capital, enterprise and talent are flowing to countries where the government can be trusted, where the workforce is well-educated and skilled, and where the quality of life is high. (Budget Speech, 2007)

To what extent has globalisation brought more benefits than costs to Singapore in recent years? [25] Students are expected to interpret what is meant by globalisation and to discuss the effects of globalisation on the Singapore economy. They are also expected to make a judgement as to whether the positive effects outweighed the negative effects in recent years.

Introduction: Define Globalisation

o Globalisation is the growing economic interdependence of countries worldwide through increasing volume and variety of cross-border transactions due to freer trade in goods and services, freer flows of international capital and greater mobility in the movement of labour.

o Brought about by technological advancements, FTAs etc.

Effects on Singapore economy: o Microeconomic Effects: Efficiency and Income Inequality

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o Macroeconomic Effects: Economic growth, Unemployment Rate, Inflation Rate and Balance of Payments/ER

Body:

Approach: Discuss by issue – T-A-S

Issue 1: Freer flow of trade in goods and services

Economic Framework: Removal of trade barriers diagram/AS/AS framework

Benefits Costs

1. Removal of trade barriers on Singapore’s exports in the global market will enlarge Singapore’s export markets as exports become more competitive. This is because free trade will enable countries to trade according to the theory of comparative advantage. As Singapore has CA in the capital-intensive and knowledge based industries, this will lead to an increase in Qty DD for Singapore’s exports in these sectors as she has lower opportunity costs in the production of these goods and services assuming PEDx > 1 this will lead to an increase in export revenue and rise in NX.

Effects on the economy

Micro Effects: Increase export markets will lead to greater efficiency in production due to IEOS. Greater competition for domestic industries will lead force domestic firms to be productively efficient and dynamically efficient. Trade creation overall improvement in society’s welfare.

Macro Effects: If NX increases overall, will lead to EG, lower UN rate, improvement in BOT and BOP.

Cheaper imports (due to more sources of

1. Removal of barriers on imports increases in the quantity demand for imports. This will lead to competition for import substitution industries due to loss in CA in these industries e.g. labour-intensive production fall in DD for domestically produced goods. This will lead to rise in import expenditure and fall in NX.

Effects on the economy

May lead to structural unemployment in import substitution industries.

If NX increases overall, may lead to demand-pull inflation in the SR if economy is near full employment.

P

Q

GPL

Real NY

D

S

Pw+ tariff

Pw AD0 AD1

AS0

AS1

Use diagram to explain lower price of imports and/or lower price of Singapore’s exports.

Use diagram to explain the effects of lower price of imports and more competitive exports on the Singapore economy.

P0 P1

Y0 Y1

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imports as more countries engage in international trade) and greater competition will lead to fall in GPL and dampens inflation.

Synthesis:

Whether Singapore benefits more than costs depends on the overall net effect on net exports. If net exports increases, benefits > costs Benefits from economic growth, lower unemployment rate, improvement in BOT and BOP will outweigh the costs of higher inflation and structural unemployment.

In recent years, Singapore has restructured its economy to focus on new niche areas of growth. This has ensured that Singapore’s exports are competitive in the world economy and to benefit from globalisation.

May evaluate that Singapore is unlikely to be negatively impacted because Singapore has minimal import tariffs imposed even before the breaking down of trade barriers globally.

Issue 2: Freer capital flow

Economic Framework: AD/AS diagram

Benefits Costs

1. Freer capital flow will lead to FDI inflows. This will lead to increase in investments in Singapore. Effects:

If there is net inflow of FDI AD and AS increases NY increases (through the k-process) EG (actual and potential growth), lower UN rate.

Will lead to an improvement in the capital account and BOP in the short run.

Attracting FDIs will help Singapore to develop CA in new niche areas.

2. Singapore firms have greater access to foreign markets. Outsourcing more efficient and lower cost production. Improves competitiveness of Singapore’s

1. Freer capital flow will lead to outflow of FDI. Singapore may not be as competitive as other developing countries. Effects:

May lead to structural unemployment as domestic firms outsource the production process.

If net inflow of FDI over-heating in the SR DD-pull inflation.

Crowding out of domestic investments over-reliance on FDI for economic growth more susceptible to international shocks.

Worsening of current account in the LR due to repatriation of profits.

GPL

Real NY

AD0 AD1

AS0 AS1

Use diagram to explain the effects of FDI flows on the Singapore economy.

P0 P1

Y0 Y1

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exports if they outsource parts of the production process.

Synthesis:

Whether the benefits > costs depends on net capital flows. It is likely that Singapore will benefit more than the costs because of the ease of setting up businesses, coupled with favourable government policies in Singapore. In recent years, Singapore has positioned itself well to attract net FDI inflows.

Singapore has a small domestic base, so it is beneficial for Singapore gain easier access to overseas markets.

While it has led to over-heating in Singapore, enough policies in place to boost productivity and potential growth.

Issue 3: Freer movement of labour

Economic Framework: Labour market diagram/AD/AS diagram

Benefits Costs

1. Freer movement of labour will lead to increase in the supply of labour in Singapore – both highly skilled and low skilled.

Effects:

Lower wages: reduces wage-push inflation and Singapore remains competitive as costs of production are maintained.

Increase in productive capacity increase in AS with increases in AD Singapore will be able to achieve non-inflationary sustainable EG.

Influx of foreign talent allows Singapore to develop new niche areas in the knowledge based industries and also a transfer of skills that can boost productivity.

1. Freer movement of labour will lead to brain drain, where local talents chose to work overseas. fall in labour supply fall in AS limits potential growth.

2. Inflow of labour into Singapore

Effects:

Dampens wages especially for the lower-skilled workers. Rising income inequality.

Low cost labour fall in rate of productivity growth no incentive to innovate and improve efficiency not sustainable?

Worsens current account due to repatriation of profits.

Increases DD-pull inflation due to rise in C. (housing prices etc.)

Synthesis:

It is likely that Singapore benefits from the movement of labour (net inflow of labour) because we

GPL

Real NY

AD0 AD1

AS0 AS1

Use diagram to explain the effects of labour flows on the Singapore economy.

P

Q

D

S1

Q0

Use diagram to explain effects on wage rates.

S0

W1

W0

Q1

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are able to attract and retain talent through favourable tax policies and high standard of living. Labour flows are also necessary to boost economic growth given our low birth rate. However, cost of living in Singapore has increased quite significantly with inflation rates highest in

recent years. (Evaluate if it has do with inflow of labour) While there are groups of people in Singapore who are made worse off, there are government

policies to reduce the impact of income inequality.

Overall Evaluation and Conclusion:

Given the nature of the Singapore economy, globalisation has worked in Singapore’s favour, leading to more benefits than costs to Singapore. We achieved healthy economic growth rates, low unemployment rates, BOP surpluses.

However, Singapore has become more susceptible to external shocks with globalization as seen from the recent recession in 2009 economy is a lot more volatile as we are influenced by the performance of other countries.

However, these benefits and costs of globalization are not even in Singapore. While not everyone in Singapore has benefitted from globalisation and costs such as

inflationary pressure has worsened the standard of living for some groups of people, government policies may help to alleviate these costs.

Question 7

The globalization of trade puts pressure on natural resources around the world, helping to drive the rapid depletion of tropical forests and the collapse of many ocean fisheries. On the other hand, some countries has benefited from the flow of labour into their countries.

(a) Explain how pattern of trade will change as a result of the changes in factor endowments stated above. [10]

(b) Discuss the role of government in the age of globalization. [15]

Suggested answer

a. Explain how pattern of trade will change as a result of the changes in factor endowments stated above. [10]

Introduction

Pattern of international trade is based on the theory of CA. Based on the theory of CA, countries should specialize in the production of goods that they have comparative advantage in and export it for goods it does not have CA in producing. The amount of factor endowments a country has affects the comparative advantage a country has.

Body

Explain theory of CA and how pattern of trade is determined based on a country’s comparative advantage in producing a good.

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Use examples such as China, being labour abundant, has comparative advantage in the manufacturing of labour-intensive goods such as toys and textiles. Singapore, after years of strategic human and capital investment, has a comparative advantage in the production of electronic goods and pharmaceutical products.

Application to context:

Let’s assume a country A, with tropical forests that a rapidly depleted. It would imply that the country would face a decrease in the exports possible and would have to look for another product, which it has comparative advantage in to export. In other words, country A cannot rely on exporting of wood to generate export income for the country. If country A consumes a lot of wood, she may end up being a net importer of wood.

Let’s assume a country B, with abundant fish and timber could have been exporting timber or fish due to her having abundance of it and CA in producing these products.

With the depletion of such resources, another country, C, which breeds fish in fish farms but had a higher opportunity cost previous, could now have a lower opportunity cost compared to country B and should now be exporting the fish instead of Country B, based on the theory.

If there is country D, which previous lack skilled labour and now has open immigration policies that allows and attracts skilled labour from into the country, the country could now have a comparative advantage on the production of high end electronics and hence should specialize and export that.

Conclusion

Pattern of trade will change when the factor endowments change.

(b) Discuss the role of government in the age of globalization. [15]

Introduction

Define globalization: Globalization is often used to refer to economic globalization, that is, “integration of national economies into the international economy through trade, foreign direct investment, capital flows, migration, and the spread of technology.”

The age of globlisation brings about many challenges as well as opportunities for countries. As a result, there is a need for the government to step in to reap the benefits and minimize the costs.

Body

(There are many possible points the answer must cover the problem/ benefit brought about by globalization and evaluate the role the government has to play.)

What comes with globalization? Increase in international trade at a much faster rate Increase in international flow of capital including foreign direct investment

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An increase in movement of labour across boundaries An increase in international outsourcing and offshoring by multinational corporations

(MNCs) Riding above the wave of globalization to reap its benefits:

Sustained economic growth via maintaining export competitiveness

The government can remove trade barriers to allow for greater specialization based on CA and reap the benefits of increased consumption.

Trade policies – signing of FTAs, lower tariffs higher export sales growth of X-oriented industries meet the higher increase in AD by increasing production and create employment.

Supply side policies – subsidise R&D to improve the non-price competitiveness of our exports

Attract more FDI

Government can have policies that will attract FDI such as low corporate taxes or good infrastructure. increase I higher AD in SR and increase AS in LR.

Flexible wage system to keep labour costs low

Attract more foreign talent

Lower income tax Immigration law less stringent – grant PR-ship to diploma holders and not just

graduates.

Illustrate with AD-AS – AD and LRAS increase – lead to higher actual and potential growth and also price stability.

Limitations of all policies or any negative implications:

To compensate for the loss in government revenue due to lower direct taxes, the government has to increase indirect taxes such as GST or VAT. This may lead to tax-push inflation. Government will then need to off GST-offset packages to help the poor to tide over the rise in cost of living.

Policies to curb the ill-effects of globalization:

Contagion Effect – susceptible to cyclical unemployment

Countries that are open to free trade will be more prone to contagion effects of other countries’ economic crisis. These shocks can be transmitted from one country to another through various channels - trade, financial and mechanical spillovers.

Governments will have to have sufficient policy tools and leeway to adjust to the rise and fall due to the contagion effects.

Expansionary demand management policies to increase AD in the SR: the effectiveness of such policy is limited since recession is externally induced and especially when the affected country is highly dependent on trade.

Diversification of export products and more countries to spread the risks. At

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the same time, make demand for exports more price-inelastic via R&D. Once again the effectiveness is questionable as the world is interconnected and trading partners of one are usually of others. Through FTAs with many countries, it at best slows down the contagion effect but it can’t prevent it from happening. Also, when income falls, even if exports are price inelastic won’t help. As long as it’s normal goods, demand will fall with income. A country also can’t just diversify into any kind of exports as it should be producing goods it has CA in.

Structural Unemployment and growing income gap

If the globalization leads to rapid economic changes, this can result in various negative outcomes/ cost such as high unemployment in the sunset industries that have lost CA.

This leads to growing income gap: Wages of lowly skilled labor will generally grow slower than that of highly skilled labor.

Thus rapid growth might not necessarily improve the standard of living for the majority. In fact, people in countries in US might even face problems of unemployment due to outsourcing e.g. of call centres to India and the textile manufacturing to China.

Government may want to protect the industry in the short run but concurrently retrain the workers in these industries to equip them with skills to work in industries that the country has CA in. This is because protection is a SR policy and cannot solve the root of the problem. The country needs to go through structural change and equip the people with the correct skills in the ‘new industries’. So there is a need to use supply-side policy – retraining of workers allow for better match of skills and jobs available while speeding up its restructuring of the economy

Infant industries will also not be able to realize their potential. Government should protect these industries till they are competitive. But it may be difficult for the government to remove the BOE later.

Susceptible to import-price push inflation

For Singapore, it can maintain a strong S$ to reduce the imported inflation – a gradual appreciation to prevent cost escalation of imported raw materials as well as final goods and services.

Prices and income policies - cushion the impact of rising import prices but they are only temporary.

Supply-side policy to improve productivity to reduce unit costs in the SR to offset the higher import prices and increase productivity in the LR

Conclusion

Globalisation results in cost and benefits. Governments have a key role to play to maximize the benefits and minimize the cost of globlisation.

OR

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Conclusion/Evaluation

There is a need to constantly review current policies to ride on waves of globalisation Coping with globalisation is about coping with change. To sum up, markets open to trade

and investment and which instill competitive pressures among businesses ultimately increase our material well-being. At the same time, highly dynamic markets represent a source of insecurity for workers and the costs of adjustment can fall on a number of people.

The appropriate response is not protectionism. Rather, it calls for more open, well-governed markets coupled with policies that facilitate adjustment, while addressing the needs of vulnerable workers and spreading the benefits of globalisation. This way, countries like Singapore will benefit fully from the spoils that stem from market openness while the adjustment costs are minimised.

Question 8

Globalisation of trade and investment can raise global output. Unfortunately, the impact on prosperity both between and within different countries is very variable, with some groups suffering an absolute decline in incomes.

Examine the claim that globalisation whilst beneficial overall has adverse economic consequences for certain firms and households. [25]

Approach:

This question focuses on material and non-material benefits / costs related to globalisation. Reference must be made to selected micro / macro objectives related to globalisation. Eg: economic growth, unemployment, efficiency and equity as these will have impacts on firms / households

In discussing the benefits of globalisation, some issues that could be raised include global output, higher consumption possibilities, choices, EOS, rising income. In the case of adverse consequences of globalisation, issues include rising income inequity, structural unemployment and negative externalities

The essay should discuss issues related to o the country / countries as a whole o different extent of gains made by different countries (eg: LDCs vs DCs) o different extent of gains made by different sectors within the country eg industries

with CA vs those without, skilled vs unskilled workers As the question calls for impacts on firms and households, hence explicit links must be

made to them. Concepts related to o Firms: revenue, costs, profits, efficiency, market share and producer surplus o Households include a) providers of factors of production; and b) consumers:

price, choice, wages, consumer surplus Use of contrasting country examples is important in this essay to enhance the quality of

discussion.

Outline

- Explain the meaning of globalisation and how it brings about reorganization of production, trade and the integration of financial markets. For example, with the lowering of transport

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costs and communication costs, barriers to movement of goods and services, labour, and capital are lowered.

- Explain the benefits to countries that are engaged in globalisation: Explain that with freer movement of goods and services, countries could

specialise and trade in goods in which they have comparative advantage, that is, those in which they could produce at lower opportunity costs according to differences in their factor endowments. [Give contrasting examples of countries with an abundance in unskilled labour [China?] and capital/technology/expertise [USA? Japan? Germany?], and the goods they would specialize in, Highlight the benefits:

Micro concepts: More consumption possibilities [beyond their PPC] given that

resources are more efficiently utilized. Quantity increases, prices fall, increasing households’ material welfare. Trade is not limited to countries with differing factor endowments. Countries with similar factor endowments such as Japan and Germany also trade with each other in goods such as cars, giving households more variety too. [intra-trade]

Firms will see larger markets for their products, TR increases. EOS reaped due to larger global market higher revenue, increase productive and allocative efficiency, lowers unit cost more profits for firms

Cost is further lowered outsourcing the more labour intensive production processes [such as simple assembly and call centres] by firms (from DCs) to LDCs lower unit costs and higher profits for firms as the wages in China and India are relatively lower.

When these cost savings are passed onto consumers, households enjoy lower prices and higher material welfare.

Faced with more global competition, firms would also have to be more efficient to maintain their price and non-price competitiveness. This again would benefit households in terms of production quality, variety as well as prices.

Specialisation according to different factor endowments meant that DCs which are likely to be endowed with skilled workers in capital / knowledge based industries or capital owners will benefit from greater production. Similarly, LDCs’ CA in labour intensive products and the lower-end manufacturing sector will gain due to higher employment for lower-skilled workers and hence income for them

FDI are likely to rise in DCs / LDCs based on the countries’ factor endowments the above group of workers will further reap the gains from these investments. In addition, rise in I rise in AD rise in actual EG

Macro Ideas Export revenue for both DCs and LDCs would increase. Countries can

also expect an increase in FDI. This increase in AD, this would lead to more real economic growth and employment opportunities, increasing the material welfare of households, especially those who are in sectors in which the countries have comparative advantage.

An increased flow of FDI and technology, and unrestricted access to markets

in DCs will benefit LDCs to a greater extent and help them move up to higher

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value added sectors and catch up with the DCs. The higher productivity means LDCs enjoy increasing productive capacity and can potentially earn higher income and greater consumption ( rise in AD & AS rise in EG)

- Explain the adverse consequences to countries that are engaged in globalisation: [Note: It would be good if candidates can highlight that DCs and LDCs face different problems]

Structural unemployment – this is likely to affect the DCs more than LDCs. This could be due to: a) Globalization exposing firms in DCs, esp those in more labour intensive sectors such as manufacturing [e.g. tyres and steel in the USA] to competition from low cost countries such as China and India. b) Outsourcing: This means that workers in certain industries eg production workers in manufacturing industry in the US and service-sector workers in industries where the business processes have been outsourced like IT software design or auditing may be unemployed. c) influx of cheap labour displacing local blue-collar workers. The demand for low-skilled workers would fall. Furthermore, theseworkers may have difficulty acquiring relevant skills to move up to higher value added sectors such as finance, biotechnology etc in which DCs enjoy CA.

Income inequality [this follows naturally from structural unemployment] This problem is likely to apply more to DCs. Given that DCs specialize in

high-end goods, skilled workers will see a rise in demand for them. Given the inelastic supply, the income of workers in these industries will rise very fast. Eg “mind" workers like engineers, attorneys, scientists, professors, journalists, consultants are able to compete successfully in the world market with globalization. On the other hand, unskilled workers in DCs are likely to see a fall in demand for their services, and hence a fall in wages. Worse, supply of these workers from the LDCs is increasing, depressing wages further. Hence different sectors within the economy will see different extent of gain, leading to widening income gap.

[Not required in this question, but good to know if you want to develop this point further: The inequality may be worsened by trade unions of these industries with weak negotiating power since they now hold less power over firms that are able to easily replace workers, often for lower wages, and have the option to not offer unionized jobs anymore. Hence workers in such industries may see a decline in their income or be unemployed. However, it can also be argued that these lower-skilled workers (those in the lower / middle income groups) may potentially enjoy more from free trade. This is because they are likely to spend a larger proportion of their income on low end manufactured good eg clothes, shoes, and the like whose prices are often directly affected by free trade. On the other hand, the higher income group tends to spend more on services eg education, leisure and these are less subject to competition from abroad.]

In LDCs, the income gap could arise due to geographical immobility. Most industries are found along the coastal / urban areas due to better transport and infrastructure facilities [e.g eastern coastal states in China vs the western ones]. Globalisation implies that production is like to take place in these places leading to increasing income disparities between urban and rural areas.

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Negative externalities experience by LDCs due to weak policing of its resources. Households / firms who are not involved in the production / consumption of these products may incur external cost like healthcare or lower productivity of its workers due to pollution or depletion of its resources worsen non-material SOL. Examples: China has the most polluted cities in the world. Amazon forests in Brazil are cut down to make way for urbanization. Excessive dependence on primary sectors as seen fast depletion of natural resources in Russia and Brunei.

Exploitation of child labour: In many LDCs, globalization will result in MNCs utilizing workers to take advantage of the lower wage rates. This could mean exploitation of child labour with low pay. An example is the use of sweat shops by sports shoe manufacturers like Nike. The factories are often set up in these countries where employees agree to work for lower wages than would be required in DCs. However, one could argue if this is really exploitation. Will these workers be better off without globalization? Or is the lower wage rate offered a reflection of the country’s CA?

Nature of products exported: the main export of LDCs is usually agricultural goods which are income inelastic. On the other hand, DCs exports mainly manufactured goods which are income elastic to the LDCs. Given rising income over time, this means that DCs are likely to see a faster rise in demand for their goods than LDCs. This translates into faster increase in revenue for firms in DCs than in LDCs

Assumptions of CA principle: it assumes fair trade ie no dumping etc so that all will benefit from the higher trade volume. However, in reality, this is not true and LDCs are often accused of dumping their goods to markets in DCs. Like the issue on child exploitation, is it a question that LDCs possess CA in these areas or is it a manipulation of currencies ( eg China). However, when DCs dumped its products to LDCs, it is usually not due to CA.

Volatility: the close interconnectedness due to globalisation implies that any crisis in one country may have adverse impacts on others. Eg: collapse of the subprime mortgage market in the U.S. led to a global financial crisis and recession in other countries, especially those very reliant on external demand such as Singapore. Such unpredictability can reduce a country’s long term growth

Conclusion

In the long run, globalization is an important determinant of long run growth and rising living standards and arguably benefits would outweigh the costs arguably for most nations For example, globalization has played an indispensable role in lifting many people in emerging developing countries such as China and India out of poverty. However, the gains and costs ,maybe unequally distributed between different countries and between different firms and households in a particular country. Furthermore, not all countries stand to gain from globalization. For example, while the African countries, have a lot of potential to gain from trade, they continue to be undeveloped and poor largely due to corruption and weak institutions. The role of governments is therefore critical. Through policies such as retraining, transfer payments, strengthening environmental and labour regulations, as well as R&D to identify and develop potential areas of CA, the government could help in minimizing the adverse consequences and maximize the full benefits of globalization. These policies would also

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go a long way in ensuring a more equitable distribution of the benefits between different parties.

Q9 RJC JC2 Preliminary Examinations 2008

The sources of growth can be internal or external, but countries like China will need to prepare for a

future in which it relies more on the strength of growth at home rather than on the strength of growth

in the rest of the world.

Discuss this assertion. [25]

Possible approach

The essay can be approached in two parts: the explanation of sources of growth and the discussion of

the relative merits/demerits/importance of external sources and internal sources of growth.

Introduction & Clarification

Define economic growth potential and actual

It is preferred that an economic framework (PPC or AD/AS) be used to illustrate the difference

between potential and actual growth.

Clarify “prepare for a future” sustained economic growth

Development of answer:

(I) Explain that “sources of growth can be internal or external”

1. Growth due to internal sources

- AS‐side o Abundant natural resources

Inputs into production of goods and services E.g., huge land area, abundant mineral deposits

o Abundant human resources of high quality Utilise natural resources and turn them into products Quantity larger population size + longer work week = higher growth Quality better education + health + mobility of workers = higher growth

o High rate of capital formation Stock of equipment and structures that are used to produce goods and

services Quantity more capital = more production = more growth Quality up‐to‐date Depends on rate of savings which determines the rate of investment

o Advanced technology Given amount of resources to result in larger output E.g., new production techniques, improvement in performance of machines,

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better organisation and management, more efficient transport and communication systems, etc

- AD‐side o Supply side factors alone is insufficient must have increase in AD to “absorb” the

extra goods and services produced o Depends on changes in the components of C, I and G, which in turn may depend on

many other factors, e.g., expectations, affluence, government policies, etc - Other non‐economic reasons

o Political stability o Social harmony

2. Growth can be due to external sources

- AS‐side o Foreign talents abroad may move into the domestic country

Might be due to low wages in foreign countries (push‐factor) Augments the quality and quantity of labour Possibly also reduces labour cost in the domestic country

o FDI inflow Might be due to political instability in home country (push‐factor) May bring in transfer of technological knowledge

- AD‐side o Strong growth in the region or globally

Improves external demand for exports from domestic country (X – M) affected

Especially relevant for open economies - Government policies in domestic countries may influence domestic sources of growth

o Due to relaxed domestic immigration laws pull‐factor for foreign talent o Due to domestic tax incentives for MNCs pull‐factor for FDI o Due to domestic export subsidies that lower price of exports to foreigners induces X

Some candidates provided a different approach to the first part of this question. Instead of

approaching the question in terms of internal and external sources of growth, they approached the

question via sources of actual and potential growth before subdividing them into internal and external

sources. Such an approach was also accepted.

(II) Discuss whether internal growth or external growth is more important for China

1. Thesis: Internal growth is more important for China

- Supply‐side o Increasing competitiveness from other developing countries to attract FDI (e.g.

Vietnam, Indonesia) increasing difficulty to attract FDI o Internally, China becoming less attractive to FDI (rising wages, quality scandals) o Benefits from FDI diminishing (scope for transfer of technology and know‐how will

diminish as China catches up) o More FDI means less profit retained in China lower contribution to SoL compared to

domestic I - Growth in aggregate demand

o Need to re‐balance economy to insulate from external shocks (X‐dependency means recessions in foreign countries will have a larger drag on Chinese economy)

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o High I and X compared to C means SoL is lower than it potentially could be. - Other non‐economic reasons

o Nationalistic feelings support local brands!

2. Antithesis: External growth is more important for China

- Supply‐side o Large swathes of China (North‐west) are not geographically conducive to investment.

Need foreign know‐how to develop it (e.g. need foreign technology to make mining activities profitable)

o Population dividend will run out soon (onset of ageing population). Need foreign sources to make up for shrinking labour force

- Demand‐side o While middle‐class is growing, purchasing power of Chinese still not enough to sustain

current levels of economic growth (i.e. C cannot replace X and I (FDI) as drivers yet) 3. Link to AD/AS framework

Conclusion:

Make a stand and justify

Ultimately, internal and external growth sources are complementary. One needs to look at the trade‐

off to determine whether this is the right time to be making a switch.

Q10

GCE ‘A’ Levels November 2010

When there are large increases in the price of oil and other primary products, they are usually

expected to lead to rising inflation throughout the world’s economies.

Discuss the extent to which these factors are likely to affect the rate of inflation in Singapore.

[25]

Introduction

‐Define inflation and identify types of inflation: demand‐pull, cost‐push

Body

‐Explain how large increases in the price of oil and other primary products lead to inflation in Sg

Sg is an importer of oil and other primary products

Increases in the price of oil and other primary products represent an increase in costs of production AS shifts up inflation

‐Explain how there may be other factors that lead to inflation

Government action: Expansionary fiscal or monetary policy, devaluation (demand‐pull + imported)

Demand pull inflation due to increased population and consumption (increase C increase AD)

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Demand pull inflation due to inflow of FDI (increase I increase AD)

Demand pull inflation due to inflow of ‘hot money’ (increase MS lower i/r increased C and I)

Other possible demand‐pull factors

Imported cost‐push due to currency changes (depreciation *note: not the same as devaluation)

Cost‐push due to increased labour costs

‐Evaluate the extent that each factor is likely to affect the inflation rate

Government action: Effect of fiscal policy is small due to small multiplier (small shift in AS). Sg government can’t affect interest rates so cannot have inflationary effects due to fall in i/r. Devaluation may have significant effect but SGD long‐term path is largely one of mild appreciation. MAS has not had any significant devaluation since AFC in 1997.

Increases in price of oil and primary products: Effect should be significant for two reasons. First, increases in prices were large. Also, Singapore imports close to 100% of these products. No chance of substituting with domestic (and presumably cheaper) products. Second, these products affect the prices of other secondary products that Singapore imports. Increase in costs is felt at all levels.

Increased population: Only leads to inflation in the event of economy operating close to full employment. However, increase in population largely due to inflow of foreign labour. AS shifts out at the same time. Hence, inflationary effects moderated.

FDI inflows: Similar argument as increased population. FDI also increase productive capacity of economy.

‘Hot money’ inflows: Extent of inflows may not be great as portfolio investments have seen a trend of going towards developing economies. Also, C and I in Sg may be i/r inelastic due to the general lack of borrowing to spend (for C) and high business confidence (for I).

Currency changes: Sg did not show depreciation during this period. In fact it appreciated and took the edge off the imported inflation.

Increased labour costs: No significant increase in wages in this period. In fact, inflow of foreign labour increased labour supply and moderated wages. Effect especially apparent in more labour‐intensive industries (e.g. construction) where wages take up the highest proportion of costs.

‐Conclusion

Increased prices of oil and primary products must have contributed to inflationary pressures in Singapore. However, extent of effect depends on how much the SGD appreciated too. Additionally, although other factors were likely to individually have had weak effects, the sum of them all may diminish the proportion that higher prices of raw materials contribute to inflation.

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Question 11

In the light of America's growing twin deficits (budget deficit and current account deficit), the US government is putting pressure on China to revalue her domestic currency. a. Explain the problems faced by a country if it incurs a twin deficit [10] b. Discuss whether conflicts in achieving macroeconomic objectives will arise for

the Chinese authorities when she revalues her domestic currency. [15]

Suggested outline

Part (a)

Introduction:

Clarify key terms: “Twin deficits” i) Budget deficit (G>T), ii) Balance of trade deficit (M>X)

Body:

Explain the problems faced by a country if it incurs a growing budget deficit (G>T) i. Expansionary FP inflationary pressures problems associated with

high inflation ii. Financing problems/How to finance

1 Borrow from other countries a. Indebtedness to other countries

2 Borrow from public a. Crowding out effects b. Inter-generational equity problems

3 Print money inflationary pressures 4 Any others

Explain the problems faced by a country if it incurs a growing balance of trade deficit (M>X)

iii. If the growing balance of trade deficit results in growing balance of payments deficit, => total currency outflow > total currency inflow => net increase in dd for foreign currency / net increase in ss of domestic currency domestic currency will be under pressure to depreciate / Central Bank under pressure to devalue her currency.

1 For countries operating on a fixed exchange rate regime Central Bank must buy domestic currency and sell foreign reserves to support the domestic currency.

i. However, if unable to do so because of insufficient foreign reserves domestic currency will depreciate.

ii. Consequence: 1. Prices of imports in terms of domestic currency

increase hurt ability to buy imports and greater risk of imported inflation especially if heavily reliant on imports => compromise on cost competitiveness of X and cost of living.

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2. If depreciation is excessive speculative attacks on the domestic currency => higher degree of uncertainty => difficult for investment plans and trade.

2 Countries operating under flexible exchange rate regimes will see their currency depreciating

i. This will reduce their ability to buy imports ii. Imported inflation rising iii. The impact on the United States of America is different (the

US$ is still strong relative to other foreign currencies) because the US$ is being demanded by other countries as a reserve currency

iv. Contractionary effect on the economy slowdown in economic growth v. Indebtedness to other countries vi. Inter-generational equity problems

May consider broad characteristics of America in the answer (optional)

Conclusion:

Make a stand on what the main problems are that these countries will be facing i. Combined effects on a country if it incurs a twin deficit

1 Inflationary pressures intensifies due to demand-pull inflation and cost-push inflation rising (problems arising from high inflation)

2 Financing problems a. Indebtedness to other countries domestic currency weaken b. Inter-generational equity problems

-Higher taxes in the future will contract the economy even further

Part (b)

Introduction:

a. Clarify that a revaluation of the Chinese Yuan suggests that China gives in to the pressure from US government (preamble) i. Allow the Chinese domestic currency to appreciate against US$ ii. State and explain briefly the 4 macroeconomic goals: Low inflation rate, economic

growth, full employment and external balance.

Body

Thesis: Revaluation of the Chinese domestic currency can lead to conflicts in achieving macroeconomic objectives for the Chinese authorities

Slowdown in actual growth and rise in unemployment Revaluation of the Chinese domestic currency Px in terms of foreign currency

increases while Pm in terms of domestic currency falls according to the Marshall-Lerner’s condition, so long as the sum of PEDx and PEDm is greater than one, a revaluation of the Chinese Yuan will worsen China’s balance of trade and in turn, balance of payments, ceteris paribus.

Fall in BOT will lead to a fall in AD and hence a more than proportionate fall in National Income ceteris paribus.

Burden of debt

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The slowdown in economic growth results in increased unemployment social instability and other costs of unemployment.

(Use AD/AS framework for analysis)

Anti-thesis: Revaluation of the Chinese domestic currency need not lead to conflicts in achieving macroeconomic objectives for the Chinese authorities

Ease of inflationary pressure Imported inflation will fall as price of imported raw materials fall in terms of domestic currency assuming China imports a significant amount of raw materials for her industries reduce cost of production (increase in AS) fall in cost-push inflation.

Positive effects on economic growth and employment The benefits of achieving low domestic inflation relative to foreign inflation can also

bring about improvement in export competitiveness economic growth (actual) and reduction in unemployment

Cheaper imports including import of cheaper capital goods larger volume of import of capital goods and equipment lead to capital deepening in the long run, increase in potential growth for China.

Conclusion: (Possible evaluation)

1. Make a stand and explain your stand taking into consideration the context of China, that is, they should take into account some of the characteristics that are unique to China. For eg, consider the extent of revaluing the Chinese domestic currency and whether it will have a significant impact on the 4 macroeconomic goals – starting point in pricing of their products. Even if China’s exports are more expensive to the foreigners after revaluation of the Yuan, given that the prices of China’s exports were relatively much lower than what the rest of the world could offer, the impact of this revaluation could be might just be minimal.

2. Other evaluative points: More of a political decision to revalue the Chinese domestic currency rather than an

economic one The decision to revalue the Chinese domestic currency is in line with economic

principles based on the Theory of Comparative Advantage that in the absence of protectionism, gains from specialization and trade can be maximized

China should implement complementary policies (e.g supply-side) to mitigate ill-effects /minimize the potential conflicts between macroeconomic objectives arising from revaluing her domestic currency

macro nov 2012

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