Written by: Edmund Quek

CHAPTER 19 MACROECONOMIC POLICIES

LECTURE OUTLINE 1 1.1 1.2 1.3 1.4 2 2.1 2.2 2.3 2.4 3 3.1 3.2 3.3 4 5 DEMAND-SIDE POLICIES: FISCAL POLICY The objective of fiscal policy The limitations of fiscal policy The supply-side effect of fiscal policy Fiscal policy in Singapore DEMAND-SIDE POLICIES: MONETARY POLICY The objective of monetary policy The limitations of monetary policy The supply-side effect of monetary policy Monetary policy in Singapore EXCHANGE RATE POLICY The objective of exchange rate policy The limitations of exchange rate policy Exchange rate policy in Singapore SUPPLY-SIDE POLICIES PRICES AND INCOME POLICIES (optional)

References John Sloman, Economics William A. McEachern, Economics Richard G. Lipsey and K. Alec Chrystal, Positive Economics G. F. Stanlake and Susan Grant, Introductory Economics Michael Parkin, Economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics

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Written by: Edmund Quek

1 1.1

DEMAND-SIDE POLICIES: FISCAL POLICY The objective of fiscal policy

Demand-side policies are policies that are used to influence aggregate demand. There are two demand-side policies: fiscal policy and monetary policy. Fiscal policy is a demand-side policy that is used to control government expenditure or taxation to influence aggregate demand. Expansionary fiscal policy To increase economic growth or reduce unemployment, the government can increase aggregate demand by increasing expenditure on goods and services or by increasing consumption expenditure through decreasing direct taxes or through increasing transfer payments. In addition to increasing consumption expenditure, a decrease in corporate income tax will also increase investment expenditure and hence aggregate demand. Contractionary fiscal policy To reduce inflation, the government can decrease aggregate demand by decreasing expenditure on goods and services or by decreasing consumption expenditure through increasing direct taxes or through decreasing transfer payments. In addition to decreasing consumption expenditure, an increase in corporate income tax will also decrease investment expenditure and hence aggregate demand. In reality, contractionary demand-side policies are more commonly used to reduce the growth of aggregate demand.

1.2

The limitations of fiscal policy

Inflexibility of government expenditure and taxation Increasing government expenditure and changing taxation involve a high degree of inflexibility because fiscal budgets are subject to parliamentary debates and approvals, which may take weeks, if not months. This is commonly known as the decision time lag. It is also difficult to decrease government expenditure significantly as a large part of it is made in important areas such as education, healthcare, infrastructure and national defence. Crowding-out effect (only for expansionary fiscal policy) An increase in government expenditure not financed by taxes will lead to a budget deficit. When the government runs a budget deficit, it will issue securities (i.e. bonds and bills) to finance the deficit, assuming it does not have sufficient reserves. When this happens, the demand for loanable funds will rise which will lead to a rise in interest rates. Higher interest rates will reduce investment expenditure and consumption expenditure which will partially offset the initial increase in government expenditure. This is known as the crowding-out effect.

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Small multiplier An economy with high income taxes, high savings and high imports will have a small multiplier which will limit the effect of fiscal policy on the national income, unemployment and inflation. Effectiveness time lag The effect of fiscal policy is spread out over time and hence the full effect will be realised only after a period of at least several months. Note: Loanable funds can be defined as funds available for loan in the form of bank loans or funds available for loan in general. By the first definition, the supply of loanable funds will fall when the government issues securities to finance a deficit. By the second definition, the demand for loanable funds will rise. In either case, interest rates will rise. I use the second definition. It is important to note that some of the limitations of fiscal policy do not apply in Singapore which will become obvious by the end of this chapter.

1.3

The supply-side effect of expansionary fiscal policy

Fiscal policy is referred to as a demand-side policy because it is used to influence aggregate demand. However, it may also have an effect on aggregate supply in the long run. For instance, an increase in government expenditure on education and training will increase the productivity of the labour force. An increase in government expenditure on research and development will increase the productivity of the capital stock. An increase in government expenditure on infrastructure will increase investment expenditure and hence the size of the capital stock. An increase in government expenditure on capital goods will increase the size of the capital stock. A decrease in corporate income tax will increase expected after-tax returns on planned investments and hence investment expenditure resulting in an increase in the size of the capital stock. A decrease in personal income tax will increase the incentive to work and hence the size of the labour force. However, when economists talk about fiscal policy, they are normally referring to the use of it to influence aggregate demand.

1.4

Fiscal policy in Singapore

The Singapore government has adopted a prudent fiscal policy to provide mainly essential goods and services. Therefore, the government expenditure in Singapore is only about 10 per cent of the national income compared to about 20 per cent in the US. As a result, the Singapore government has consistently achieved modest budget surpluses in normal years and has hence built up a large amount of reserves.

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Due to the small multiplier in Singapore and the small government expenditure relative to the exports, the fiscal policy is used for its supply-side effect to increase aggregate supply and this is commonly known as fiscal policy with a supply-side intent which involves an increase in government expenditure on education and training, research and development or infrastructure, or a decrease in corporate income tax, or to a lesser extent, personal income tax. Assuming aggregate demand in Singapore is rising, which is the normal state of the economy, an increase in the aggregate supply will lead to higher economic growth and lower inflation. Expansionary fiscal policy is used in Singapore in recession years such as the 2008-2009 global financial crisis. However, unlike many other economies where expansionary fiscal policy is used to increase aggregate demand in times of recession, due to the small government expenditure in Singapore relative to the exports, it is used mainly to cushion hardship in recession years in Singapore in the form of giving transfer payments to households and firms. Contractionary fiscal policy is not used in Singapore in times of high inflationary pressures. Due to the small size of the government expenditure in Singapore, there is limited room for decreasing government expenditure. Further, the Singapore government does not favour increasing direct taxes as this will have an adverse effect on inward FDI and immigration of foreign talents.

2 2.1

DEMAND-SIDE POLICIES: MONETARY POLICY The objective of monetary policy

Demand-side policies are policies that are used to influence aggregate demand. Monetary policy is a demand-side policy that is used to control the money supply and hence interest rates to influence aggregate demand. Expansionary monetary policy To increase economic growth or reduce unemployment, the central bank can increase aggregate demand by increasing the money supply. If the central bank increases the money supply, interest rates will fall which will lead to an increase in aggregate demand due to three reasons. First, lower interest rates will reduce the incentive to save which will lead to an increase in consumption expenditure. Second, lower interest rates will lead to more profitable planned investments resulting in an increase in investment expenditure. Third, lower interest rates will lead to a decrease in hot money inflows and an increase in hot money outflows and hence a decrease in the demand for domestic currency and an increase in the supply of domestic currency resulting in a fall in the exchange rate. When domestic currency depreciates, domestic goods and services will become relatively cheaper than foreign goods and services which will lead to an increase in net exports. The increase in consumption expenditure, investment expenditure and net exports will lead to an increase in aggregate demand.

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Contractionary monetary policy To reduce inflation, the central bank can decrease aggregate demand by decreasing the money supply. If the central bank decreases the money supply, interest rates will rise which will lead to a decrease in aggregate demand due to three reasons. First, higher interest rates will increase the incentive to save which will lead to a decrease in consumption expenditure. Second, higher interest rates will lead to less profitable planned investments resulting in a decrease in investment expenditure. Third, higher interest rates will lead to an increase in hot money inflows and a decrease in hot money outflows and hence an increase in the demand for domestic currency and a decrease in the supply of domestic currency resulting in a rise in the exchange rate. When domestic currency appreciates, domestic goods and services will become relatively more expensive than foreign goods and services which will lead to a decrease in net exports. The decrease in consumption expenditure, investment expenditure and net exports will lead to a decrease in aggregate demand. In reality, contractionary demand-side policies are more commonly used to reduce the growth of aggregate demand. Note: Hot money refers to money that moves quickly between countries in search of the highest short-term returns. For simplicity, students can think of hot money inflows as bank deposits that flow into the economy and hot money outflows as bank deposits that flow out of the economy. 2.2 The limitations of monetary policy

The demand for money is interest elastic (only for expansionary monetary policy) If the demand for money is interest elastic, which is likely to occur at low interest rates, an increase in the money supply will not lead to a significant fall in interest rates.

In the above diagram, an increase in the money supply (M) from M0 to M1 leads to only a small fall in the interest rate (r) from r0 to r1. Examples include Japan and the US where the interest rates are very low.

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Investment is interest inelastic If investment is interest inelastic, a change in interest rates will not lead to a significant change in investment.

In the above diagram, a fall in the interest rate (r) from r0 to r1 leads to only a small increase in investment (I) from I0 to I1. An example is Singapore where most of the investments are made by foreign firms with foreign sources of funds. Credit crunch (only for expansionary monetary policy) Sometimes, although households and firms are willing to borrow, banks are unwilling to lend due to pessimism about the economic outlook which results in a credit crunch. Small multiplier An economy with high income taxes, high savings and high imports will have a small multiplier which will limit the effect of monetary policy on the national income and hence unemployment and inflation in the economy. Effectiveness time lag The effect of monetary policy is spread out over time and hence the full effect will be realised only after a period of at least several months.

2.3

The supply-side effect of expansionary monetary policy

Monetary policy is referred to as demand-side policy because it is used to influence aggregate demand. However, it also has an effect on aggregate supply in the long run. Expansionary monetary policy will lead to an increase in investment and hence the size of the capital stock. However, when economists talk about monetary policy, they are normally referring to the use of it to influence aggregate demand.

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2.4

Monetary policy in Singapore

Monetary policy is not used in Singapore due to four reasons: the choice of a managed float exchange rate, the role of an interest rate-taker, the small consumption expenditure and investment expenditure relative to the exports and the low interest elasticity of consumption and investment (this will be explained in section 3.3). Although monetary policy is not used in the conventional way in Singapore, it is used to ensure adequate liquidity in the banking system to meet banks demand for reserves. This is to maintain the exchange rate of the Singapore dollar in the policy band and is commonly known as the exchange rate-centred monetary policy. For instance, when the Singapore government runs a budget surplus, it will deposit the money with the MAS. When this happens, the supply of reserves and hence the money supply in the banking system in Singapore will fall and the resultant rise in the interbank overnight rate will lead to a rise in the interest rates. Higher interest rates in Singapore will lead to an increase in the hot money inflows and a decrease in the hot money outflows which will result in a rise in the exchange rate of the Singapore dollar. To maintain the exchange rate of the Singapore dollar in the policy band, the MAS will increase and hence restore the money supply. Note: It is important to note that unlike the conventional monetary policy, an increase in the money supply under exchange rate-centred monetary policy will not lead to a fall in interest rates. Rather, the objective is to prevent interest rates from rising.

3 3.1

EXCHANGE RATE POLICY The objective of exchange rate policy

Exchange rate policy is a policy that is used to control the exchange rate to influence aggregate demand or aggregate supply. To increase economic growth or reduce unemployment, the central bank can increase aggregate demand by devaluing domestic currency through selling domestic currency and buying foreign currency. A depreciation of domestic currency will make domestic goods and services relatively cheaper than foreign goods and services which will lead to an increase in net exports and hence aggregate demand. To reduce inflation, the central bank can decrease aggregate demand by revaluing domestic currency through buying domestic currency and selling foreign currency. An appreciation of domestic currency will make domestic goods and services relatively more expensive than foreign goods and services which will lead to a decrease in net exports and hence aggregate demand.

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3.2

The limitations of exchange rate policy

A weaker domestic currency will lead to a rise in the prices of imported goods and services, which include both consumer and intermediate goods, which may lead to high imported inflation. The rise in the prices of imported intermediate goods may also lead to high cost-push inflation. If the Marshall-Lerner condition does not hold, which may happen in the short run, a devaluation of domestic currency will lead to a deterioration in the current account and hence the balance of payments. A continual devaluation of domestic currency may lead to currency instability. If this happens, inward foreign direct investments and hence aggregate demand may fall. A stronger domestic currency will lead to an increase in the costs of investing in the economy in foreign currency which will lead to a decrease in inward foreign direct investments. Further, if the central bank does not have sufficient foreign exchange reserves, it will not be able to revalue domestic currency. If the Marshall-Lerner condition holds, a revaluation of domestic currency will lead to a deterioration in the current account and hence the balance of payments.

3.3

Exchange rate policy in Singapore

Singapore operates under the managed float exchange rate system due to the small and open nature of the economy. As a small and open economy, the exports and imports of Singapore are high relative to the national income. Therefore, the MAS holds the view that the exchange rate is the most effective policy instrument for achieving low inflation in Singapore. Further, due to Singapores diverse trade links, the MAS manages the exchange rate of the Singapore dollar against a trade-weighted basket of currencies of Singapores major trading partners and competitors within an undisclosed policy band. The trade-weighted exchange rate of the Singapore dollar, also known as the nominal effective exchange rate of the Singapore dollar (S$NEER), is a trade-weighted average of the bilateral exchange rates between the Singapore dollar and the currencies of Singapores major trading partners and competitors. The various currencies are given different weights depending on the extent of Singapores trade dependence with that particular economy. The composition of the basket is revised periodically to take into account changes in Singapores trade patterns. Exchange rate policy in Singapore, which the MAS calls the monetary policy, is reviewed on a semi-annual basis to provide recommendations on the slope and width of the exchange rate policy band consistent with economic fundamentals and market conditions, thereby ensuring non-inflationary sustained economic growth over the medium term. The MAS publishes a semi-annual Monetary Policy Statement (MPS) in April and October which explains its assessment of Singapore's economic and inflationary conditions and outlook, and sets out its monetary stance for the following six months.

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When its external economic environment is strong, Singapore will experience high inflation in the absence of central bank intervention. When Singapores trading partners expand rapidly, their national incomes and general price levels will rise rapidly. When this happens, the prices of imported goods and services in Singapore, which include both consumer and intermediate goods, will rise rapidly which will lead to high imported inflation. The rapid rise in the prices of imported intermediate goods in Singapore will also lead to high cost-push inflation. Further, the external demand for Singapores goods and services will increase rapidly which will lead to high demand-pull inflation in Singapore. When the MAS predicts a strong external economic environment, it will raise the policy band gradually and modestly to allow a gradual and modest appreciation of the Singapore dollar in a pre-emptive strike against inflation. When the Singapore dollar becomes stronger, the rise in the prices of imported goods and services in Singapore will be smaller which will lead to lower imported inflation. The smaller rise in the prices of imported intermediate goods in Singapore will also lead to lower cost-push inflation. Further, a stronger Singapore dollar will lead to a smaller increase in the external demand for Singapores goods and services which will lead to lower demand-pull inflation in Singapore. When the MAS predicts a weak external economic environment, it will keep the policy band unchanged. In other words, it will adopt a neutral exchange rate policy stance with a policy band centred on a zero per cent appreciation of the S$NEER. When the MAS predicts a very weak external economic environment, it will lower the policy band to allow the Singapore dollar more room to depreciate. A weaker Singapore dollar will make Singapores goods and services relatively cheaper than foreign goods and services which will lead to a smaller decrease in exports and hence aggregate demand in Singapore resulting in a smaller decrease in the national income. However, the MAS will not devalue the Singapore dollar dramatically to prevent high imported inflation and high cost-push inflation in Singapore. Over the last few decades, due to the strong external economic environment of Singapore, the Singapore dollar has been on an appreciating trend and this has helped achieve low inflation in Singapore. Monetary policy is not used in Singapore because of its inability to control interest rates due to the choice of a managed float exchange rate and the role of an interest rate-taker. According to the Impossible Trinity or the Open-Economy Trilemma, an economy cannot have simultaneously a fixed exchange rate, free capital mobility and an independent monetary policy. Therefore, due to the larger external demand of the Singapore economy and hence the choice of a managed float exchange rate, the MAS cannot use monetary policy. For instance, if the MAS increases the money supply to lower interest rates, the hot money inflows will decrease and the hot money outflows will increase which will cause the exchange rate of the Singapore dollar to fall below the policy band. To bring the exchange rate of the Singapore dollar back into the policy band, there are two measures that the MAS

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can use. First, it can reverse the monetary policy which will make it ineffective. Second, it can intervene in the forex market to prevent the Singapore dollar from depreciating by buying Singapore dollars and selling foreign currency but this will also reduce the money supply. As a small and open economy, Singapore is an interest rate-taker in the sense that it cannot change the money supply to influence interest rates. For instance, if the MAS increases the money supply to lower interest rates, the hot money inflows will decrease and the hot money outflows will increase which will lead to a decrease in the money supply. Due to the small and open nature of the Singapore economy, the money supply will fall back and hence the interest rates will rise back to the initial levels. Interest rates in Singapore are largely determined by foreign interest rates, particularly interest rates in the US. For instance, when interest rates in the US rise, interest rates in Singapore will become relatively lower and these will lead to a decrease in the hot money inflows and an increase in the hot money outflows, resulting in a decrease in the supply of loanable funds (or a decrease in the money supply) and hence a rise in the interest rates. Empirically, interest rates in Singapore follow interest rates in the US. However, they have typically been below interest rates in the US due to market expectations of an appreciation of the Singapore dollar against the US dollar. In addition to the inability to control interest rates, monetary policy is not used in Singapore due to the small consumption expenditure and investment expenditure relative to the exports and the low interest elasticity of consumption and investment. The exports of Singapore are over 300 per cent of the sum of the consumption expenditure and investment expenditure. Therefore, it is more effective to manage the Singapore economy by controlling the exports rather than the consumption expenditure and investment expenditure. Further, a fall in interest rates in Singapore will not lead to a significant increase in the consumption expenditure due to the culture of thrift, and it will not lead to a significant increase in the investment expenditure as most of the investments are made by foreign firms with foreign sources of funds.

SUPPLY-SIDE POLICIES

Supply-side policies are policies that are used to increase the production capacity in the economy and hence aggregate supply. They are often used to increase economic growth, reduce unemployment or reduce inflation. The production capacity in the economy and hence aggregate supply will rise when there is an increase in the size of the capital stock, the productivity of the capital stock, the size of the labour force or the productivity of the labour force. Supply-side policies are often classified into market-oriented policies and interventionist policies.

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Education and training (Interventionist policy) Human capital is the skills and knowledge that workers acquire through education and training. Education and training will increase human capital and hence the productivity of the labour force. The government can provide education and training directly, by setting up educational institutes, or indirectly, by giving subsidies or tax incentives to firms to induce them to send their workers for education and training. Research and development (Interventionist policy) Research and development will lead to technological advancement and hence increase the productivity of the capital stock. The government can engage in research and development directly, by setting up research institutes, or indirectly, by giving subsidies or tax incentives to firms to encourage them to engage in research and development. Deregulation (Market-oriented policy) Deregulation refers to the removal of restrictive regulations. Deregulation will lead to an increase in the number of firms in the market and hence greater competition which will induce firms to increase labour productivity, which is output per hour of labour, to reduce costs. To increase labour productivity, firms will engage in education and training and research and development. Research and development will lead to technological advancement and hence increase the productivity of the capital stock. Education and training will increase human capital and hence the productivity of the labour force. Privatisation (Market-oriented policy) Privatisation refers to the conversion of a state-owned industry to a private industry. Privatisation will lead to an increase in the number of firms in the market and hence greater competition which will induce firms to increase labour productivity, which is output per hour of labour, to reduce costs. To increase labour productivity, firms will engage in education and training and research and development. Research and development will lead to technological advancement and hence increase the productivity of the capital stock. Education and training will increase human capital and hence the productivity of the labour force. Foreign worker policy (Interventionist policy) If the government allows more foreign workers into the country through changing the dependency ceiling or the foreign worker levy, the size of the labour force will increase. Immigration policy (Interventionist policy) If the government allows more foreigners to migrate to the country, the size of the labour force will increase. Government expenditure on infrastructure (Interventionist policy) An increase in government expenditure on infrastructure will increase investment expenditure and hence the size of the capital stock.

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Government expenditure on capital goods (Interventionist policy) An increase in government expenditure on capital goods will increase the size of the capital stock. Free trade (Market-oriented policy) A reduction in tariffs and non-tariff barriers will lead to greater competition which will induce firms to engage in research and development. Research and development will lead to technological advancement and hence increase the productivity of the capital stock. The government can promote free trade by entering into more free trade agreements with other economies in the international community or by reducing tariffs and non-tariff barriers unilaterally. Personal income tax (Market-oriented policy) A decrease in personal income tax will increase the incentive to work and hence the size of the labour force. Further, it will reduce the extent of the unemployment trap. The unemployment trap occurs when the pay that will be received by the unemployed are not significantly higher than the unemployment benefits that they are currently receiving. This discourages movement into work and affects particularly low-skilled workers. Corporate income tax (Market-oriented policy) A decrease in corporate income tax will increase expected after-tax returns on planned investments and hence investment expenditure resulting in an increase in the size of the capital stock. Capital gains tax (Market-oriented policy) A capital gain is a profit that is made from the sale of certain types of asset that include both physical assets and financial assets. A decrease in capital gains tax will increase the incentive to invest and hence investment expenditure resulting in an increase in the size of the capital stock. Trade union reforms (Market-oriented policy) The government can implement trade union reforms to reduce the power of trade unions such as making industrial action without a ballot unlawful. This will reduce wages and hence the cost of production in the economy. Unlike other supply-side policies, trade union reforms do not increase the production capacity in the economy. A major limitation of supply-side policies is the long period of time it takes for the effects to be realised. Therefore, supply-side policies are a policy option in a recession. Nevertheless, the Singapore government does use short-term supply-side measures in a recession. Short-term supply-side measures are measures that are used to reduce the cost of production in the economy and hence increase aggregate supply. In Singapore, they include reducing the employers CPF contribution and helping firms pay a certain proportion of wages to reduce labour cost. When the cost of production in Singapore falls, the aggregate supply and hence the national income will rise. However, such measures may lead to an increase the profits of firms resulting in a less equitable distribution of income.

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PRICES AND INCOME POLICIES (optional)

Prices and income policies are wage and price controls used to fight inflation. Such policies were widely used in the 1960s and 1970s as a method of fighting stagflation. They may be in the form of a voluntary agreement with firms and/or trade unions, or there may be statutory limits imposed. There are, however, problems with such policies. First, income policy may lead to strikes. This was exactly what happened in the UK in the late 1960s and 1970s. Second, by arbitrarily interfering with price signals, prices policies provide an additional bar to achieve economic efficiency, potentially leading to shortages and declines in the quality of goods on the market, while requiring large government bureaucracies for their enforcement. These shortages may lead to black markets.

Note: Some economics teachers discuss prices and income policies as supply-side policies. However, although this can be done for income policy, it is inappropriate to do so for prices policy.

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