Macroeconomic policies explained

Macroeconomic Policies
3.2 HOW THE MACROECONOMY WORKS Macroeconomic Policies

Enduring Understandings The students will understand that: 1) 2) 3) macroeconomic policies can help to solve macroeconomic problems in order to achieve macroeconomic aims a government could implement a policy mix to solve the macroeconomic problems. all policies, though could solve macroeconomic problems, do have its disadvantages/limitations. There are two types of disadvantages/limitations: (i) Desired extent of the change in macroeconomic indicator in order to solve a macroeconomic problem could not be achieved. (i.e. The policy aims to increase NY in order to recover an economy out of a recession but the extent of the increase in NY is limited or smaller than expected) (ii) Conflict of aims may arise. 4) the effectiveness of macroeconomic policies to solve a macroeconomic problem depends on the: a) ability of the policies to solve the root cause of the problems b) characteristics and nature of economy c) mix of the policies to minimise the conflicts of aims.
Essential Questions 1) How do macroeconomic policies help an economy to achieve its macroeconomic aims? 2) Why do we need different macroeconomic policies? 3) How and why does a government implement a policy mix? 4) What makes a macroeconomic policy effective?
SAJC/2012/JC2/H1 and H2
Contents
2 FISCAL POLICY ......................................................................................................... 5 2.1 Government Budget ............................................................................................ 5 Government expenditure ......................................................................................... 6 Taxes ........................................................................................................................... 6 2.2 Discretionary Fiscal Policy ................................................................................. 7 2.3 The Disadvantages/Limitations of Fiscal Policy ............................................. 9 Limitation of Fiscal Policy: Conflicts of Macro/Micro Aims ................................. 9 Limitation of Fiscal Policy: The desired extent of the change in macroeconomic indicator in order to solve a macroeconomic problem could not be achieved. ...................................................................................................... 11 Time lags .................................................................................................................. 11 The accuracy of forecasting .................................................................................. 13 Size of multiplier (H1 Economics need to have a broad understanding of how multiplier could limit the extent of change an macroeconomic indicator) ....... 13 2.4 Automatic Fiscal Stabilisers............................................................................. 15 Effectiveness of Automatic Fiscal Stabilisers ..................................................... 16 2.5 Effects of Fiscal Policy on Aggregate Supply ............................................... 18 2.6 Effectiveness of Fiscal Policy .......................................................................... 18 2.7 Fiscal Policy in Singapore ................................................................................ 18 Budget 2007: Reducing Direct Taxes, Raising the Goods and Services Tax Rate ........................................................................................................................... 19 Budget 2009: The Resilience Package ............................................................... 20 3 MONETARY POLICY .............................................................................................. 22 3.1 What is Money? ................................................................................................. 22 3.2 Who conducts MP? .............................................................................................. 22 Reserve Requirements........................................................................................... 23 Discount Rate .......................................................................................................... 23 Reserve requirements ............................................................................................ 23 Discount rate ............................................................................................................ 23 Open-market operations ........................................................................................ 24 3.1 Expansionary Monetary Policy ........................................................................ 25 (A) Quantitative Measures ..................................................................................... 25 (B) Qualitative Measures ....................................................................................... 27 3.2 Contractionary Monetary Policy ...................................................................... 28 (A) Quantitative Measures ..................................................................................... 28 (B) Qualitative Measures ....................................................................................... 29 3.3 The Effectiveness of Monetary Policy ............................................................ 30 3.3.1 Pros of Monetary Policy ............................................................................... 30 3.3.2 Cons of Monetary Policy .............................................................................. 30 Other problems of using MP are: .......................................................................... 30 3.4 Monetary Policy in Singapore........................................................................... 31 3.4.1 Openness to Trade Flows ............................................................................ 31 3.4.2 Openness to Capital Flows .......................................................................... 32
Annex A ............................................................................................................................ 33 Credit Creation and Destruction in the Economy ............................................... 34 4 EXCHANGE RATE POLICY ................................................................................... 36 4.1 Adopting a Flexible Exchange Rate System ................................................ 37 4.2 Adopting a Fixed Exchange Rate System..................................................... 38 4.3 Adopting Managed Float Policy ..................................................................... 40 4.4 Exchange Rate Policy in Singapore ................................................................ 40 4.5 Possible policy conflicts.................................................................................... 46 5 PRICES AND INCOMES POLICIES .................................................................... 47 5.1 Incomes Policy to minimise cost-push inflation......................................... 47 6 SUPPLY-SIDE POLICIES...................................................................................... 48 6.1 Types of Supply-side measures ......................................................................... 49 6.1.1 Reducing Government Expenditure - Release More Resources ...... 49 to the Private Sector ............................................................................................... 49 6.1.2 Reducing taxes to raise work incentive ................................................. 49 6.1.3 Reducing the Automatic Entitlement to Welfare Benefits: Encourage Greater Self-reliance............................................................................................... 50 6.1.4 Encouraging Competition through Policies of Deregulation and Privatisation .............................................................................................................. 50 6.1.5 Adopt Exchange Controls to Influence the Movement of Capital ...... 51 6.1.6 Ease Business Costs in Difficult Times (Reduce Costs of Production) 51 6.1.7 Raise Productivity Levels ......................................................................... 51
Figure 1 Expansionary Fiscal Policy (AD-AS approach) ....................................... 7 Figure 2 Expansionary Fiscal Policy (Y-AE approach).......................................... 8 Figure 3 Crowding Out Effect ...............................................................................11 Figure 4 The Problem of Time Lags.....................................................................12 Figure 5 Effects of Expansionary Monetary Policy (AD-AS approach).................26 Figure 6 Effects of Expansionary Monetary Policy (Y-AE approach) .............Error! Bookmark not defined. Figure 7 Effects of Contractionary Monetary Policy (AD-AS approach) ...............29 Figure 8 Effects of Contractionary Monetary Policy (Y-AE approach)............Error! Bookmark not defined.
FISCAL POLICY
Readings: (i) John Sloman, 'Economics' 7th Edition, Pg 562-573 (ii) Maunder, Economics Explained Revised 3rd Edition, Pg 486-497 Fiscal policy, is a demand side management policy, which involves the government changing the level of government expenditure (G) and/or tax receipts (T) so as to affect the level of aggregate demand (AD) in order to achieve macroeconomic stability. This refers to achieving macroeconomic objective of 1) increasing national income and hence strong economic growth (through increasing AD when AD is too low, cutting the horizontal portion of AS curve) 2) lowering unemployment and 3) lowering inflation (through decreasing AD when AD is too high, cutting the vertical portion of AS curve). Besides solving inflation or recession, fiscal policy can be used to achieve microeconomic aims of reducing income disparity through the tax system (see 2.7 Fiscal Policy in Singapore). It is noteworthy to point out that fiscal policy has the ability to influence AS. In other words, fiscal policy has SS-side effects. Main aims of Fiscal Policy 1. To increase national income and hence strong economic growth 2. To lower unemployment 3. To lower inflation 4. To reduce income inequality 5. To influence aggregate supply
2.1
Government Budget
The government budget consists of two components: 1. Government expenditure (G)1 2. Government revenue whose main source is from taxes (T) A budget deficit implies G exceeding T whereas a budget surplus implies T exceeding G.
1
Government expenditure here refers to total government expenditure. Its impact can be analysed using G on goods and services or as transfer payments through C and I. When there is an increase in the level of transfer payments, this shows up in Aggregate Demand as a change in the level of household consumption, as it directly affects the ability of households to buy goods and services.
A Brief Introduction to Taxes A tax is a compulsory payment made to the government by various groups of economic agents. There are two main types of taxes from which the government collects its revenue. They are direct taxes (e.g. personal income tax, corporate income tax) and indirect taxes (e.g. excise tax (a sales tax on individual products such as alcohol, tobacco, and gasoline), tariffs, Goods and Services Tax). Taxes are considered as leakages out of the circular flow of income. In the analysis of its effect, one needs to make a distinction between direct and indirect taxes. Direct taxes affect the households' and firms' disposable income whereas indirect taxes do not. Government expenditure Government expenditure on public works (e.g. construction of highways, irrigation network, bridges, etc.) could be deliberately increased. The government can deliberately relax eligibility rules to enable more people to qualify for transfer payments. Reducing taxes and raising government expenditure are aimed at increasing aggregate demand or aggregate expenditure to create income and employment. For Budget 2010, Singapores Expenditure on Education was 3.5% of GDP, while Defence was 4.1%, Health was 1.5%. Taxes The government could deliberately reduce personal income tax rate and/or indirect taxes to raise consumption. A reduction in personal income tax rate will increase disposable income and hence encourage consumption, increasing aggregate demand indirectly. If the tax cut is in favour of the lower income group, the multiplier effect will be greater. This is because the marginal propensity to consume is higher for lower income group than for higher income group. So the additional induced consumer spending on the increase of an additional dollar of income is higher (smaller leakage) and, hence, the multiplier effect is greater.
A lower corporate income tax increases the incentive to raise investment in order to stimulate aggregate expenditure. (Corporate income taxes reduce the after-tax income to the firms and, thus, limiting the funds available for investment.)
2.2
Discretionary Fiscal Policy
This refers to the deliberate changes in the level of government expenditure and/or tax rates in order to change the level of AD or AE to affect national income through the multiplier effect. In other words, it is the discretionary fiscal policy which the government can use to regulate economic activities to tackle macroeconomic issues. Discretionary fiscal policy can either be Expansionary or Contractionary. For example, during a recession, government may use expansionary fiscal policy to increase the level of government expenditure on infrastructure, public goods, healthcare, etc. to increase aggregate demand and hence boost the level of economic activities in the economy. The government may also choose to lower taxes to stimulate spending and investment, thus boosting aggregate demand. How would a government adopt expansionary fiscal policy to solve a macroeconomic problem? General Price Level AS Increase in government spending and reduction in taxation cause AD to move to AD, and equilibrium income increases from Y to Y. AD AD 0 Y Y Real NY
Upward pressure on prices
P P
Figure 1 Expansionary Fiscal Policy (AD-AS approach)
AE Y = AE AE =C + I + G + (X-M) AE = C + I + G + (X-M)
Increase in government spending and reduction in taxation causes AE to move to AE, and equilibrium income increases from Y* to Y** through the multiplier effect.
Y*
Y**
Nominal NY
Figure 2 Expansionary Fiscal Policy (Y-AE approach for H2 Economics only)
The government may experience a budget deficit when the economy is experiencing a deflation, high unemployment or recession. This is because as the government adopts an expansionary fiscal policy in order to recover the economy out of recession, there would be an increase in G and/or a reduction of T, which results in a budget deficit. Workings of Contractionary Fiscal Policy During high inflation, government may use contractionary fiscal policy to decrease the level of government expenditure on infrastructure, public goods, healthcare, etc. to decrease aggregate demand and hence dampen the level of economic activities in the economy. The government may also choose to raise taxes to reduce spending and investment, thus reducing aggregate demand (AD). Due to the fall in AD, there would be a downward pressure on the general price level. This is because as total spending in the economy decreases, the firms would cut down production which in turn causes the producers to hire less factors of production or retrench workers. This would result in a surplus of factors of production which drives the price of factor of production such as wages and hence cost of production down. Since cost of production falls, the producers could pass down the lower cost of production in terms of lower price. As a result, if this applies to all firms in general, general price would fall, thus helping to address the problem of high inflation. (Do you know how to draw a AD-AS diagram to illustrate?) The government may experience a budget surplus when the economy is experiencing a high inflation. This is because as the government adopts a contractionary fiscal policy in order to solve the problem of
high inflation, there would be an decrease in G and/or a increase of T, which results in a budget surplus.
2.3
The Disadvantages/Limitations of Fiscal Policy
There are two types of disadvantages/limitations that a government might encounter as a government implement any policy: (i) Extent of solving the macroeconomic problem is limited. (i.e. The policy aims to increase NY in order to recover an economy out of a recession but the extent of the increase in NY is limited) (ii) Conflict of aims may arise. What are the conflict of aims that might arise as a government implements expansionary fiscal policy? Limitation of Fiscal Policy: Conflicts of Macro/Micro Aims a) Cost-push inflation: If the economy is overheating and inflation is rising, the government may raise taxes. A higher tax in the form of higher GST has to be passed on to the consumer in terms of higher prices. This in turn could lead to higher wage claims and, thus, costpush inflation. b) Welfare and distribution: The government may want to introduce a cut in public expenditure in order to reduce inflation. A cut in welfare benefits may have an impact on the people who depend on such benefits in addition to their meagre disposable income. c) Disincentives to work: Progressive income taxes could be a disincentive to work, since tax rates get higher with higher income earned. That is, for every increase in income earned, a larger and larger proportion of that increase in income gets taxed away, leaving a smaller and smaller proportion of disposable income. Limitation of Fiscal Policy: The desired extent of the change in macroeconomic indicator in order to solve a macroeconomic problem could not be achieved. d) Crowding-out effect: An expansionary fiscal policy that involves increase in government spending (G) leads to a rise in AD and NY. However, this rise in G may crowd out private investment spending (I) because of the resulting increase in the interest rate. The assumption here is that increase in government spending is funded by borrowing
from the financial sector. Another such crowding out effect could be due to resource constraints. With limited resources, increase in government spending will mean that there is increased competition for scarce resources as well. This would usually push up the prices of such resources, causing cost of production to rise. This higher cost of production may cause investors to withdraw or halt their investment in the economy. For instance, when the government borrows money to finance its purchases to boost aggregate demand, it will drive up interest rate. It increases the demand for money in the money market and this increase in the demand for money increases interest rate. As a result of the higher interest rate, consumers may decide against buying a car, a house or other interest sensitive goods, and businesses may cancel or scale back plans to expand or buy new capital equipment. In short, the higher interest rate will choke off private spending on goods and services, and as a result, the impact of the increase in government purchases may be smaller than we first expected. As a result, the increase in AD and NY will be limited by the fall in I. Expansionary fiscal policy G Assuming that government needs to amount of loanable interest rate
borrow from banks to finance government spending funds available for business investors would decrease cost of borrowing
business investment (G crowds out investment) via the multiplier effect
AD may not increase by the desired amount
NY might not increase by the desired amount and hence may not recover from recession
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General Price Level
AS
P P P AD 0
Figure 3 Crowding Out Effect
Starting from AD, an expansionary fiscal policy with no crowding out effect shifts AD to AD and income rises from Y to Y. However, with some degree of crowding out, the same policy will cause a fall in I, resulting in a shift of AD to AD and Y to Y instead.
AD
AD Y Y Y Real NY
How come a government may not achieve desired extent of solving the problem (i.e extent of solving the macroeconomic problem is limited)? Limitation of Fiscal Policy: The desired extent of the change in macroeconomic indicator in order to solve a macroeconomic problem could not be achieved. Time lags a) Recognition Lags: It takes time for policymakers to recognise the existence of a boom or slump. b) Implementation Lags: This is as a result of the time that it takes to put the desired policies into effect once economists and policymakers recognise that the economy is in a slump or a boom. For example, time for analysis and problem of red tape. c) Response Lags: The lags that occur because of the operation of the economy itself. Even after the government has formulated and implemented a set of policies, the economy takes time to achieve the expected outcome. Overall, the timing of fiscal policy is crucial. Because of the significant lags before fiscal policy has its impact, the increase in aggregate demand may occur at the wrong time. E.g., imagine the economy is currently suffering from low levels of output and high rates of unemployment. In response, policymakers decide to increase government purchases and implement a tax cut. But from the time when the policymakers recognise the problem to the time when the policies have a chance to work themselves through the economy,
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business and consumer confidence might have already improved thus, shifting the aggregate demand curve rightward increasing real output and employment. By the time the fiscal policy runs its full course, the economy might end up experiencing the undesired effect of demandpulled inflation! Recession Expansionary fiscal policy G and tax which C and I
because of Recognition lag, Implementation lag or Response lag (please explain the lags in yr answers) AD does not increase immediately, it more than necessary desired
might increase after the economy recovers by itself increase in AD
desired increase in AD may not achieved
increase in NY may not achieved (more than necessary increase NY will increase DD pull inflation).
Real National Income 3 3 Path A Path B 4 2 2 4 Path C
Stage 1
Figure 4 The Problem of Time Lags
1 Time
From the illustration above, Path B shows the course of business cycle without government intervention. Ideally, with no time lags, the government should intervene by contractionary policies at Stage 2 and expansionary at Stage 4. This will result in the economys business cycle following the course of Path C which ensures more stability. However, with time lags, contractionary fiscal policies at Stage 2 may not come into effect until Stage 4, and expansionary policies at Stage 4 may not come into effect until Stage 2. In this case, the resulting course of the business cycle may likely be Path A. Thus, a stabilising
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policy using fiscal tools may make it even more destabilising because of time lags!
The accuracy of forecasting Inaccurate forecasts can affect the governments decision to act swiftly to address a problem of excess or deficient demand. For example, if the government inaccurately predicts the magnitude of an economic slowdown next year and over-exercises expansionary fiscal policy to boost the economy, it may cause the economy to expand more rapidly and risk experiencing inflationary problems! In addition, the government might also need to take into consideration whether there are any other withdrawals (import, saving) or injections (export, investment) that are expected to take place before deciding on the extent of contraction/expansion the fiscal policy tools should bring. While the government is pursuing an expansionary fiscal policy by increasing G to generate higher AD and hence income and employment, a fall in net exports may negate the effect. Similarly, a contractionary fiscal policy by reducing G will be offset by an increase in I (itself not entirely within the control of the government). Size of multiplier (H1 Economics need to have a broad understanding of how multiplier could limit the extent of change an macroeconomic indicator) The overall impact of government spending or taxes will depend on the size of its multiplier. Recall that the multiplier effect is: NY = k x AE An increase in government spending of $1 million ( AE) will generate a higher level of national income ( NY) if the multiplier (k) is larger. Recall that
For example, if mpc = 0.5, k = 2 and mpc = 0.8, k = 5. This means that the larger the mpc, the larger the value of k. With an increase in government spending of $1 million, a country with a larger multiplier (k = 5) will generate a larger increase in national income ($5 million) while one with a smaller multiplier (k = 2) will generate a smaller increase in national income ($2 million). The size of the multiplier is dependent on the size of the marginal propensity to withdraw (mpw = mps + mpt + mpm). Various factors affect mps, mpt and mpm. For example, an open economy with higher dependence on imports, such as Singapore will experience
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lower multiplier effect compared to one with less sources of withdrawals. With a given level of government spending, its multiplied increase in national income will be lower as compared to other less open economies. Recession AD Expansionary fiscal policy NY G and tax which C and I
via the multiplier effect
With a given amount of increase in AD, the desired amount of the increase in NY may not be achieved if the multiplier is too small. What determines the size of multiplier? Higher the savings rate (Marginal Propensity to Save - MPS), import rate (MPM), and tax rate (MPT) multiplier will be very small Qn: Given the above withdrawal rates (mpm, mpt, mps), what is the consumption rate within the economy (i.e. mpc) MPC = 1 (mpm+ mpc+mpt) Formula of multplier:
Is Singapores multiplier small? Why?
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Limitation of Fiscal Policy: The desired extent of the change in macroeconomic indicator in order to solve a macroeconomic problem could not be achieved. Factor Type of tools that the government utilise when implementing fiscal policy Fiscal Spending vs. Taxation However, a fall in T results in a smaller multiplier effect compared to the same increase in G, because of the withdrawal effect of mps. For instance, assuming mpc = 0.7, a $1m injection of government spending will generate $3.33m in income. Conversely, a tax cut of $1m will increase consumption by $0.7m, resulting in only $2.33m increase in income. While both may seem to be similar in effect, an increase in spending is more effective in raising G than by reducing T as lower taxes to boost spending has to depend on the marginal propensity to consume. Lower taxes boost disposable income, and the subsequent increase in aggregate demand will be lower due to mpc (0.7) whereas government spending that raises aggregate demand will be injected in full.
Other limitations of tax cuts to boost national income: If tax cuts are temporary, consumers may not increase spending. An increase in induced consumption through a tax cut depends on the level of consumer confidence.
2.4
Automatic Fiscal Stabilisers
As the name suggests, automatic fiscal stabilisers stimulate aggregate demand automatically during periods of recession and dampen aggregate demand during periods of expansion as opposed to deliberate government action that is used via discretionary fiscal policy. In other words, they refer to the built-in mechanisms that will automatically stabilise the economy during recessions and booms. E.g. of automatic fiscal stabilisers are: For instance, based on the Year of Assessment 2012, a person earning $20,000 or below per year will pay a 0% tax rate. However, as the economy booms and his income increases above $20,000 per year, his tax rate automatically increases to 2% as he moves up the
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income bracket. This increase in tax rate is progressive as a person moves up the income brackets (a persons earnings above $320,000 will be taxed at a rate of 20%)2. As can be seen from the above example, when national income rises, a progressive income tax system (a kind of automatic fiscal stabiliser) will automatically raise the tax revenue for the government. On the other hand, governments spending on the unemployment benefits (a kind of automatic fiscal stabiliser) will fall as more people are employed during economic boom, and requires less government assistance. Both of these will act as a lower injection into the circular flow of income and help to dampen the increase in national income without any deliberate action to increase tax rates and/or reduce government expenditure. Conversely, when the economy is in recession, unemployment increases and tax revenues fall more, so disposable income does not fall as much as does real GDP. Thus, an income tax, cushions declines in disposable income, in consumption, and in aggregate demand. Recession individuals would earn less income assuming
the automatic fiscal stabailiser such as progressive income tax system and unemployment benefts in place change provided and does not less income means less tax revenue would be an individuals Yd would not decrease by much Consumption would not decrease by much
collected and more unemployment benefits needs to be during recession
helps to stimultes Aggregate demand.
Effectiveness of Automatic Fiscal Stabilisers 1. Immediate impact of such measures Automatic stabilisers have the advantage of acting instantly as soon as aggregate demand fluctuates. In contrast, it may take some time before discretionary changes in government taxes or expenditure can be implemented, especially if information is not readily available for policymakers to finalise their policies.
2
Ministry of Finance website, Personal Income Tax Rates (http://app.mof.gov.sg/personal_income_tax_rates.aspx)

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2. Automatic stabilisers cannot prevent fluctuations they merely reduce their magnitude Unlike discretionary fiscal policy, automatic stabilisers merely reduce the severity of fluctuations, not eliminate them altogether. For example, as income rises, progressive taxes will help to moderate the rise in income. However, the government can use discretionary fiscal policy to contract the economy and cause the income to change direction (fall). 3. Fiscal drag Fiscal drag is defined as the tendency of automatic fiscal stabilisers to reduce the recovery of an economy from recession. Automatic stabilisers are useful in helping to reduce upward or downward movements in national income by controlling the expansion of the economy during a boom and help to boost the economy during a recession. A fiscal drag can occur if the economy moves from a deep recession and begins to recover. Instead of helping the recovery process, automatic stabilisers can instead slow down the recovery and act as a drag on the expansion. Suppose that the government has adopted an expansionary fiscal policy to help the economy to recover from recession by lowering taxes. This boosts the economy and helps the economy recover via the multiplier process. However, as the economy recovers and national income increases, automatic stabilisers will dampen the increase in consumption (by raising tax revenue or lowering government spending). AD would therefore not rise as much as when there was no automatic stabiliser in place, thus dampening the effect of expansionary policy to help increase national income. Therefore, there is a fiscal drag as the automatic stabiliser slows down the recovery when the government is trying to adopt expansionary fiscal policy. Expansionary Fiscal Policy G and T AD NY Individual earn more income assuming automatic fiscal stabilisers such as progressive income tax are in place
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4. Unemployment and income-related benefits High unemployment benefits (given to alleviate the loss of income due to unemployment) may discourage workers to take up new jobs. Similarly, high income-related benefits may discourage people in very low-paid jobs from seeking better ones, if the next job they take on offers them very little more (or no better off) than before. As Singapore government does not provide unemployment benefits, we do not suffer from the above problem as much as other countries such as the U.K. and Australia.
2.5
Effects of Fiscal Policy on Aggregate Supply
Fiscal policy can be used to influence aggregate supply. For example, the government can increase its expenditure on infrastructure (spending on roads and hospitals), merit goods (education and healthcare), public goods (national defence) or give tax incentives for investment. All these government spending would increase the amount of capital goods and hence increase the productivity capacity of the economy. As a result, such expansionary fiscal policy will not only increase AD (achieving actual growth) but also increase LRAS (achieving potential growth). Therefore, the implementation of fiscal policy not only has the main intended effect of increasing AD but also has the side effect of increase LRAS (i.e. Fiscal policy has SS-side effects).
2.6
Effectiveness of Fiscal Policy
The effectiveness of macroeconomic policies to solve a macroeconomic problem depends on the: a) ability of the policies to solve the root cause of the problems b) characteristics and nature of economy c) mix of the policies to minimise the conflicts of aims.
2.7
Fiscal Policy in Singapore
As the open nature of Singapores economy results in much leakages if fiscal policy is employed, fiscal policy mainly supports economic growth by promoting macroeconomic stability through fiscal prudence (living within our means) and by enhancing supply-side conditions. Fiscal Policy is directed mainly at promoting long-term economic
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growth by investing in infrastructure, education, research and development while taxing demerit goods like vehicle congestion and pollution). The Singapore Government has adopted the following principles to meet its objectives3: 1. The private sector is the engine of growth and the governments role is to provide a stable and conducive business environment; 2. Tax and expenditure policies should be justified on microeconomic grounds and focus on supply-side issues; 3. The counter-cyclical role of fiscal policy is limited, due to high import leakages. With such prudent fiscal policy, Singapore enjoyed consistent budget surpluses that contributed to its high savings rate that allowed it to achieve one of the highest investment rates in the world. Raising sufficient revenue while maintaining a competitive tax structure and containing expenditure growth. Direct taxes (in particular corporate taxes) should be lowered while indirect taxes should be raised to make up for the shortfall. This will enhance business competitiveness. In addition, the Government is expected to balance the budget within its 4-5 year term and can only draw on past reserves with the approval of the President. This Constitutional framework protects past reserves by enforcing financial prudence, while allowing the Government to draw on them in times of need. Budget 2007: Reducing Direct Taxes, Raising the Goods and Services Tax Rate4 In Budget 2007, the Singapore Government raised the GST rate from 5% to 7%. The rationale of this was to raise government revenue while keeping direct taxes competitive. Corporate and Personal income taxes have been reduced worldwide. To attract more foreign investments, Singapore has to keep its Corporate and Personal Income Taxes competitive. Corporate Tax was lowered in Budget 2007 from 20% to 18% and in Budget 2009
3
Monetary Authority of Singapore website, Macro Overview (http://www.sgs.gov.sg/macro_overview/macrooverview_fiscal.html) 4 Ministry of Finance website, Budget 2007 (http://www.mof.gov.sg/budget_2007/budget_speech/downloads/FY2007_Budget_Statement.pdf)
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from 18% to 17%5. Personal Income Taxes has also been lowered. In Budget 2007, the top tier (annual income of more than $320,000) tax rate was lowered from 22% to 20%. This is to maximise the incentives for all Singaporeans to work hard and reap rewards of their efforts while attracting and keeping both international and Singaporean talent here. Lower tax revenue from these sources will have to be replaced by other sources. By increasing the GST rate, it will broaden the tax base and enable the government to implement its fiscal policies. GST rate was increased in Budget 2007 from 5% to 7%. Budget 2009: The Resilience Package In 2009, together with the rest of the world, Singapore faced the most severe and widespread economic recession in the last 60 years. Singapore introduced the largest countercyclical Budget since Independence (1965) to help us see through the downturn. It includes extraordinary measures such as Jobs Credit Scheme and SPUR (Skills Programme for Upgrading and Resilience)6, to prevent severe loss of jobs and to upgrade the skills of workers. In addition, Singapores advantage in responding to the crisis is its availability of resources or its huge budget reserves accumulated over the years from prudent fiscal policies. Prudence implies spending within our means and building up reserves through accumulating budget surpluses during economic upturns. Budget 2009 therefore introduced the measures that resulted in a large budget deficit $2.9 billion for 2009. This is done in the hope of reversing the decline in the economy by boosting our Aggregate Demand (AD). Figure 5 Singapore's Budget Position 2007 2008 2009 2010
5
$7.6 billion $0.2 billion -$2.9 billion -$3.0 billion*
Ministry of Finance website, Budget 2009 (http://www.mof.gov.sg/budget_2009/speech_toc/downloads/FY2009_Budget_Statement.pdf) 6 Ministry of Finance website, Budget 2009 (http://www.mof.gov.sg/budget_2009/speech_toc/downloads/FY2009_Key_Budget_Initiatives1.pdf)
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*budgeted (based on Budget 2010)
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MONETARY POLICY
Recommended Readings: (i) John Sloman, 'Economics', 7th Edition, Pg 574-589 (ii) Peter Maunder, Economics Explained, Revised 3rd Edition, Pg 486-497
Introduction:
Monetary Policy (MP) is a discretionary policy used to affect AD by changing the money supply or the interest rate to support the achievement of a countrys key macroeconomic objectives. Money supply is commonly defined as the quantity of money available in the economy. Interest rate is the cost of borrowing money or the returns to savings.
Monetary Policy also affects the volume and direction of credit, the quantity of money available for loan, in the banking system so as to achieve these objectives. (See Annex A Definitions of Money).
3.1
What is Money?
Economists define money as anything that is regularly used in economic transactions or exchanges. There are several major functions of money, for example, as a medium of exchange or a store of value (See Annex A Functions of Money).
3.2 Who conducts MP?

MP is formulated and implemented by a countrys monetary authorities. These are the central bank and government departments dealing with monetary matters. In the U.S., the central bank is called the U.S. Federal Reserve (The Fed). In Singapore, the central bank is called the Monetary Authority of Singapore (MAS). Note: Central Bank is NOT Commercial Banks. Commercial banks are financial intermediaries that are usually privately-owned and profit-seeking businesses. They accept deposits from savers and give out loans to borrowers. Examples of commercial banks in Singapore are United Overseas Bank (UOB) and Development Bank of Singapore (DBS).
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3.3 How is MP conducted?

A central bank controls the money supply in an economy through the use of Quantitative and/or Qualitative tools or instruments. Such tools are used in the credit creation process when money supply increases or credit destruction when money supply decreases (See Annex A Credit Creation and Destruction).
Quantitative Tools
Reserve Requirements Discount Rate Open-market Operations Quantitative Tools: Reserve requirements
Qualitative Tools
Interest Rate Moral Suasion
Reserve requirements are regulations on the minimum amount that banks must hold against deposits. The minimum amount could be in the form of a ratio, i.e. a percentage of deposits that banks must keep in reserves which cannot be loaned out. These deposits could be stored in the banks own vault or within the Central Bank. If the Central Bank reduces the reserve requirement, banks can now loan out more money as compared to earlier resulting in an increase in money supply. Note: This tool is rarely used because it can be disruptive to banks business. If the Central Bank increases reserve requirements, banks suddenly find themselves short on reserves, with no change in deposits. They will then have to curtail lending until they build reserves to the new required level. Discount rate The discount rate is the interest rate on the loans that the Central Bank makes to commercial banks. Commercial banks may borrow from the central bank to meet reserve requirements in the event of too many loans being taken out or increased withdrawals of saving deposits. When the Central Bank makes such a loan to commercial banks, the banking system has more reserves than it otherwise would and this allows the banking system to create more money and increase the money supply. Thus, the Central Bank can change the money supply by changing the discount rate increasing the discount rate will discourage
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commercial banks from borrowing from the Central Bank and lower the amount of reserves in the banking system. At times, the Central Bank may make such loans not to control money supply, but to help troubled financial institutions and commercial banks. Open-market operations Open market operations refer to the buying and selling of government bonds. Anyone may buy and sell government bonds in the open market, including private individuals, businesses and commercial banks. A bond is a certificate of indebtedness the buyer of a bond will pay the seller (issuer) of the bond a sum of money. Upon the maturity of the bond, the seller will have to redeem the bond by paying back the sum of money which the buyer had earlier surrendered plus interest. To increase the money supply, the Central Bank will buy bonds from the public in the open market, thereby increasing the amount of local currency in circulation. To reduce the money supply, Central Bank will sell government bonds and the public pays for these bonds using their own holdings of cash or bank deposits. Therefore, Open-market operations change the quantity of money in circulation in the economy. Note: The trading of government bonds by the Central Bank is also a way for the government to borrow money from the public to finance its debts. If the government wants to borrow money, would the Central Bank buy or sell bonds?
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Qualitative Tools: Moral suasion Central Bank or the government can use moral suasion to persuade individuals to increase or decrease savings and spending. Moral suasion can also be used on commercial banks to encourage or discourage lending activities. Regulations Central Bank can change the regulations relating to loans, hire purchase and mortgages to influences borrowing and lending. Interest Rate Since interest rates are both returns to savings as well as costs of borrowing, changing interest rates will affect consumers incentives to save and firms incentive to borrow funds. Decreasing savings and increasing borrowing will increase the money supply in the economy which will encourage consumption and investment since individuals and firms have increased credit (money) to purchase consumer (consumption) or capital (investment) goods.
3.1
Expansionary Monetary Policy
A Central Bank usually implements an expansionary MP (also known as monetary easing) during a recession or a period of sluggish growth. The main macroeconomic objectives of doing so are to: 1. stimulate economic growth; 2. increase real national income; and 3. reduce unemployment (mostly cyclical in nature). A central bank can increase the money supply through both quantitative and qualitative measures. What can be implemented: (A) Quantitative Measures (B) Qualitative Measures - Reduce reserve requirement - Reduce interest rates directly - Reduce discount rate - Moral suasion - Conduct open market operations - Ease regulation (A) Quantitative Measures 1. Central Bank can reduce the reserve requirement (e.g. the cash reserve requirement, liquidity ratio and special deposits) that commercial banks are required to keep as reserves within their own bank or with the central bank.
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2. Central Bank can reduce the discount rate which will encourage commercial banks to borrow more from the Central Bank and increases the money supply. 3. Central Bank can also conduct open market operations by buying government bonds or securities from banks or private individuals with cash. Banks with the extra cash (or excess liquidity) will be able to give out more loans which encourages consumption (C) and investments (I) thus increases Aggregate Demand (AD) and real national Income (NY) will increase via the multiplier process, as shown in Figure 6, Y to Y. Banks might try to lend out the extra cash by lowering the interest rates to encourage more borrowing which will increase consumption (C) and investments (I) as well. General Price Level AS E P P E AD2 AD1 0 Y Y Real NY
Figure 6 Effects of Expansionary Monetary Policy (AD-AS approach)
Reducing interest rates reduces the opportunity cost of borrowing funds for consumption and hence gives more incentives for the public to borrow for hire purchase or home loan mortgages. It also reduces the incentive to save. Both effects increase consumption (C). Reducing interest rates also reduces the opportunity cost of borrowing funds for business investment and increases the potential rate of return on investments. Businessmen will have more incentive to borrow for further investments (I). Another way of viewing expansionary MP is that the central banks open market purchase of government securities (or bonds) from
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banks increases banks money reserves and thus increasing their ability to give out loans (fuel credit creation or loan growth). Therefore quantitative measures can influence (C) and (I) directly by changing the money supply or indirectly by changing in the interest rate. (B) Qualitative Measures 1. Besides influencing interest rates via money supply, Central banks can also reduce interest rates directly. This usually works for large economies, but not for small and open economies like Singapore (refer to section on Singapores monetary policy). 2. Central Banks can persuade commercial banks to extend more credit to companies (moral suasion). 3. Central Bank can also ease regulations to make it easier for banks to lend money for hire purchase or home loan mortgage purposes. Note: Both quantitative and qualitative measures can be used to influence the money supply which would influence consumption (C) and investments (I) thus changes Aggregate Demand (AD) and real national Income (NY) will change via the multiplier process.
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3.2
Contractionary Monetary Policy
A central bank usually adopts a contractionary monetary policy (or monetary tightening) when the economy is over-heating7 and when the objective is to reduce inflationary pressures. What can be implemented: (A) Quantitative Measures (B) Qualitative Measures - _______ reserve requirement - ________ interest rates directly - _______ discount rate - Moral suasion - Conduct open market operations - __________ regulation (A) Quantitative Measures 1. Central Bank can _______ the reserve requirement.
2. Central Bank can _______ the discount rate.
3.
Central Bank can also conduct open market operations by _______ government bonds or securities from banks or private individuals with cash.
Over-heating occurs when its productive capacity is unable to keep pace with growing aggregate demand.
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General Price Level
Real NY
Figure 7: Effects of Contractionary Monetary Policy (AD-AS approach)
(B) Qualitative Measures 1.
2.
3.
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3.3
The Effectiveness of Monetary Policy
3.3.1 Pros of Monetary Policy If prudently and effectively managed, monetary policy can be effective in influencing the overall money supply in an economy and interest rates, thereby influencing consumption, investments, aggregate demand, economic growth and employment. Monetary policy involves commercial banks which are the main financial intermediaries in any economy. These banks subsequently influence consumption and investment decisions which exert large impacts on the economy.
3.3.2 Cons of Monetary Policy The effectiveness of using monetary policy as a macroeconomic tool depends on the interest elasticity of demand for loans. If the demand for loans is interest inelastic (an increase in interest rate will lead to less than proportionate decrease in the amount of loans provided), the central bank needs to raise the interest rates substantially. Reasons for interest inelasticity: A rise in interest rates, particularly during recession, may force many firms into borrowing merely to survive; Investment decision depends on many factors other than interest rates. These factors include political stability, market conditions (if business outlook is positive, firms would not reduce borrowing by much even when interest goes up), etc.
Other problems of using MP are: Imperfect market information in a dynamic financial environment to formulate a perfectly sound and effective MP there may be insufficient information as to the extent of change required to reach desired AD;
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Long and variable time lags from policy formulation, announcement, implementation to desired policy effects. Changes in MP can be mis-timed and worsen economic growth cycles; MP may not be effectively and efficiently implemented in some countries due to command and control problems, as in the following case study on China.
Furthermore in the event of a contractionary MP, a high interest rate could lead to the following problems: Discourage investment in the long run, and hence long-term economic growth; Add to the costs of production, to the costs of house purchase and generally to the cost of living, thus leading to cost-push inflation; Attract inflow of foreign capital, pushing up the exchange rates and reducing the export competitiveness. This may lead to an unfavourable current account. Overall, MP should still be an indispensable tool of macroeconomic policy and is best complemented by other policies, such as fiscal policy and supply-side policies.
3.4 Monetary Policy in Singapore

The objective of Singapores monetary policy (MP) is to achieve domestic price stability as a basis for sustained economic growth. Singapore does not have an independent MP. Since 1981, its MP is centred on the exchange rate. This is often referred to as our exchange rate policy and hence we do not have an independent domestic monetary policy. This is because Singapore has a small economy which is open to trade and capital flows. This will be discussed in detail in the next section, Exchange Rate Policy) 3.4.1 Openness to Trade Flows In 2010, Singapores total trade (sum of export and import values of goods and services) with the rest of the world was about 3 times its GDP. Domestic expenditures also have high import content. Exports
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have an estimated import content of 70%. The implication is that domestic prices in Singapore are largely determined by world prices for a given exchange rate. Hence, Singapore is a price taker on world markets. Singapores interest rates tend to follow the world-wide movement in interest rates.
3.4.2 Openness to Capital Flows Singapore has no control over capital inflows and outflows of foreign currency funds by residents and foreigners. It adopts a liberal policy towards foreign direct investments and allows for almost perfect capital mobility. The implication is that MAS can either manage the exchange rate or interest rate (money supply) but not both. Exercising monetary independence will be neither effective nor desirable for Singapore. Imagine if the MAS were to target domestic interest rates to be higher than world interest rates, then massive inflows of hot money or short term capital will occur and this will expand money supply in Singapore. Thus the contractionary MP pursued earlier would be ineffective. Conversely, if the Singapore government pursues an expansionary monetary policy by reducing interest rates. This will result in massive outflows of hot money which will eventually lead to a fall in money supply. Hence expansionary monetary policy would be countered by the fall in money supply due to the exodus of hot money, rendering the policy ineffective. These massive amounts of hot-money inflows to and outflows from Singapore can create excessive short-term volatility in the exchange rate, which is disruptive for investors and businesses. Hence, an independent MP is also not desirable. Singapores conduct of monetary policy is centred on the exchange rate, rather than controlling money supply or interest rates. The choice of the exchange rate as the main instrument of monetary policy must imply relinquishing control over domestic money supply and interest rates.
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Annex A
Functions of Money Money has 4 major functions. The first important function of money is to serve as a medium of exchange money can be used to buy goods and services. A seller will accept money for his goods because he knows the money he accepts can be used to buy other goods and services. In the case of hyperinflation, money can no longer serve as a medium of exchange because prices of goods are so high that the money used no longer has sufficient value (i.e. the internal value of a currency) to serve as a medium of exchange. A second function of money is that it serves as a standard of value, i.e. money is a standard by which we can measure the value of different goods. For example, a book and a pizza, two goods of different values, are measured using different amounts of money. The dollar or currency is usually the common measurement of money in society because there is a standard currency. It would be very difficult to use cows as money because each cow is different and would therefore indicate a different standard of value. A third function of money is that it serves as a store of value. Therefore, people can use money to spend at a later time on goods and services. Thus, money is a claim on future goods and services. Lastly, money functions as a measure of debt, i.e. it records the amount of money to be paid in the future. This is only possible because money can be a store of value. Definitions of Money Money supply is the quantity of money in the economy. However, there are different definitions of money supply because there are various forms of money that can serve the above 4 functions of money. M1 is the narrowest definition of money supply and consists of the forms of money which can readily serve as a medium of exchange. This refers to currency in circulation, as well as checkable deposits (deposits in a checking account that can be easily transferred quickly from one party to another i.e. writing a cheque draws down on your checking account). The broader forms of money supply include M2, M3 and M4, in which these forms of money serve as a store of value. For example, M2 includes savings deposits on top of M1. M3 is the most commonly used measure of money supply in most economy. It
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includes M1, which serves primarily as a medium of exchange. In other words, money supply in the economy can be easily and conveniently used to buy goods and services. As such, by changing the money supply in the economy, it is possible to affect the amount of goods and services people can buy using available money. If people have less money, then they will buy or consume less goods and services in the economy. In addition, because money functions as a standard of value, the value of money in terms of how much goods and services it is worth (the internal value of currency) also determines how much goods and services one can consume. If the value of money falls, the same amount of money can no longer buy the same amount of goods and services. In cases where money loses its value rapidly, it can then cease to become a medium of exchange. Credit Creation and Destruction in the Economy The quantity of money circulating in the economy can be changed through the processes of credit creation and destruction through the commercial banking system. A commercial bank is any bank that accepts checkable deposits. Commercial banks are privately-owned and profit-seeking businesses. Credit creation occurs when banks make loans to individuals and firms. The funds for these loans come from deposits in savings accounts made by individuals and firms in the commercial bank. If this process is repeated many times, the quantity of money in the economy will be multiplied many times. Credit destruction occurs, when loans are paid back to the bank, decreasing the quantity of money circulating in the economy. Banks give individuals and firms incentives to deposit money as savings in banks by giving them a certain percentage of the amount deposited the interest rate, in this case acting as a return on savings. On the other hand, they charge individuals/firms for taking out loans in terms of a percentage of the amount loaned. In this case, the interest rate represents the cost to borrowing. Hence, to make a profit, banks usually charge a higher interest rate for loans as compared to the interest rate which accrues for savings accounts. The total profits earned are the interest rate differential multiplied by the amount of money loaned out.
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As such, the bank would make the most profit if it could loan out all the savings deposited. However, if that were the case, no individual or firm would deposit in the bank because they would not be able to retrieve their savings when they want to. As such, banks usually keep a portion of savings which are not loaned out, known as reserves. As such, commercial banks have the ability to create credit or increase the money supply and destroy credit, or reduce the money supply. However, this ability is regulated by the central bank through regulations that central banks have over commercial banks. It is through this that the government can conduct monetary policy and adjust the quantity of money circulating in the economy.
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EXCHANGE RATE POLICY

i) John Sloman, 6th Edition, Economics, Chapter 24.
Recommended Reading:
The governments intervention in the foreign exchange market is to manipulate the exchange rate in order to achieve its macroeconomic goals. Exchange rate policy impacts both the internal and external equilibrium of the country. A change in the exchange rate can affect the internal components of the economy such as an economys output, employment and income and general price levels. It may also affect the external components of the economy - the balance of payments status. Recall from Foreign Exchange: the 3 types of exchange rate systems There are three different types of exchange rate systems which a government can utilise/adopt: Flexible or Freely Floating System where the exchange rate is determined entirely by the market forces of demand and supply in the foreign exchange market with no government intervention. Eg. Brazil adopted free floating exchange rate system from 1999 onwards. Fixed Exchange Rate System where the government takes necessary measures to maintain the exchange rate at an optimal level. Eg. Chinas fixed exchange rate system Managed Float Policy Exchange rates are allowed to float within a stipulated band, with the government intervening from time to time to prevent excessive exchange rate fluctuations. Eg. Singapores managed float exchange rate system since 1981.
We are now going to focus on how exchange rate policy affects the balance of payments (BOP) status. How is a BOP disequilibrium rectified in the respective types of exchange rate systems?
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Exchange rate systems chosen by a government have an impact on how BOP disequilibrium is rectified.
4.1 Adopting a Flexible Exchange Rate System

4.1.1 How a Flexible Exchange Rate System solves BOP Disequilibrium There is automatic adjustment to BOP disequilibrium because the system is self-regulating through the market forces of demand and supply. Suppose a country is suffering from a BOP deficit, that is the value of imports of goods and services and capital outflow is greater than the exports of goods and services and capital inflow. This implies that the demand for the countrys currency will be less than the supply. This will cause the currency to depreciate in value and this depreciation will make her exports relatively cheaper and her imports relatively more expensive. Value of imports is will fall and export revenue will rise till BOP equilibrium is established. What condition is necessary for a flexible exchange rate system to solve BOP disequilibrium?
Whether exchange rate adjustments can successfully correct balance of payment disequilibrium depends on the price elasticity of demand for imports and exports and its price elasticity of supply of exports and imports. In the case where the demand for exports and imports are price inelastic, a depreciation of the currency will lead to higher import expenditure and lower export earnings. Thus, it may worsen the status of the balance of payments. Why? If the PED for exports is less than one, a depreciation of the currency will decrease the price of her exports. The increase in quantity demanded will be less than proportionate to the fall in price. Therefore the export earnings will fall. If the PED for imports is less than one, a depreciation of the currency will increase the price of imports in terms of domestic currency. The fall in quantity demanded will be less than proportionate to the increase in price. Therefore the import expenditure will rise.
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If the demand for imports and exports are price elastic, this will help to correct the BOP deficit. This is the so-called automatic adjustment of the flexible exchange rate system. The necessary condition for for a flexible exchange rate system to solve BOP disequilibrium is stated below: In general, the Marshall-Lerner Condition (PEDx + PEDm > 1) is required for a fall in exchange rate value to restore Balance of Trade equilibrium. What is the other benefit (advantage) of adopting flexible exchange rate system? The implication of adopting a flexible exchange rate system is that it is possible to pursue an independent domestic policy aimed at securing internal equilibrium. The government can pursue internal policy objectives of reducing inflation, promoting economic growth and full employment while leaving market forces to determine the exchange rate that would automatically restore balance of payment equilibrium. For example,a BOP disequilibrium eg. BOP deficit can be corrected by depreciation without causing inflation. So a country can make good use of domestic policies such as monetary policy to achieve internal aims while any BOP disequilibrium can be automatically corrected due to the flexible exchange rate system.
4.2
4.2.1
Adopting a Fixed Exchange Rate System

How a Fixed Disequilibrium Exchange Rate System solves BOP
BOP deficit (outflow > inflow) exchange rate
government needs to buy up excess increase interest reduce correct
domestic currency in forex market in order to maintain the fixed contract MS in domestic country reduce C and I rate in domestic country general price level expensive BOT reduce AD
exports relatively cheaper, imports relatively
assuming Marshall-Learner condition holds
correct BOP assuming ceteris paribas

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Alternatively, the government may change the fixed exchange rate. See 4.2.2 4.2.2 Devaluation Government may choose to devalue the currency, especially when the country is having persistent BOP deficit. As the result of devaluation, imports will become relatively more expensive while exports become relatively cheaper. Assuming Marshall-Lerner condition holds, the balance of payment deficit can be corrected. (Note: In the event of a BOP surplus, the government can revalue the currency. As a result of revaluation, exports will become relatively more expensive while imports become relatively cheaper.)
What problem (disadvantage) arises when a country adopts fixed exchange rate system?
However, it is impossible to pursue an independent domestic policy with goals aimed at securing internal equilibrium policy conflict! Monetary authorities have to pursue expansionary domestic policies when countries enjoy BOP surplus (due to BOT surplus and KFA surplus as a result of net inflow of FDI) in order to maintain BOP equilibrium. However, the economy is likely to be facing internal problems at the same time it is experiencing BOP surplus. This is because the increase in (X-M) and FDI lead to rise in AD, triggering demand-pull inflation, assuming economy is near or at Yf. So there is a need to reduce inflation (internal problem). So the government may wish to adopt a contractionary monetary policy. However, the necessity of maintaining external aims takes precedence due to the country adopting a fixed exchange rate system (have obligation to maintain the peg/ fixed exchange rate). So a policy conflict arises since expansionary not contractionary policy has to be adopted to maintain the external (BOP) equilibrium which will however worsen internal equilibrium!
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Why policy conflict? BOP surplus (inflow > outflow) government needs to sell domestic increase MS in domestic increase C exports assuming correct BOP
currency for foreign currencies in exchange in forex market in order to maintain the fixed exchange rate country and I increase AD decrease interest rate in domestic country increase general price level correct BOT
relatively more expensive, imports relatively cheaper Marshall-Learner condition holds assuming ceteris paribas.
However, the further rise in general price level worsen the situation of inflation and hence this shows that pursuing fixed exchange rate system makes a country lose control or freedom of using domestic policies such as monetary policy to achieve internal aims or objectives. Analyse whether there will be also be a policy conflict when BOP deficit is experienced in a country with a fixed exchange rate system.
4.3 Adopting Managed Float Policy The exchange rate is allowed to float freely within the band in the managed float set by the government. Thus the external BOP will automatically adjust to equilibrium as long as the rate is within the band. If the rate falls/rises beyond the band, the government intervenes to bring the rate back within the band. This will minimise the fluctuations and stabilise the economy.
4.4 Exchange Rate Policy in Singapore

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Compulsory Reading: Economics Explorer #2 (www.mas.gov.sg) Singapores monetary policy is centred on the exchange rate. WHY? (A) Small size and openness Singapore is a price taker. Changes in world prices directly impact domestic prices. Exchange rate can influence overall demand and hence inflation. (B) Openness to trade - Imports and exports amount to over 100% of GDP. - High import content of final expenditure: 54 cents of every $1 is spent on imports. (C) Openness to capital flows Small differences between domestic and foreign interest rates can lead to large and quick movements of capital. This makes it difficult to control money supply. Domestic interest rates are largely determined by world interest rates. Thus, Singapore cannot effectively control money supply and interest rates, unlike the U.S. The Monetary Authority of Singapore can however use exchange rate to manage the economy more effectively. 4.4.1 Managed float system (Recall from Forex) The MAS manages the S$ exchange rate against a trade-weighted basket of currencies of Singapores major trading partners and competitors. The MAS maintains the trade weighted exchange rate within an undisclosed target band by intervening to prevent massive fluctuations of the exchange rate, consistent with the exchange rate policy and underlying economic fundamentals. 4.4.2 The transmission mechanism of monetary policy The transmission mechanism refers to the channels through which the exchange rate policy of the MAS affects inflation and economic activity in Singapore. Refer to Economics Explorer Series #2 from MAS.
Keynesian Transmission mechanism

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THE TRANSMISSION MECHANISM
Import Prices A B Trade-weighted S$ exchange Rate Domestic Demand External Demand Total Demand INFLATION
C Interest Rate Expectations/ Confidence Asset Prices
See the diagram 1 below for Channel A: Impact of ER on import prices Domestic pr of imported gds rises Inflation Pr of locally produced gds using imported inputs rises
Weaker S$ ER
Each S$ is worth less in US$
Imported gds cost more when converted to S$
Diagram 1
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See the diagram 2 below for Channel B: Impact of ER on external demand Higher X growth & over-heated economy
Weaker S$ Exch Rate
More competitive X in the SR
Inflation Diagram 2
Surge in Labour costs
Rise in wages & rentals
Channel C: Impact of ER on Domestic Demand (No diagram. See the explanation below) Besides the main channels A and B, the exchange rate/monetary policy also impacts the economy through its influence on domestic demand, e.g. via interest rate (Channel C). Changes in the monetary policy also influences consumer confidence, expectations about future course of the economy and asset prices, although their ultimate impact on domestic demand is difficult to assess. How does a change in exchange rate impact interest rate? The Central Bank can affect interest rate through its influence on market expectations of future movement of the exchange rate. For example, if the market expects the S$ exchange rate to appreciate over time, this will result in huge inflow of foreign currency to purchase domestic currency. Increase in domestic currency deposits by foreigners will increase money supply, hence driving down the interest rates. How does interest rate affect the economy? Lower domestic interest rate Rise in C and I
rise in AD
Evaluation of the extent to which interest rate change can affect the economy:
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Interest inelastic investment: When business firms are pessimistic about future economic activity, a decrease in interest rates will do little, if anything to increase investment. Similarly if consumers are pessimistic about future economic activity, little increase in C. So no or minimal increase in C and I will have negligible impact on AD. Liquidity trap: Demand curve for money could become horizontal at some low interest rate. Any fall in interest rate will result in no change in investment and, hence, aggregate demand.
Next, we are going to examine the role exchange rate policy plays in reducing BOP deficit. We will also consider other policies that can be used to reduce BOP deficit. Role of Exchange Rate Policy in Removing BOP Deficit BOP Deficit Expenditure-Switching Policies Expenditure-reducing policies Expenditure-switching policies aim to These policies aim to rectify the switch expenditure from imports to deficit by reducing expenditure on domestically produced substitutes. imports. Devaluation( Exchange rate policy) ( Increase relative price of imports) When a country devalues its currency, its exports become relatively cheaper in overseas markets and foreign imports become relatively more expensive when denominated in domestic currency. This encourages people in the country to switch from relatively more expensive imports to relatively cheaper import substitutes in the country. Export revenue would rise and import expenditure would fall. Deflation This is an expenditure-reducing policy which tries to cure the current account deficit by reducing AD for goods and services so as to reduce the demand for imports. Both monetary and fiscal measures can be used to deflate the level of AD in the economy. When AD and NY falls, demand for imports will also fall. Hence M will fall.
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Tariffs and import duties (Protectionist measures that increase price of imports that cause a switch from imports to similar domestic goods and services) Tariffs and imports duties aim to discourage expenditure on imports and encourage expenditure on domestic goods by increasing the price of imports relative to domestically produced substitutes, leading to domestic consumers switching to import substitutes. This could however, provoke retaliation by the countrys trading partners. (To be examined further under International Trade)
Direct Controls (Protectionist measures that reduce quantity of imports) Direct controls can be in the form of quotas and embargoes. The former aims to restrict the quantity of imports and the latter to prevent expenditure on imports so as to eliminate the deficit. Direct controls can also be in the form of exchange controls. Exchange controls are aimed at limiting the amount of foreign currency spent on imports. An added effect of exchange control is that it can also check the outflow of capital.
Is deflation a good measure to reduce the BOP deficit? This may be an appropriate measure when the cause of the BOP deficit is recession abroad or when the local inflation rate is higher than foreign inflation rate.
However, deflation also causes reduction in real output which leads to rise in unemployment.
Question: Will deflation be effective to reduce current account deficit in Singapore?
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4.5 Possible policy conflicts i) Expansionary fiscal policy to create jobs and boost the economy is this through increased government spending and/or reduced tax rates? How is this government spending financed? Is it through increasing direct taxes such that there might be disincentive to work and the implication on income creation and spending which may counter the effects of an expansionary policy? What about the external equilibrium i.e. the balance of payments of the country? What about the competitiveness of its currency? ii) Contractionary fiscal policy to reduce inflationary pressure may see the government increasing tax and reducing government spending But would this push cost of production up and thereby increasing prices further? Does this run contrary to the monetary policy of the country? Does this conflict with the external equilibrium of the country? iii) Contractionary monetary policy (to reduce the inflationary pressure in the economy) may require a fall in money supply so as to raise interest rates. However, this causes crowding out effects as well. Does this complement the fiscal policy and the external equilibrium? Does the increase in interest rates make exports more expensive? iv) Expansionary monetary policy where MS is increased, interest rate falls in order to encourage more investments How would this affect the external equilibrium and the exchange rate policy? Is this in conflict with the fiscal policy of the country?
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PRICES AND INCOMES POLICIES
Recommended Reading: (i) Economics, Hoon Hian Teck et al, pp 293-295 A Prices and Incomes Policy is defined as an attempt by the government to influence directly the setting of wages and prices. These policies attempt to act directly on prices and/or wages. The goals of these policies are to achieve low unemployment and stable prices.
5.1
Incomes Policy to minimise cost-push inflation
Incomes policy is an attempt by policy makers to moderate increases in wages and prices either by persuasion or by legal rules. If labour leaders can be persuaded or made by the force of law to reduce or moderate wage demands, and employers to cap or moderate increases prices of their products, then this will help to lower inflationary expectations. Singapore has an incomes policy which is one of the reasons why it generally has a low rate of inflation. One of these is a wage policy in the form of guidelines put forward by the National Wages Council (NWC). The NWC is a tripartite body consisting of representatives from labour unions, employers and the government. It enables the government to play a mediating role between employers and employees to monitor and guide the course of wages and prices in Singapore. The NWC guidelines help to keep wage growth in tandem with labour productivity growth. The incomes policy in Singapore goes one step further to even implement wage cuts as in the case of the 1985-86 recession. Then, the workers accepted a 15 percentage point cut (from 25% to 10%) in employers CPF contribution rate. When the economy recovered, the unionised employees faith in the tripartite arrangement is maintained when employers contribution to employees CPF is restored. Currently, for the bulk of the workforce, the employees contribution is 20% and employers is 14.5%. Besides adjustments to CPF, NWC recently encouraged employers to introduce (besides bonus), a monthly variable component (MVC) above their employees fixed wage component. This component acts a variable cost to employers and can be cut in difficult business times.
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SUPPLY-SIDE POLICIES
Recommended Readings: (i) Economics, John Sloman, 6th Edition, pp 413 (ii) Economics, Roger Arnold, 6th Edition, pp 266-270 Supply-side policies are government policies designed to affect aggregate supply (AS) directly, specifically policies to reduce costs or raise productivity. They are also to minimise friction in markets and to improve information flow. It seeks to achieve economic gains by long-term measures designed to raise the rate of economic growth by shifting the long-run aggregate supply curve to the right rather than manipulating aggregate demand. Important Note However, supply-side policies often have demand-side effects just as demand-side policies have supply-side effects. You should reflect this in AD-AS diagrams and analysis. For example, in 2002, the Singapore government set up the Workforce Development Agency (WDA) to collaborate with various industries to re-train and re-skill workers displaced by structural unemployment. The government expenditure on re-training (G) our skilled workforce is an additional incentive for foreign investors to locate their business in Singapore (I). Increase in both G & I led to an increase AD. But the re-skilling also enhances the employability of our workforce in new jobs and industries and can increase potential output (AS) in the long run. Hence it is important for a government to take into account all effects when deciding on their economic strategies. The aims of these supply-side policies are to encourage and reward individual enterprise and initiative, and to reduce the role of government; to put more reliance on market forces & competition, and less on government intervention & regulation.
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6.1 Types of Supply-side measures 6.1.1 Reducing Government Expenditure - Release More Resources to the Private Sector A more efficient use of resources within the public sector and a reduction in the size of the sector can allow private investment to increase with no overall rise in aggregate demand. Thus the supplyside benefits of higher investment could be achieved without the demand-side costs of higher inflation. In the UK, cash limits were imposed on various government departments and local authorities to force them to become more efficient. Grants and subsidies were reduced. When subsidies were reduced, many nationalised industries would increase their prices since their objective is to maximise profits. However, these policies were not without problems. In some sectors, the effect was to cut services rather than increase efficiency. Since it was found much easier to cut long-term capital (developmental) expenditure than recurrent expenditure (example wages), there was a sharp decline in new roads, schools, etc. 6.1.2 Reducing taxes to raise work incentive Supply-side advocates alleged that high taxes discourage work. Hence, one way to encourage labour force to increase their propensity to work to reduce personal income tax rates and shift the emphasis to taxes on consumption. This would then encourage more work as the disposable income would now be larger, hence offering higher SOL to income earners. During the 1980s, the basic rate of income tax was reduced from 30% to 25% in the U.K. However, it was to be found that lowering tax rates may not necessarily induce more work. Say a worker can choose to work 8 hours a day and earns a monthly salary of $2,000 or 6 hours a day and earn $$1,500 a month. The prevailing tax rate is 40% and he decided that he would need a disposable income of at least $1,200 to make ends meet. Hence, he works 8 hours a day and earns $2,000 a month. He pays income tax of $800 (40%) leaving him with a disposable income of $1,200.
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Suppose the government now reduces the income tax to 20%. He might now choose to work 6 hours a day and earn $1,500 a month, paying 20% tax, which leaves him a disposable income of $1,200 the same as before! Hence, the lowering of income tax in this instance has led to lower amount of work willing to be offered by the worker. Business income is taxed firstly as the income of firms when it is earned and secondly as the income of households, when it is paid out as wages (employees of firm) and dividends (shareholders of the firm). This will reduce business profits and diminish the return to investing in company shares. Thus, it will discourage households from investing in businesses that are the mainspring of economic growth. In Singapore, the rate of corporate tax on business profits was lowered from 33% in 1980s and to 17% in 2009. 6.1.3 Reducing the Automatic Entitlement to Welfare Benefits: Encourage Greater Self-reliance Some economists claim that a major cause of unemployment is the small difference between the welfare benefits of the unemployed and the take-home pay of the employed. This causes voluntary unemployment (i.e. frictional unemployment). Therefore, a dramatic solution to this problem would be to cut unemployment benefits. Instead of welfare benefits for low-income households, which can breed a dependent mentality, the Singapore government introduced a workfare scheme instead. Under this scheme, the government gives one months bonus for those aged 40 and for earnings up to S$900, and half a months wage for those with earnings from S$900S$1,200 on the condition that they must have worked for a minimum period of 6 months. But 10% of the grants go to the Medisave account. Singapores method offers incentive to work, incentive for training and forced savings via the CPF scheme. 6.1.4 Encouraging Competition through Policies of Deregulation and Privatisation If the government can encourage more competition, this should have the effect of increasing national output and reducing inflation. Privatisation can involve the transfer of a natural monopoly to private hands (e.g. Singapore Telecommunications SingTel) or it can involve the introduction of private services into the public sector (e.g. private contractors providing cleaning services in hospitals) which may well lower the cost of provision.
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Deregulation involves the removal of monopoly rights. In 1973, the National Bus Corporation in the U.K. lost its monopoly of long distance coach haulage. Private operators were allowed to compete. This substantially reduced coach fares on a number of routes. In Singapore, there is the introduction of competition in various industries such as the telecommunications industry, airline and public transportation. 6.1.5 Adopt Exchange Controls to Influence the Movement of Capital The opening-up of international trade and investment is central to a market- orientated supply-side policy. One of the first measures of the Margaret Thatcher government was to remove all exchange controls, thereby permitting the free inflow and outflow of capital, both long-term and short-term. Most other industrialised countries also removed or relaxed exchange controls during the 1980s. 6.1.6 Ease Business Costs in Difficult Times (Reduce Costs of Production) The Singapore government implemented two off-budget measures to ease business costs when Singapore was hit by SARS in 2003. These measures included property tax rebate, rental rebate and reduction in foreign worker levies.
6.1.7 Raise Productivity Levels Since the 1970s and 1980s, the Singapore government has launched productivity campaigns and introduced incentives for employers to train their workers, e.g. Skills Development Fund (SDF), job redesign, setting up of Workforce Development Agency to help train workers and workfare. These measures are designed to reduce unemployment and to raise the productivity of the existing workforce.
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General Price Level
AS
AS
P P E
E AD AD
Yf
Yf
Real NY
Figure 4: Effect of Supply-side policy on AD and AS Supply-side policies have the effect of increasing potential output (Yf). Thus AS shifts rightwards. As supply-side policies may have demand-side effects, AD also shifts right. For example, the increase in labour productivity, which shifts AS to the right, as a result of training and skills development on a national basis, can be a key factor drawing more foreign direct investments (I) to a country, and hence causing AD to shift to the right. Any demand-pull inflationary pressures can be eased if AS shifts substantially to the right. NOTE: Supply-side policies have a primary effect of shifting AS to the right. In the event that a consequence of the policy also affects the demand side, the AD curve would then shift.
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Content Mastery By now, you should be able to: 1. 2. 3. explain the objectives of macroeconomic policies; explain the different types, aims and instruments of these policies; analyse how fiscal, monetary, prices and incomes and supply-side policies can be used to resolve macroeconomic problems using the AD-AS model or Y-AE approach; analyse the monetary policy framework in a small and open economy such as Singapore; explain Singapores choice of using exchange rates rather than interest rates as an instrument of monetary policy; evaluate the effectiveness of governments macroeconomic policies using the Y-AE approach or AD-AS approach, especially with reference to the Singapore economy; discuss the possible conflicts in government objectives and the links between macroeconomic problems and their inter-relatedness.
4. 5. 6.
7.
Reflection/Notes:
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Appendix A Budget Themes

(Summary: Beyond Stewardship: 50 Years of Ministry of Finance 1959-2009, (A supplement of Challenge) by Gloria Chung) 1960s Building the Foundation for Economic Growth Emphasis on fiscal prudence, development of basic infrastructure and rapid industrialisation to create employment. Governments immediate task balance 1959 FY operating budget. Salaries of civil servants were cut. End of year surplus of $21 million instead of the planned deficit of $14 million Balancing the budget became the cornerstone of fiscal prudence. 1969 $2.4 billion from 1965 $6.31 million. End of
Key Developments: o Developed industrial estates, schools and low-cost housing funded from domestic loans (mainly from CPF) and external loans (World Bank and other United Nations agencies). o Tax incentives to pioneer industries and agreement with foreign countries to avoid double taxation. o Export-oriented and labour-intensive industries were promoted to address the issue of unemployment (all time high of 10% in 1965). Employment expected to worsen with the impending withdrawal of British Military Bases in Singapore by 1971.
1970s By early 70s achieved full employment Plans made for industries to shift towards more technology-intensive and higher value-add products/services. Identified trade, manufacturing and tourism as main areas of growth. Diversification of economic base, together with its reserves weathered oil crisis of 1973 which brought many economies into a recession. After which achieved remarkable average GDP growth of 9.4% a year for the decade. However, oil crisis slowed down the move to higher-value-add industries.
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Key Developments: o Educational institutions (polytechnics and universities) expanded to meet the demand for skilled and professional manpower. o Immigration and work permit restrictions were eased to attract foreign skilled labour. o Defence budget increased from $205 million (FY 1969) to $530 million (9.5% of FY 1971 GDP) to build up defence capability in view of British withdrawal.
1980s Economic Restructuring 1980 - 1985 Beginning of decade, labour-intensive industries faced stiff competition from labour-abundant countries. Productivity fell as low-skilled workers were recruited to fill labour shortage. In response Government restructured economy based on science, technology, skills and knowledge. Key Developments: o High wage policy to induce employers to mechanise and computerise, and reward employees with better pay for the higher skills. o Top tier personal income tax (direct tax) progressively reduced from 55% (1980) to 33% (1989). o Programmes for employees to upgrade skills funding support from Skill Development Fund. o National Computer Board set up in 1982 to lead in computerisation. Educational institute provide training to contribute to this pool of talent e.g. NTI produce practice-oriented engineers. o Tax incentives grants to encourage R&D (Science and Technology Park was developed)
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1986-1989 Mid-decade global slowdown in international trade, GDP 100,000 jobs lost.
1.8% contraction
Singapore government conducted a review implemented restructuring strategies and cost cutting and fiscal measures to enable Singapore to stay competitive and stimulate economic activities. Key developments: o CPF employers contribution cut from 25% to 10% o Corporate Income Tax down from 40% to 33% o Govt expenditure on infrastructure (land reclamation, development of industrial estates, building of roads and MRT system) o Flexible wage system to enhance the ability of business to cope with economic uncertainties
1990s Plugging into the Global Economy Key thrust plugging into global network of investment flows, trade and communications to ensure competitiveness Focused on building up technological capabilities and capacity Measures put in place to protect past reserves and share budget surpluses Measures put in place to help Singapore weather 1997 Asian Financial Crisis Key Developments o External link with APEC and Singapore-Johore-Riau growth triangle o Personal and corporate income tax rates were progressively reduced from 26% and 28% respectively by end-1999. o GST 3% introduced in 1994 o Funds established to help promising enterprises and regionalisation of local industries o National Science and Technology Board established to build Singapore Technological capabilities and capacity
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o Constitution Amended in 1992 to have past reserves locked can only be drawn upon with Presidents consent o Sharing of past reserves direct payment into citizens CPF account, bank account or trust funds; endowment funds for education, healthcare and training.
2000s Building Resilience Recommendation by 2001 Economic Review Committee o Tax system be structured to ensure competitiveness as Singapore economy matures o Economy diversified through greater engagement with emerging economies like China and India; development of an environment conducive to build an ecosystem of large and small industries.
o Framework for spending revised to provide inter-generational benefits. Reserves enabled Singapore to respond quickly and be decisive in putting together the Resilience Package for citizens and businesses to weather the 2008 global economic crisis. Key developments: o Corporate and personal income tax rates reduced to 17% and 20% respectively. To offset loss in tax revenue, GST was increased progressively from 3% (2004) to 7% (2007). Impact cushioned with comprehensive GST rebates to all citizens. o Favourable tax measures were introduced to attract global SMEs and start-ups to Singapore and to encourage pervasive R&D in these enterprises. o Past reserves were used to guarantee up to $150 billion in the deposit guarantee scheme to provide stability during the financial crisis which started in 2007. o For the very first time, Singapore drew on past reserves to provide $4.9 billion Resilience package in 2009.
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Appendix B
Sample Concept map for your own summary Work out the details for each of the macro problems.
Recession
Causes
Fall in AD (Dd Deficiency)
others
Fall in AS
Demand side Policies
Supply side policy
Expansionary FP lowerTax raise Govt
Policies relating to increasing productivity and lower cop MP increase MS lower i/r ER Policy technology Training Outsourcing Alternative Supply
Must Evaluate on the effectiveness of policies in achieving the aims.
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Appendix C
Overview of Macroeconomic Policies (Extracted from Singapore Economic Survey of Singapore, 2008 and 2009) 2008 Fiscal Policy
Strong economic growth and high profit margins from earlier years continued to contribute to operating revenues. Expenditures increased due to spending on key investments in human capital, healthcare and infrastructure.
2009
The deterioration in global economic conditions in the second half of 2008 led to weak growth in 2008 and an overall contraction in 2009, dampening revenue collections.
Expenditures increased due to fiscal stimulus measures as well as continued spending on key investments in human capital, healthcare and infrastructure.
Monetary Policy
In October 2008, against a weakening external economic environment and easing inflationary pressures, the Monetary Authority of Singapore shifted its monetary policy stance to a zero per cent appreciation of the S$NEER policy band, without altering the width nor the centre of the band.
In April 2009, amidst dissipating inflationary pressures and weak growth prospects for the Singapore economy, the Monetary Authority of Singapore (MAS) re-centred the exchange rate policy band downwards to the prevailing level of the S$NEER, while maintaining the zero percent appreciation path which was adopted in October 2008.
In October 2009, due to continuing uncertainties in the external economic environment, MAS maintained the policy stance of a zero per cent appreciation of the S$NEER policy band. There was no change to the width of the policy band and the level at which it was centred.
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Budget Focus Budget 2008

Budget 2008 focused on Creating a Top Quality Economy, Building a Resilient Community. The forward-looking budget aimed to create new advantages and fresh opportunities for Singapore in a competitive world. Leveraging on Singapores strong fiscal position at the end of FY2007, the Budget shared a significant proportion of the budget surplus with Singaporeans. Some of the key budget initiatives were: Tax measures to enhance business competitiveness, support startups, and make innovation pervasive in the Singapore economy. More than $3 billion in surplus sharing, comprising: $1.06 billion worth of Growth Dividends (GD), including a 50 per cent enhancement to the second instalment of GD in August 2008; $560 million in GST credits and Senior Citizens Bonus; $300 million in Workfare Income Supplements; $200 million in Utilities-Save and Service & Conservancy Charges rebates; $480 million in property and income tax rebates; $500 million in top-ups to Post-Secondary Education Accounts; $226 million in Medisave top-ups. -
Budget 2009
Budget 2009 focused on Keeping Jobs, Building for the Future. It was brought forward to January (from the usual schedule in February every year) to provide timely support to households and businesses in response to the global financial crisis and credit crunch. Even as the budget dealt with the immediate problems caused by the economic downturn, it also took the opportunity to build up Singapores capabilities and infrastructure, and position Singapore for the next phase of growth.
The centre piece of Budget 2009 was the $20.5 billion Resilience Package, consisting of five components:
$5.1 billion to help preserve jobs for Singaporeans
$5.8 billion in government capital for a Special Risk-Sharing Initiative (SRI) to stimulate bank lending
$2.6 billion worth of tax measures and grants for businesses to enhance cash-flow and competitiveness
$2.6 billion to support Singaporean households, on top of the benefits they would derive from the measures to preserve jobs
$4.4 billion for infrastructural developments and expanded provisions for education and healthcare to build a home for the future
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Macroeconomic policies explained

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Macroeconomic Policies

3.2 HOW THE MACROECONOMY WORKS Macroeconomic Policies

Discretionary Fiscal Policy

Upward pressure on prices

Figure 1 Expansionary Fiscal Policy (AD-AS approach)

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

The Disadvantages/Limitations of Fiscal Policy

business investment (G crowds out investment) via the multiplier effect

AD may not increase by the desired amount

General Price Level

might increase after the economy recovers by itself increase in AD

desired increase in AD may not achieved

Real National Income 3 3 Path A Path B 4 2 2 4 Path C

via the multiplier effect

Is Singapores multiplier small? Why?

Automatic Fiscal Stabilisers

collected and more unemployment benefits needs to be during recession

helps to stimultes Aggregate demand.

Ministry of Finance website, Personal Income Tax Rates (http://app.mof.gov.sg/personal_income_tax_rates.aspx)

Effects of Fiscal Policy on Aggregate Supply

Effectiveness of Fiscal Policy

Fiscal Policy in Singapore

$7.6 billion $0.2 billion -$2.9 billion -$3.0 billion*

*budgeted (based on Budget 2010)

3.2 Who conducts MP?

3.3 How is MP conducted?

Expansionary Monetary Policy

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

Contractionary Monetary Policy

2. Central Bank can _______ the discount rate.

General Price Level

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

(B) Qualitative Measures 1.

The Effectiveness of Monetary Policy

3.4 Monetary Policy in Singapore

EXCHANGE RATE POLICY

4.1 Adopting a Flexible Exchange Rate System

Adopting a Fixed Exchange Rate System

BOP deficit (outflow > inflow) exchange rate

government needs to buy up excess increase interest reduce correct

exports relatively cheaper, imports relatively

assuming Marshall-Learner condition holds

correct BOP assuming ceteris paribas

4.4 Exchange Rate Policy in Singapore

Keynesian Transmission mechanism

THE TRANSMISSION MECHANISM

C Interest Rate Expectations/ Confidence Asset Prices

Each S$ is worth less in US$

Imported gds cost more when converted to S$

Weaker S$ Exch Rate

More competitive X in the SR

Surge in Labour costs

Rise in wages & rentals

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

PRICES AND INCOMES POLICIES

Incomes Policy to minimise cost-push inflation

General Price Level

Appendix A Budget Themes

Demand side Policies

Supply side policy

Expansionary FP lowerTax raise Govt

Must Evaluate on the effectiveness of policies in achieving the aims.