Macroeconomic Aims and Policies (these are suggested approaches to the

following essay questions – there are not exhaustive; you may consider other

approaches too)

UCLES November 2002

A government’s macroeconomic aims are low inflation, low unemployment, balance of payments

equilibrium and economic growth. Which of these aims do you consider most significant for

Singapore and why? [25]

Suggested Content Ideas:

Introduction

Define key terms – inflation, unemployment, balance of payments equilibrium and economic growth

Clarify what’s meant by most significant aim

Primary objective/most important goal

Short run vs long run aims

Urgent vs important aims

A means to an end vs the end in itself

Body: Use AD/AS framework to explain that to have sustainable growth, Spore needs to have a

low inflation.

1. Explain the situation for Singapore Singapore is highly dependent on imported raw materials as she is lacking in natural

resources vulnerable to imported inflation (cost-push inflation) imported inflation results in leftward shift of the aggregate supply curve which results in higher general price level and lower levels of real national output

Singapore has a small domestic market heavily dependent on exports to ensure sustainable economic growth

2. Explain why Singapore aims to achieve sustainable economic growth. Growth is needed for increased standards of living and greater choice for consumers. low unemployment and avoid high unemployment: efficient use of a nation’s resources,

low benefit payments, and low crime rates. 3. Explain how with low inflation, associated with low and stable inflationary expectations,

Singapore will be able to achieve sustainable growth and hence the other macroeconomic goals in the long run. In other words, low inflation is the prerequisite to the attainment of Singapore’s aim of sustainable growth and other macroeconomic goals in the long run.

a. Explain how direct foreign investment, which is affected by inflation, affects growth. Use AD/AS diagram to explain.

When Singapore’s inflation is low, foreign direct investment is attracted into Singapore as foreign investors are better able to predict future returns on investment projects. Higher levels of FDI lead to both actual and potential growth, which in turn generate higher levels of employment. (vice-versa)

When Singapore’s inflation is kept lower relative to other countries’ inflation, Singapore’s export competitiveness improves, hence improving her balance of trade and balance of payments. An improvement in Singapore’s balance of trade will cause AD to increase and result in actual growth, ceteris paribus.

Needs to keep out imported inflation in order to lower cost of producing exports and thus maintain export competitiveness in the international market

The size of multiplier in Singapore is close to one. It is relatively low due to her high marginal propensity to save and high marginal propensity to import. This small size of the multiplier in Singapore limits the extent to which real national income will increase for a given increase in autonomous spending. Inflationary pressures in Singapore will further dampen the effects of the multiplier. Keeping inflation low helps to reduce the dampening effects inflation will have on the size of the multiplier which is already small to begin with.

b. Inflation and long run balance of payments equilibrium Avoid problems associated with persistent balance of payments deficit like running

down on foreign reserves (which will in turn reduce its ability to intervene in the foreign

exchange market should the domestic currency depreciate too much) and having to borrow from foreign countries to finance its deficit (which will in turn lead to foreign countries laying a claim on the country’s assets).

Too much balance of payments surplus means that the current generation is not enjoying as high a standard of living as they could otherwise have done so (inter-generational equity issue). It may also lead to other foreign countries retaliating by imposing trade restrictions on the domestic country’s exports as one country’s BOP surplus means that another country is experiencing a BOP deficit.

Costs arising from high inflation 4. However, in the short run, by aiming for low inflation, Singapore may have to trade-off some

amount of actual growth. In the short run, to reduce the level of inflation, contractionary demand-side policies

(like fiscal policies and exchange rate policies) may be implemented. Contractionary fiscal policies include reducing government spending and increasing taxation which will lead to a fall in aggregate demand and in turn, a fall in demand-pull inflation. However the fall in aggregate demand not only dampens inflation but also slows down actual growth. When actual growth slows down, the demand for labour falls (assuming labour is a derived demand) and demand-deficient unemployment rises.

An appreciating exchange rate reduces both demand-pull inflation and imported inflation (a type of cost-push inflation). However, by increasing the price of exports in terms of foreign currencies and reducing the export competitiveness, the balance of trade and in turn, the balance of payments will worsen, ceteris paribus.

Explain that even though generally speaking, Singapore’s primary objective is to achieve low inflation, there are instances when targeting other objectives become more important than targeting inflation. Such instances arise because these other objectives are identified to be a more pressing and urgent problem to tackle than inflation.

For instance, there were two periods in which Singapore allowed the Sing dollar to depreciate because inflation was within the targeted rate but economic growth was slowing down.

Current situation of Singapore: In the last year, the most pressing problem was the global financial crisis and the economic recession that follows. A government’s stimulus program undertaken to take up the shortfall in export earnings succeed to lift the economy out of the technical recession. A low inflationary situation caused by more benign commodity prices also helped in keeping interest rates low and spending encouraged.

Conclusion

Singapore’s most significant aims depend on the current situation the Singapore economy is in and

whether it is a short term aim or a long term aim. In the short run, the most significant aim tend to be the

one that deals with the most urgent and pressing problem. In the long run, to achieve sustainable

growth, it is necessary to make sure that low inflation is achieved as it helps lead to the attainment of the

other macroeconomic goals best given Singapore’s constraints.

RI 2010 CT2

The annual growth rate for the Singapore economy fell from 7.8% to 1.1% from 2007 to 2008. At the

same time, the annual inflation rate has increased from 2.1% to 6.5%.... Business costs have

increased, notably wages and rentals, in tandem with global food and oil prices.

Explain the key macroeconomic aims of the Singapore government and to what extent have the main

macroeconomic problems faced by Singapore in 2008 been caused by increases in business costs?

[25]

Suggested Outline

Students are expected to elaborate and explain the 4 macroeconomic aims and apply them to the

context of Singapore. The 4 main macroeconomic goals are: Low inflation, Sustained economic

growth, Full employment and a Healthy balance of payments, together with a strong and stable

exchange rate. For each macroeconomic aim, students are required to explain the concept, the

economic indicator/statistical measurement used and the rationale for attaining each goal.

1. Low inflation (Price Stability)

Definition of inflation: a sustained and inordinate increase in general price levels over a period of time, usually a year.

Low inflation = price stability

In Singapore’s case, low inflation inflation rates of between 1 – 3%

Inflation rate is measured as the percentage change in the consumer price index over a period of time.

Low inflation is important for the following reasons: Provides a conducive environment for savings and investment. This is because low

inflation ensures a stable value of money. Hence the real value of savings is protected. For investors, the low inflation means that they can more easily project future returns on investments. Hence they are more willing to undertake risks of investments. Price stability also ensures that cost of production will be relatively low, hence raising the profitability of investments, this further encourages investments, which is of particular importance to Singapore since foreign investments in particular, takes up a huge proportion of total investments in Singapore.

Low inflation helps to improve export competitiveness for Singapore as it ensures that cost of production is relatively lower hence making Singapore’s exports more price competitive. This raises export demand for Singapore. Given that demand for Singapore’s exports is price elastic (availability of substitutes for our manufactured exports), quantity demanded of exports will increase more than proportionately, benefiting the Singapore economy.

The significant increases in X & I are particularly important for Singapore since trade and investments are the twin engines of Singapore’s growth. AD will increase in Singapore, leading to a higher level of employment of FOP, moving the economy closer to full employment and helping Singapore achieve actual growth with better utilisation of its resources.

The inflows of foreign investments as well as the increase in X earnings will also help to improve Singapore’s capital account as well as current account respectively, hence leading to an improvement in our BOP position since both current and capital accounts are components of BOP an appreciation of Singapore’s exchange rate.

Low inflation also protects the purchasing power of wage earners and thus the SOL of Singaporeans since more consumption can be made.

2. Sustained Economic Growth

Definition: An increase in real GNP/GDP in a country. There are two concepts of economic growth – actual and potential growth. Actual growth refers to the increase in amount of goods & services produced in a country while potential growth refers to the increase in the full employment level of national output. This can occur when there is an increase in the productive capacity of the economy due to increase in quantity and quality of factors of production as well as improvement in technology.

Measurement: % change in real GDP/GNP

Economic growth is important due to the following reasons: Economic growth raises the SOL of the population. Ceteris paribus, economic growth

means that national income increases and this means that people enjoy a greater ability to purchase goods and services and thus are able to enjoy higher material well-being. In the non-material sense, an increase in national income seen with economic growth allows the ability to gain access to better educational and healthcare facilities etc, hence the possibility of increasing the quality of life.

Economic growth is also necessary to improve the income distribution. This is because with economic growth, there will be an increase in tax revenues to be used for redistribution of incomes. In other words, economic growth means that there is a bigger pie to be shared among the population.

3. Full employment (Low unemployment)

Definition of unemployment: Unemployment occurs when a person is willing and able to work but is unable to find a job.

Unemployment is usually measured using the unemployment rate, which is the % of those in the labour force who are unemployed.

In Singapore’s case, full employment = unemployment rate of between 2 to 3%

Achieving full employment is important for the following reasons: Full employment ensures full and efficient utilisation of Singapore’s resources and

hence the country is able to attain its potential. In an economy with limited natural resources like Singapore, it is even more important to ensure that each worker is gainfully employed so that there is less wastage of scarce human capital.

Full employment also prevents the loss of potential output due to the underutilisation of resources.

It also reduces the strain on the government’s budget as there would be a greater collection of tax revenues and a lesser need to spend on providing social safety nets.

4. Healthy Balance of Payments and a stable & strong exchange rate

Definition: BOP is a record of international transactions between a country’s residents and the rest of the world. The main elements in the BOP account include both the current as well as capital/financial accounts.

A healthy BOP = BOP equilibrium that is not in a deficit.

A healthy BOP is important for the following reasons: Singapore is a country that is very dependent on international trade. Hence it is

important to maintain a healthy BOP because it has a direct impact on economic growth.

Also, a healthy BOP means that the country is accumulating foreign exchange reserves, instead of depleting it. In times of need, these reserves can be used to finance purchase of imports as well as maintaining the strength of the Singapore dollar.

A healthy BOP also signals strong fundamentals of the Singapore economy, hence attracting FDI inflows which are particularly important to enhancing the potential growth of Singapore.

For the second part of the question, students are required to identify from the preamble that

Singapore is suffering from a variety of macroeconomic problems, ranging from slow growth to cost-

push inflation during 2008. Out of the 2 sources of cost-push inflation, one of which is import-induced

inflation due to the increase in global oil and food prices and the other being cost-push inflation due to

a rise in business costs, wages and rentals in Singapore. Students are then required to evaluate the

extent to which these macroeconomic problems have been caused solely by increases in business

costs.

Thesis: To show that the rise in business costs is indeed the cause for the various

macroeconomic problems faced.

The rise in business costs, wages as well as rentals in Singapore makes the COP for Singapore firms rise significantly; producers in Singapore will therefore reduce production of goods and services, translating into a fall in the SRAS, shifting the SRAS leftwards. With less goods available in the economy, this results in an increase in general price levels from 2.1% to 6.5% in the economy and a fall in the level of national income. Hence, this rise in business costs has culminated in cost-push inflation as well as the slower growth felt in Singapore.

The higher business cost will hence raise the prices of locally-produced goods and services, which include exports, worsening Singapore’s X competitiveness. Given the export-oriented nature of the Singapore economy, the loss of X competitiveness will significantly reduce the amount of X sold since PED>1, hence lowering AD significantly in Singapore as X is a component of AD.

The higher inflation levels in Singapore also creates greater uncertainty to the prediction of profits and raises the cost of investments in Singapore, hence reducing the incentive for FDIs as well as local SMEs to invest and since investments is a component of AD, this fall in I also reduces AD. This fall in investments will create a significant negative impact on Singapore as she is very dependent on investments as an engine of growth.

On the whole, a fall in AD (or a fall in the rate of increase in AD) will lead to firms cutting back on production to reduce unplanned investment; hence this reduces the hiring of FOP, leading to greater levels of unemployment, moving the economy further away from full employment. The fall in AD in this case results in an adverse effect on actual growth and hence the fall in annual growth rate from 7.8% to 1.1%.

Anti-thesis: To show that the rise in business costs is not the only cause for the rise in

inflation rates as well as the fall in economic growth rates.

The increase in business costs due to the rise in wages and rental costs is further compounded by the rise in the global prices of food and oil. This led to the higher inflation levels faced. With increases in global prices of oil and food, Singapore firms face a rise in cost of production due to the rise in prices of imported raw materials. This is worsened by the fact that Singapore is extremely reliant on these imports. It is in fact, a combination of these increases in costs that result in the fall in the SRAS (leftward shift) due to firms cutting back on production. This led to the rise in the annual inflation rate from 2.1% to 6.5%. Therefore, the macroeconomic problems of slower growth as well as higher inflation rates in Singapore are a result of wage-push as well as import-induced inflation.

Besides, there are other external factors that have contributed to the slow growth in Singapore during the year 2008. The housing slump in the US which led to the global financial crisis have caused consumer as well as investor confidence to dip significantly worldwide and the loss in incomes also led to a significant fall in X as well as FDIs for the Singapore economy. Being extremely export-oriented and reliant on FDIs, Singapore therefore suffered a significant fall in AD (or a fall in the rate of increase in AD), which led to the slower growth as mentioned.

As a result of the global financial crisis as well as the general fall in national incomes, consumer as well as investor confidence within Singapore also fell and this leads to a fall in C and I and worsened the impact of the fall in AD (or a fall in the rate of increase in AD) in Singapore and hence the contraction of the Singapore economy. Therefore, the contraction of the Singapore economy was not solely caused by the rise in business costs, but was also largely due to the global recession.

In the long run, with a reduction in FDIs as well as local investments, there will be less resources diverted into capital accumulation and R&D. With less investments made in capital accumulation as well as R&D, productivity levels may not rise and so does productive capacity in the economy. This creates an adverse effect on potential growth.

Also, as mentioned previously, high inflation rates erode the value of savings, hence discouraging savings in the economy, the effect of this, would be a smaller amount of loanable funds available for firms to invest in capital accumulation and R&D, therefore, creating an adverse effect on potential growth as well.

Conclusion:

Rise in business costs one reason Singapore suffering from inflation as well as slower growth, it

is however, not the only cause of these macroeconomic problems. To a large extent, due to the

export-oriented, import as well as FDI-dependent nature of the Singapore economy, the economic

problems due to external factors like import-induced inflation (rise in oil & food prices) as well as

the global recession adverse effects on Singapore’s macroeconomic goals, (SR & LR). In view of

this, the Singapore government might wish to implement appropriate demand as well as supply

management policies to overcome the negative effects.

GCE ‘A’ Level 2007

“To be considered successful, an economy needs to achieve low unemployment, low inflation and stable economic growth.”

(a) Explain this statement. [12] (b) Discuss whether fiscal policy is the most effective way for Singapore to sustain a

successful economy. [13]

Part (a) - Define key terms: Low unemployment, low inflation and stable economic growth

Body:

- Explain the potential benefits brought about by low unemployment and potential costs associated with high unemployment

o The most common reasons were efficient use of a nation’s resources, low benefit payments, and low crime rates.”

- Explain the potential benefits brought about by low inflation and potential costs associated with high inflation

o Most referred to the effect on business confidence and ease of exports, with surprisingly few mentioning ‘shoe-leather’ and ‘menu’ costs.”

- Explain the potential benefits brought about stable economic growth and potential costs associated with unstable economic growth

o “Good answers explained both the need for stability and that stable growth can lead to increased standards of living and greater choice for consumers.”

Conclusion: Possible ideas

- Evaluate what is considered “low” unemployment and “low” inflation and “stable” economic growth – for instance, how low is low? What is meant by “stable”?

- Evaluate if it is possible to achieve all these objectives simultaneously. Evaluate if an economy has to accept a certain amount of tradeoffs between its objectives.

- Make a judgement regarding which is the most important objective to a government - Evaluate if these are the only yardsticks to assess whether an economy is successful. What

about other yardsticks like long run balance of payments equilibrium, minimising income inequity, efficient allocation of resources? (briefly)

Part (b)

- Define key terms: Fiscal policy refers to the use of government expenditure and taxation to influence the level of economic activity in an economy and to achieve desired macroeconomic goals. It is essentially a demand-side policy (affects the aggregate demand) but may also have supply-side effects (affects the aggregate supply).

Body: (Most effective thesis: how policy works; antithesis: limitations of policy + other

policies which include their limitations too)

- Explain how fiscal policy works o Fiscal policy is essentially a demand-side policy:

Assume an economy is in a recession, an expansionary fiscal policy will be implemented to achieve actual growth. This involves either increasing the level of government expenditure or reducing income tax rates or both. Assume the government increases the level of government expenditure, this will increase the aggregate expenditure and set off the multiplier process. Hence, real national income will increase more than proportionately to the increase in government expenditure, ceteris paribus :

Define “multiplier” and state the principle of the multiplier

Provide either the diagrammatic-stepped or numerical or intuitive illustration of the multiplier process (Diagram: Use the Keynesian Y=AE model)

- Counter-arguments: Assess the effectiveness/limitations of fiscal policy in sustaining a successful Singapore economy where the objectives are achieved:

o If the size of multiplier is small, then in order for the government to achieve a desired increase in national income, the government will have to spend an amount close to that desired increase in national income. This may exert a huge burden on the

government’s coffers who may then pass on the burden of financing onto the taxpayers

Application to the Singapore economy and its implication – implementing fiscal policy in Singapore has limited impact on the level of national income in Singapore:

Size of multiplier is small

Prudent and cautious philosophy on how and when to implement a budget deficit

Long run budget surplus o Cutting income tax rates may see even more limited results than increasing

government expenditure on aggregate demand as households may choose to save the increase in disposable income rather than to spend it on consumer goods and services

o Complementarity vs conflicts between economic objectives arising from implementing an expansionary fiscal policy:

Increase in G increase in AD increase in real national income and reduction in unemployment but an increase in inflation and worsening of balance of trade (& balance of payments), ceteris paribus

Cutting income tax rates but increasing goods and service taxes

Promotes actual growth but at the expense of income distribution o Application to the Singapore economy:

Tax system is becoming more regressive o Time lags

Application to the Singapore economy and its implication: May not be a serious problem given its

Efficient government

Small domestic market o Eventually, increases in AD alone will lead only to higher inflation without a

corresponding increase in real national income if the increase in AD is not accompanied by an increase in the productive capacity of the economy (outward shift of the AS curve)

Yet Fiscal policy may have result in supply-side effects:

If the government were to spend on education, R&D and infrastructure, in the long run, the productive capacity of the economy will increase. Likewise, when the government cuts income tax rates, this may improve work incentive, causing workers to work harder and become more productive, increasing the output per worker. Firms may also

increase their level of investment in the country and in turn, the productive capacity of the economy increases.

o In the long run, when aggregate supply increases, this will result in both actual and potential growth (sustainable economic growth), lower unemployment and lower inflation. Lower inflation brings with it other benefits like improved export competitiveness should domestic inflation be lower relative to inflation rates in foreign countries

o Application to the Singapore economy and its implication: Given its limitations as a demand-management tool

in Singapore, Fiscal policy in Singapore is targeted mainly at the supply-side

- Alternative policies for the Singapore economy

o Monetary policy centred on Exchange rate policy Explains how it works in Singapore

Singapore lacks control over her interest rates and money supply o Small open economy price taker (follow interest rates

movement of bigger economies like the US) o Limited capital controls o Impossible trinity (cannot control interest rates, money supply

and exchange rate simultaneously)

Singapore operates a managed float exchange rate system (allows market forces to determine the external value of the Singapore dollar but intervenes occasionally when the domestic currency appreciates

above or depreciates below the band. MAS intervenes by buying or selling the domestic currency in exchange for foreign currencies. Alternatively MAS may shift the band upwards or downwards to allow the Singapore dollar to appreciate or depreciate further respectively. MAS may also widen or narrow the band.

ER policy is able to keep out imported inflation. ER policy is used as a demand-management policy to reduce inflation or to improve export competitiveness, and hence BOP

Evaluate the effectiveness or limitations of Exchange rate policy in Singapore

Trade-offs between policy objectives: o A stronger Singapore dollar will lead to lower inflation but

reduce export competitiveness, particularly in the service industry (e.g. tourism industry) which has little or no import content

o E.g. Philips Curve: Trade-offs between lower inflation and higher unemployment

To minimise such unwanted side effects, anti-inflationary measures should target the cause of inflation. E.g. Structural rigidity inflation would best be addressed via retraining and skills upgrading (supply-side policies)

o Supply-side policies

Explains how it works in Singapore Evaluate the effectiveness

Time lag

Results not guaranteed

Conclusion: Possible ideas

- Evaluate if fiscal policy is the best policy, given the availability of other policy options to help Singapore sustain a successful economy.

o It depends on the objective the Singapore government is targeting at that point in time. For instance, ER policy is more effective than fiscal policy in lowering inflation in the short run. ER policy is also able to keep out imported inflation but fiscal policy cannot.

- Evaluate if there is necessarily a best policy or if a combination of policies is needed to achieve a number of objectives simultaneously.

o Tinbergen principle: Tinbergen was able to show that there is a need for at least as many instruments of control

as there are goals or important dimensions to a problem. Jan Tinbergen was awarded the

Nobel Prize in Economics (1959) partly for developing this concept. The Tinbergen

Principle is usually talked about by those interested in macro-economic policy. A separate

instrument must be used to address each policy goal, objective or target. That is, there

must be as many instruments of control as there are important dimensions to a problem.

GCE ‘A’ Levels 2009

The relative importance of the components of the circular flow of income for a small and open

economy, such as Singapore, is likely to be different from a large and less open economy,

such as the USA.

(a) Explain this statement. [10]

(b) Assess whether a change in the external value of its currency is more likely to have a

larger impact on Singapore or the USA. [15]

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 US.

- For consumption C, it is obvious that C would likely take up a significantly smaller proportion of GDP for Singapore as compared to US: o it has a significantly smaller domestic market compared to US. 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 US as compared

to Singapore, thus accounting for its relative importance to US.

- 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 US: 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.

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 to US, 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 US as compared to that of Singapore: o US operates under a huge budget deficit 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:

- Change in external value of the currency can analyse appreciation/depreciation on the economy.

- Define the scope of the answer impact of change in currency value on economic growth, unemployment rate, inflation rate and balance of payments.

Body: Explain the impact of changes in currency on the economy

- When S$ appreciates against other currencies or US$ appreciates against other currencies” o This will cause the prices of Singapore/US exports to increase (in terms of f.c.).

Exports will become less competitive. This will cause quantity demanded for exports to fall.

o This will cause prices of imports to fall (in terms of d.c.). This causes quantity demanded of imports to increase.

o Assuming M-L condition holds, NX will fall in Singapore and the US. o Fall in NX will lead to a fall in AD

Fall in national income (through the k-process) Increase in unemployment rate dampen inflationary pressure worsen the current account balance

- Assess whether it is going to have a larger impact on Singapore or US o Singapore:

Exports is a large component of Singapore GDP (% of GDP), and has a larger component of GDP as compared to the US. Any fall in NX will lead to a significantly larger fall in AD in Singapore, as compared to US.

This will impact Singapore’s economic growth more significantly than US. Singapore is also more reliant on imports as compared to the US. The

appreciation of the currency will cause price of imports to be lower, hence dampening imported inflation, causing a greater fall in the CPI, as compared to the US.

Current account will also worsen to a larger extent in Singapore as compared to the US.

o USA The size of multiplier is larger for USA compared to Singapore (due to high

withdrawals – High MPS and MPM). For any given change in NX due to changes in external value of the currency, it will have a larger impact on AD. This will have a larger impact on USA’s economic growth, unemployment rate and inflation rate.

Conclusion:

- The impact on both economies for a given change in external value of the currency depends on: o The M-L condition o NX as a component of GDP o Size of the multiplier

- The changes in exchange rate seem to have a larger impact on Singapore than the US, given that Singapore is a lot more reliant on the external economy (small and open).

GCE ‘A’ Levels 2007

(a) Explain the potential causes of a balance of payments deficit on current account. [10]

Introduction

Define BOP

Define current account

Body (Discuss only 3 of the below causes)

Cause 1: Appreciation/Revaluation of the domestic currency Px rises in terms of foreign currency, Pm falls in terms of local currency Assuming price elastic demands for exports and imports Qdx falls and Qdm rises more than proportionately TR from exports falls, TE on imports rises BOT, ceteris paribus, current account worsens and may incur a deficit

(Alternatively, assume ML condition (state) is satisfied BOT and hence CA balance worsens)

Cause 2: Higher inflation in the domestic market relative to other countries

Cause 3: Rise in income in domestic country relative to foreign countries OR fall in income in foreign countries relative to domestic country Perhaps due to recession in export markets

Cause 4: Loss of comparative advantage Due to rise of other countries as new providers (eg China, India) cost advantage lost

relative price level compared to other countries rises …

Cause 5: Drop in tastes and preference towards domestic goods and services OR rise in tastes and preferences towards foreign goods and services Maybe due to quality of exports and imports

Cause 6: Inflation in foreign country OR devaluation/depreciation of local currency Assuming price inelastic demands for exports and imports(eg oil) in SR CA worsens;

feeds into domestic inflation affects price competitiveness of X … Alternative approach (using lecture notes arrangement) Cyclical factors

Cyclical fluctuations in NY and general price levels of trading countries Structural factors

Changes in dd for specific X and M Changes in tastes and preferences; distribution of Y, availability &/or prices of related

gds; changes in tech; shifts in CA Other factors

Changes in exchange rate Government policies (eg protectionism) Random factors (war, natural disasters Japan: increase in M of capital gds &

consumption gds rebuilding; fall in X: destruction of industries) (b) Discuss which measures, if any, a government should adopt when confronted with a current account deficit. [15]

Introduction

Current account deficit M > X

Briefly suggest why this might be a problem Limited foreign reserves cannot finance deficit indefinitely depletion of reserves Foreign debt Earnings of country diverted to service debt in future lower Y & SOL

Outline the different exchange rate systems Body No measures needed if

Flexible exchange rate system with ML condition satisfied Automatic correction of a current account deficit explain process!

Surplus on capital and financial account offsets the deficit BOP remain a healthy position

Temporary and/or mild current account deficit (relative to size of foreign reserves)

Measures required if

No self corrective mechanism (eg fixed exchange rate system) Long-term deficit Measures must address cause of the problem; measures aim to reduce M / increase X Expenditure-reducing policies (if cause is due to higher inflation rate in domestic market relative to other countries):

Contractionary FP (reduce G / increase T) explain!

Contractionary MP (reduce i/r) explain!

Relieves inflationary pressures improve price competitiveness of X

Fall in NY fall in consumption of M + increases excess capacity in domestic industries induce them to seek extra X mkts to use up spare capacity

Limitations - Trade-off with growth/employment rather than prices depress I and potential growth

- Income elasticity of demand for imports - Ceteris paribus assumption what if other countries incomes are also falling? -

Expenditure-switching policies switch away from M to domestically produced substitutes)

Devaluation explain! raise domestic Pm M relatively dearer to domestic substitutes - Limitations: J-curve effect, inflation worsens in import-dependent countries, retaliation -

Protectionism (e.g., import controls like tariffs and quotas, export subsidies) explain! link to Cause 5

- Limitations: inefficiency(support inefficient domestic firms; deadweight loss; does not address root cause of problem), retaliation, sustainability (quotas require additional admin expenses to monitor adherence; X subsidies require high G)

Measures to increase X Promote price competitiveness of X through maintaining production costs at competitive levels, increasing productivity, engaging in R&D

(process innovation) Wage and price controls in domestic country link to cause 2 Restructuring of the economy link to cause 4

Improve non price competitiveness Product innovation creating better design; improving quality of goods produced

Government regulation to control quality of X link to cause 5 Intensive X promotion (international fairs; trade missions overseas)

Limitations Inefficiency Time lag Structural unemployment in the interim period

Conclusion Need to correct if current account deficit is a problem; but it may not be a problem. For managed float no measures needed with correction occurs within the band, but if correction can only be corrected outside the band, then the central bank must step in. Even under flexible exchange rate system, governments may not want to wait for automatic correction in the LR immediate solution may be required depends on urgency of the problem at hand. SR vs LR: supply-side policies might be better in the LR

International Trade a. “Both trade barriers and barriers to entry into an industry result in inefficiency.” Explain

this statement. [12]

b. Does free trade necessarily lead to an increase in the standard of living in a country? [13]

Suggested Answer Scheme

Part a

Introduction:

Define trade barriers

Define barriers to entry

Define inefficiency

Development:

Explain how trade barriers result in inefficiency

- Explain inefficiency of any trade barrier using a diagram, - - e.g.,

o Tariff o Quota o Export subsidies

- Explain clearly changes in surpluses and the resulting deadweight loss Explain how barriers to entry into an industry result in inefficiency

- Allocative inefficiency diagram for imperfect competition - Explain clearly P ≠ MC and deadweight loss - Can also bring in X-inefficiency (in words; for monopoly)

Conclusion:

Possible Counter-argument

Trade Barriers:

- LR vs SR

May be efficient in LR despite SR inefficiency short term pain for long term gain (infant industry argument/protect industries that are deemed to possess a potential comparative advantage in the production of the good; however such barriers should be imposed only temporarily and lifted once the industry develops a comparative advantage in the production of the good)

Barriers to entry into industry:

- Possible dynamic efficiency The supernormal profits which the monopolist earns provide the firm with funds to engage in research and development and innovation and in turn, achieve dynamic efficiency. This is further reinforced by the fear of competition/contestability of markets

Suggest how trade barriers are possibly a subset of barriers to entry into an industry

- Trade barriers could effectively act as barriers to entry into an industry - E.g., goods and services which are sold exclusively by a Singapore industry may be protected

from foreign firms from by both trade barriers and barriers to entry into the Singapore industry - Implication: in this case, removing trade barriers will effectively remove barriers to entry and

may force firms in that industry to become more efficient

Part b

Introduction:

Clarify “free trade” no trade barriers (protectionism)

Clarify “standard of living”

- Material standard of living – real GDP per head, income gap - Non-material standard of living – pollution, working hours, education and healthcare

Development:

1. Free trade leads to higher SOL

I. Consumption o With reference to the theory of comparative advantage, explain how specialization

and free trade maximizes the gains from trade and lead to increases in consumption levels for the countries that practice free trade

- Increase in consumption levels increase in material standard of living The theory of comparative advantage: Law/principle Assumptions Tables and explanation of each table

o Free trade increases not only the quantity of imported goods but also its variety and quality which enhances material SOL

II. Real GDP per capita o Explain how free trade leads to increased output using the AS-AS model o Free trade enables the exporting country to export more overseas

- Increase in net exports increase in AD more than proportionate increase in GDP and national income (multiplier effect – brief explanation) Increased income to spend on material possessions. (Note that the effect on real GDP per capita may depend on the inflation rate and changes in population size)

o Why “real”? takes into account inflation; - Cheaper imported goods lower cost of living in importing country - Cheaper imported raw materials reduction in cost of producing

domestically produced goods dampen cost-push inflation (AS curve shifts to the right)

- Force domestic firms in import substituting industries to be as cost efficient as possible since they now face greater competition from the cheaper imports

o Why “per capita” takes into account changes in population size III. Directly aids workers in third-world countries (comparative advantage in labour-intensive

products) 2. Free trade does not lead to higher SOL

Note that the discussion must include non-material issues like pollution, average number of working hours, the provision of education and healthcare

- Pollution due to industrialisation following free trade fall in non-material SOL - Increasing income gap that may arise due to trade – eg. trade sector benefits while sector

producing for domestic economy may remain stagnant - Increase in GDP due to labour working longer hours or exploitation through cheap wages

does not increase the standard of living. - Free trade does not automatically translate into a higher non-material standard of living.

Need government efforts to trickle the ‘fruits of success’ down to the masses especially through the subsidising of education and healthcare. (explain the impact of both on the standard of living).

- Import of demerit goods negative externalities fall in SOL (qualitative measure) - Other trade-specific issues:

Infant industries not protected may never take-off potential SOL not achieved Import substitution and loss of comparative advantage experience a fall in production and hence, jobs are lost; the retrenched workers may lack the skills to take up jobs in other industries and hence remain structurally unemployed loss of income fall in SOL for the retrenched workers (especially for developed countries)

Conclusion:

Make a stand and justify Winners vs losers in free trade net effect: benefits outweigh costs overall net increase in SOL compared to if there were protectionism may experience short-term pain for long-term gain

There is a general consensus among economists that protectionism is a bad thing.

a. Explain why protectionism exists. [8]

b. Assess the extent to which the Singapore government’s approach to international trade

needs to be adjusted in response to a growth in worldwide protectionism.

[17]

Part (a)

Define Protectionism

Protectionism is a policy of sheltering domestic industries from foreign competition through the imposition of

trade barriers on imports.

Reasons for protectionism (Explain any 3 reasons)

1. To protect strategic, infant or mature industries from cheaper imports

In the case of strategic industries e.g. good the government aims to reduce dependence on foreign countries e.g. agriculture.

Infant industries will not realize potential comparative advantage if they are not guaranteed demand from the domestic market.

Mature industries that have lost their comparative advantage may be in decline. The government may need to slow down the decline to prevent massive structural unemployment.

Use tariff diagram to analyze increase in domestic production and producer’s surplus.

2. Expenditure switching (especially in times of recession)

To divert consumption from foreign goods to domestically produced goods fall in M, cet par, improve trade balance boost domestic consumption increase AD actual economic growth

Use AD-AS model to analyze growth

Examples: Import substitution strategies pursued by many countries e.g. Singapore and Japan during the

early phase of industrialization; The recent global financial crisis also led some countries to resort to

protectionism as an emergency measure.

3. To protect domestic workers against competition from low wage countries

Pauper labour argument – Low wages in developing countries due to weak labour laws that allow workers there to be exploited results in low priced products. Competition from these cheap imports will drive wages in developed countries down if domestic firms are to survive the international competition.

4. Other possible reasons (to protect against unfair trade practices, to diversify the economy, to increase government revenue).

Conclusion:

The existence of protectionism goes against the Law of Comparative Advantage and limits the gains from

trade. The existence of protectionism is difficult to justify in the long run.

Part (b)

Introduction:

Approach to trade is seen in the county’s openness to free trade and policies undertaken to promote export growth. In view of its small domestic market and high degree of openness, Singapore has been active as a free trade advocate and its current trade policies include supply side policies aimed at increasing the competitiveness of export industries, exchange rate policies, and preferential trading (spearheading regional and bilateral free trade agreements)

Thesis (1): In terms of openness, Singapore should not adjust its approach to free trade by turning

protectionist because it is detrimental to our economy.

Restricting imports will cause a rise in our cost of production and lead to imported inflation.

Singapore’s lacks resources. Raw materials and intermediate goods need to be imported.

A high percentage of exports comprises of re-exports.

Higher price of imported inputs leads to an increase in cost of production.

The aggregate supply curve will shift upwards to the left, driving prices up.

Ultimately higher prices would affect export competitiveness.

Other reasons

Too small a domestic market, openness to trade allows Singapore to produce on a larger scale, enjoy iEOS and export to its trading partners.

By being open to free trade, its domestic industries will be subjected to heightened competition, impetus to raise productivity levels, to innovate in order to stay competitive.

Impetus for Singapore to keep shifting its comparative advantage in the face of changes global economic trends. Allows Singapore to explore and exploit niche areas and build new areas of comparative advantage so as to avoid its exports being subjected to protectionist measures.

Anti-thesis to (1): In view of rising protectionism, the gains from trade are reduced, and the approach to free trade should be adjusted accordingly.

The fall in export revenue when other trading partners unilaterally impose tariffs on our exports, will result in a lower AD for Singapore.

There is some merit in boosting domestic consumption to act as a buffer against a possible decline in AD caused by the trend in worldwide protectionism in light of the global economic downturn.

The objective of protectionism is to switch expenditure away from imports to domestic production boost domestic consumption.

The use of expenditure switching policies by Singapore may help to increase AD and achieve growth, even though it may be seen as unfair trade. However, this is at best a short-term measure given that the multiplier is small for Singapore.

Synthesis: Expenditure switching will not result in strong economic growth due to the small domestic

market size.

Due to the small market, the increase in domestic consumption from protectionism may not be significant.

Moreover, possible retaliation may further dampen growth by reducing exports

Free trade is still the best approach for Singapore even if other countries are protectionist since the benefits of restricting imports to Singapore are marginal.

Thesis (2): Exchange rate policy is effective when protectionism is rising

Explain the objectives of gradual appreciation and non-appreciation (neutral stance) as used by the MAS.

With rising protectionism and slow growth in exports, a weakening of the SGD leads to increase export competitiveness and improves the balance of trade, assuming the Marshall Lerner condition holds.

Anti-thesis to (2): Use of exchange rate policy may need some reconsideration in view of rising

protectionism

Currency devaluation or non-appreciation to boost export competitiveness in a recession is a ‘beggar thy neighbour’ policy It hurts the exports of competing countries, and increases the trade deficits in importing countries.

In view of rising protectionism, such a policy may invite retaliation or lead to competitive devaluation among countries.

A trade war will have an adverse outcome on the balance of trade. Thesis (3): The policy of free trade agreements should not be changed as it insulates the exports from rising worldwide protectionism

FTAs are legally binding agreements to reduce barriers to trade.

Singapore has already signed FTAs with its major trading partners.

Access to export markets is secured via the current policy of signing FTAs.

Exports are likely to be unaffected by the wave of protectionism if Singapore has an extensive network of FTAs.

Evaluation: Limitations of FTAs

Due to the numerous rules and regulations involved, FTAs may be not be fully utilized by domestic firms (the noodle bowl problem).

The current trend in regional free trade agreements e.g. ASEAN-China FTA may help to establish a common set of regulations for firms to comply with and therefore lessen the problem.

Thesis (4): The use of supply-side policies should be continued as it is effective in increasing export

competitiveness when protectionism is rising.

Examples of supply-side policies include grants for R&D, provision of infrastructure, subsidies for training etc.

The aim of these initiatives is to the increase productivity and competitiveness in high growth sectors.

Such policies will result in price competitive and better quality exports.

Export capability is enhanced in this way despite the protectionist measures imposed by foreign countries.

Supply-side policies are usually effective in the long-term, and are unaffected by temporary episodes of protectionism.

Anti-thesis to (4): Supply side policies should target the exports in the services sector when protectionism is growing

The government should provide greater incentives (subsidies, training, infrastructure) to promote investments in the services sector e.g. education, healthcare, logistics, financial and legal services.

This is because, unlike manufacturing, transactions in services are usually insulated from protectionist measures e.g. tariffs or quotas. Many of these transactions involve the use of Information, Communication and Technology (ICT), and hence it is not feasible for foreign countries to restrict them.

Synthesis/Conclusion While the current approach to trade will yield benefits in the long-tem, the growth in protectionism requires some minor adjustments to be made in the short-term in order to level the playing field.

Make a recommendation on which aspects of our trade policy should be adjusted and a judgment on the extent of the change required.

President Barack Obama's campaign promises and his economic stimulus package's "Buy American" provision to support domestic manufacturers and workers has sparked fears in many of its trading partners.

(a) Is unemployment always caused by competition from cheaper imports? (10) (b) Discuss the seeming view of US President Obama that protectionism is a justifiable means of supporting domestic manufacturers and workers? (15)

Part (a)

Introduction:

Define unemployment

Define imports

Body:

Thesis

1. Structural unemployment Define structural unemployment

Cheaper imports due to other countries’ comparative advantage in labour-intensive manufacturing can lead to structural unemployment. Domestic firms are unable to compete with cheaper imports due to loss or absence of CA. When domestic production of import substitutes fall, the demand for labour also falls (since labour is a derived demand). Workers who are retrenched may not be able to secure jobs in other industries as they may lack the necessary skills required by those industries, resulting in structural unemployment.

Economic framework to use: Free trade diagram, Theory of comparative advantage (numerical

illustration not relevant here)

2. Demand-deficient unemployment Define demand-deficient unemployment

With cheaper imports, demand for imports will increase leading to an increase in the value of imports and in turn, a fall in the value of net exports, ceteris paribus. This will reduce AD and lead to a more than proportionate fall in NY, ceteris paribus. When production falls, demand for labour will also fall since labour is a derived demand.

Anti-thesis:

However, there may be other reasons leading to these 2 forms of unemployment apart from cheaper

imports:

I. Structural unemployment can also be caused by technological advancement (new techniques of production) or changes in the pattern of demand due to changes in taste and preferences as well, aside from cheaper imports.

II. DD-deficient unemployment can be caused by a myriad of other factors leading to a fall in AD (affecting C, I, G or X). In other words, cheaper imports is only 1 of the reasons that can account for a fall in AD.

III. In addition, there are other forms of unemployment which are not linked to cheaper imports: a. Frictional unemployment b. Seasonal unemployment c. Real wage unemployment

Conclusion

Part (b)

Whether protectionism is a justifiable means of supporting domestic manufacturers and workers depends on whether the cheaper imports are due to other countries possessing a genuine Comparative Advantage in the production of the good or other countries are engaging in unfair trade practices like ‘dumping’ and keeping the exchange rate artificially low.

Body

Thesis:

I. Protectionism is justifiable from the importing countries’ perspective (in this case, USA) if the country from which it imports is engaging in unfair trade practices such as ‘dumping’ or keeping exchange rate artificially low. Protectionism prevents foreign firms (and countries) engaging in unfair trade practices from driving domestic firms out of business and gaining a monopolistic position in the future. It warrants retaliation. (“An eye for an eye?” But “Two wrongs don’t make it right”!) Economic terminology: Define and explain “dumping”

II. Protectionism is justifiable if it is able to help infant industries develop a comparative advantage in the production of the good. However, the protection should be lifted once the infant industries have developed a CA in the production of the good.

III. Protectionism is justifiable if it is implemented to prevent massive structural unemployment from arising in for example, sunset industries. However it should be implemented only temporarily to allow sufficient time for the retrenched workers to gain a new set of skills relevant to sunrise industries that require them.

Antithesis:

However, while protectionism will help reduce unemployment in the short-run by allowing greater

domestic production but there are serious problems associated with protectionism:

1. Tariffs result in allocative inefficiency, and lead to the creation of dead weight losses. 2. Difficult to remove once imposed and thus a hindrance to the impetus of industrial restructuring

(reallocating resources to more efficient industries). 3. May not address the root cause of the problem in that even with protectionism, demand for US

goods may not necessarily rise, given the current recession. 4. Invites retaliation which may lead to greater demand-deficient unemployment and impact the

export industries adversely. 5. Lead to greater imported inflation.

Alternative policies

1. Supply-side measures may be more effective in the LT to deal with the unemployment: a. Retrain workers so as to improve labour mobility thus addressing structural

unemployment. b. Find a new comparative advantage in a new industry. c. Improve the productivity and quality of exports through R&D

2. Use demand-management measures to address demand-deficient unemployment i. Evaluate the effectiveness and desirability of alternative policies

Conclusion

Protectionism may suffice to alleviate unemployment in the light of the current economic crisis, but only as a SR measure. To support domestic manufacturers and workers on a long run basis, America needs to address the root cause(s) of each of the problem(s) and implement policies to address these root causes.

Theory of Comparative Advantage (David Ricardo) – for questions that test on CA theory

Explain how free trade may lead to an increase in total world output

Suggested answer:

The theory of Comparative Advantage (CA) states that so long as a country has comparatively lower opportunity

cost in the production of a good (ie. it has comparative advantage), specialization and trade can benefit itself and

its trading partner. The theory assumed that there are two countries, two commodities, no currency nor trade

restrictions, no transport costs, perfect factor mobility and constant returns to scale (ie. constant opportunity

costs).

Suppose country A and country B each has 10x resources. Prior to specialization and trade, given x amount of

resources, country A produces 20 units of cloth and 200 units of wheat, while country B produces 10 units of

cloth and 150 units of wheat. If each country were to devote half of its resources to produce the two commodities,

their respective production level is as follows:

Table 1: Production pattern before specialisation and trade

With 5x resources, Cloth Wheat

Country A can produce 100 and 1000

Country B can produce 50 and 750

Total World Output 150 and 1750

Thus the total output produced by the two countries is 150 units of cloth and 1750 units of wheat.

In terms of amount of resources used, the costs of production in both commodities are lower in country A, where

the opportunity cost of 1 unit of cloth is 10 units of wheat. On the other hand in country B, the opportunity cost of

1 unit of cloth is 15 units of wheat. In terms of output of wheat forgone, cloth is relatively cheaper in country A

than in country B. Hence, country A has CA in cloth and country B has CA in wheat.

Now let country B who has an absolute disadvantage in both commodities to completely specialize in the

commodity it has CA (wheat) while country A partially specialize in the commodity it has CA in (cloth). If country

A allocates 8x amount of resources to produce cloth and 2x amount of resources to produce wheat, given such

specialization, the production level by both countries is

Table 2: Production pattern with Specialisation

Cloth Wheat

Country A produce 160 and 400

Country B produce 0 and 1500

Total World Output 160 and 1900

The total world output will then be 160 units of cloth and 1900 units of wheat. It can be seen that total world

output has increased by 10 units of cloth and 150 units of wheat as compared to the situation before

specialization. This is a result of better re-allocation of resources world wide.

Hence although a country has absolute advantage in the production of both goods, specialization and trade will

lead to an increase in world output and allow both countries to obtain gains from trade.

To show how individual countries benefit from trade, then the following would then be required:

As mentioned previously, the opportunity costs in countries A and B are 1C:10W and 1C:15W respectively. In

order for both countries to benefit from trade after specialization, the terms of trade has to be acceptable to both

countries, where 1 unit of cloth is to be exchanged for 10 to 15 units of wheat. Suppose the terms of trade settles

at 1 unit of cloth for 12 units of wheat and 55 units of cloth are exchanged for 660 units of wheat,

Table 3: Consumption pattern after trade

Cloth Wheat

Country A now has 105 and 1060

Country B now has 55 and 840

Total World Output 160 and 1900

In comparison to the situation before specialization and trade (Table 1), country A has gained 5 units of cloth and

60 units of wheat while country B has gained 5 units of cloth and 90 units of wheat. Thus the theory of CA shows

that both countries benefit from specialization and trade.

Note

Free trade can only benefit the individual economy if the rates of exchange (terms of trade) are within the respective opportunity cost ratios.

Even then, it does not mean that the gains will be equally shared so that there will be equal benefit to the participating country. Bargaining strengths of countries also affect how the gains will be shared.

In the modern context, countries that produce and export primary products have failed to benefit from free trade because the terms of trade for their goods have been deteriorating. This is due to the changes in demand and supply conditions as well as inelastic demand for and supply of the goods. (Demand development of synthetic substitutes,

lower income elasticity of demand as compared to manufactured goods. As world income

rises, dd for primary products rise at a slower rate as compared to dd for manufactured

goods. Hence prices of the primary products rise slower than that of manufactured goods.

Countries that export primary products and import more manufactured goods will experience

deteriorating TOT.

Supply rapid improvement in technology, weather conditions)

A diagrammatic illustration is also acceptable to illustrate advantages of trade (greater world output and higher consumption of goods and services) refer to lecture notes on Pg 7-8

Need to remember that if question asks for Advantages on Trade, CA theory alone is NOT enough need to give other advantages which can be also found in the lecture notes from Pg 7 - 9