Fiscal policy involves changes in the quantity of money or the interest rate.

Students can refer to Economics – A Singapore Perspective for the diagrams. The book is available in the major bookstores in Singapore.

1          INTRODUCTION

Recall that the government has four macroeconomic goals: high economic growth, low unemployment, low inflation and a balance of payments equilibrium. However, these goals may not be achieved due to domestic factors, external factors or both. In the event that the macroeconomic goals of the government are not achieved, macroeconomic problems will occur which include low or negative economic growth, high unemployment, high inflation and a persistent balance of payments disequilibrium. As these problems have adverse consequences for the economy, the government will use macroeconomic policies to solve the problems. This chapter provides an exposition of macroeconomic policies.

2          DEMAND-SIDE POLICIES: FISCAL POLICY

2.1       Objectives of Fiscal Policy

Demand-side policies are policies that are used to influence aggregate demand. There are two demand-side policies: fiscal policy and monetary policy.

Fiscal policy is a demand-side policy that is used to control government expenditure or taxation to influence aggregate demand.

Expansionary Fiscal Policy

To increase economic growth or decrease unemployment, the government can increase expenditure on goods and services. For example, the Singapore government implemented the Resilience Package which included an increase in expenditure on infrastructure to increase economic growth in the 2008-2009 Global Financial Crisis. It can also increase disposable income to increase consumption expenditure by decreasing direct taxes such as personal income tax and corporate income tax or increasing transfer payments. In addition to an increase in consumption expenditure, a decrease in corporate income tax will lead to higher expected after-tax returns on planned investments resulting in an increase in investment expenditure. An increase in consumption expenditure, investment expenditure and government expenditure on goods and services will lead to an increase in aggregate demand which will induce firms to increase production resulting in an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

Contractionary Fiscal Policy

To reduce inflation, the government can decrease expenditure on goods and services. For example, many European governments reduced expenditure on goods and services in the early 1980s to reduce inflation caused by the sharp rise in oil prices. It can also decrease disposable income to decrease consumption expenditure by increasing direct taxes such as personal income tax and corporate income tax or decreasing transfer payments. In addition to a decrease in consumption expenditure, an increase in corporate income tax will lead to lower expected after-tax returns on planned investments resulting in a decrease in investment expenditure. A decrease in consumption expenditure, investment expenditure and government expenditure on goods and services will lead to a decrease in aggregate demand. Assuming aggregate demand and hence the general price level is rising rapidly, this will reduce the growth of aggregate demand which will lead to a slower rise in the general price level resulting in lower inflation.

Note:   The Principal Economics Tutor will discuss fiscal policy in greater detail in the economics tuition class.

2.2       Limitations of Fiscal Policy

Inflexibility of Government Expenditure and Taxation

Changing government expenditure and taxation involves a high degree of inflexibility as fiscal budgets are subject to parliamentary debates and approvals which may take months, which is known as the decision time lag. An example is the United States where lawmakers often vote along party lines which hinders the passage of some fiscal budgets in the Congress. Furthermore, it is difficult to decrease government expenditure on goods and services significantly as a large part of it is made in important areas such as education, healthcare, infrastructure and national defence.

Crowding-out Effect

The crowding-out effect is the effect of an increase in government expenditure on goods and services resulting in a decrease in private expenditure. An increase in government expenditure on goods and services due to expansionary fiscal policy is likely to lead to a budget deficit. If the government runs a budget deficit, it will have to borrow by issuing securities (i.e. bonds and bills) to finance the deficit, assuming it does not have sufficient reserves. When this happens, the demand for loanable funds will rise which will lead to a rise in interest rates. Higher interest rates will increase the incentive to save and the costs of borrowing and this will lead to a decrease in consumption expenditure. Furthermore, an increase in the costs of borrowing will lead to fewer profitable planned investments resulting in a decrease in investment expenditure. A decrease in consumption expenditure and investment expenditure will lead to a decrease in aggregate demand. Therefore, the increase in government expenditure on goods and services may not lead to a significant increase in aggregate demand.

Small Multiplier

Recall that an economy with high income taxes, high savings and high imports will have a small multiplier. For example, Singapore has a small multiplier due to the high savings and the high imports. The savings rate in Singapore is high due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. The level of imports in Singapore is high due to lack of factor endowments and the embracement of free trade. If the multiplier is small, the initial change in aggregate demand due to the change in consumption expenditure, investment expenditure and government expenditure on goods and services may not lead to a significant change in national output and hence national income, unemployment and inflation.

High Public Debt-to-GDP Ratio

An increase in government expenditure and a decrease in direct taxes due to expansionary fiscal policy are likely to lead to a budget deficit. If the government runs a budget deficit, it will have to borrow by issuing securities to finance the deficit, assuming it does not have sufficient reserves. When this happens, the public debt will rise. However, if the public debt-to-GDP ratio is high, a further increase in the ratio may induce people to lose confidence in the government’s ability to repay its debt which will cause the government to lose its ability to borrow. If this happens, the government will not be able to meet its debt obligations which will lead to a sovereign default resulting in a recession. Therefore, expansionary fiscal policy is constrained by a high public debt-to-GDP ratio. An example is Greece where the public debt-to-GDP ratio is 182.2 per cent as of end-December 2018 which makes expansionary fiscal policy virtually infeasible.

Changing Sentiment

When disposable income rises due to a decrease in direct taxes or an increase in transfer payments, consumption expenditure may not increase if households are less optimistic about the economic outlook. A decrease in corporate income tax may not lead to higher expected after-tax returns on planned investments and hence higher investment expenditure if business sentiment falls. Similarly, when disposable income falls due to an increase in direct taxes or a decrease in transfer payments, consumption expenditure may not decrease if households are more optimistic about the economic outlook. An increase in corporate income tax may not lead to lower expected after-tax returns on planned investments and hence lower investment expenditure if business sentiment rises.

Note:   A budget deficit occurs when government expenditure exceeds government revenue. A budget surplus, in contrast, occurs when government revenue exceeds government expenditure. Public debt refers to the amount of money that the government owes. It is also known as national debt, sovereign debt and government debt. A budget deficit will lead to a rise in public debt and a budget surplus will lead to a fall in public debt.

Public debt-to-GDP ratio refers to public debt expressed as a percentage of Gross Domestic Product (GDP). A persistently large budget deficit will lead to a rising public debt-to-GDP ratio. Austerity measures refer to the measures used by the government to reduce a budget deficit which include spending cuts and tax increases. In order to reduce the public debt-to-GDP ratio, many European governments have been implementing austerity measures since the early 2010s.

If the government defaults on its debt, banks will incur massive losses as they are the largest investors in government securities. When this happens, many banks will close down. Furthermore, due to the interbank debt, the closure of some banks will lead to the closure of more banks and the domino effect may result in a collapse of the whole banking system. For example, the sovereign default in Russia in 1998 led to the collapse of many banks including Inkombank, Oneximbank and Tokobank. If this happens, some households will not be able to borrow for consumption which will lead to a decrease in consumption expenditure, and some firms will not be able to borrow for investment which will lead to a decrease in investment expenditure. Households hold their wealth mainly in the form of bank savings, properties and financial assets such as stocks and bonds. Therefore, a sovereign default will lead to a fall in the wealth of households. When this happens, consumption expenditure will fall. A decrease in consumption expenditure and investment expenditure will lead to a decrease in aggregate demand which will lead to a decrease in national output and hence national income resulting in a rise in unemployment.

The Principal Economics Tutor will discuss the limitations of fiscal policy in greater detail in the economics tuition class.

2.3       Supply-side Effect of Fiscal Policy

Fiscal policy is referred to as a demand-side policy because it is used to influence aggregate demand. However, apart from aggregate demand, fiscal policy may also have an effect on aggregate supply. For example, government expenditure on education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy. Government expenditure on research and development will lead to technological advancement which will increase the efficiency of capital in the economy. Government expenditure on infrastructure will lead to an increase in investment expenditure resulting in a more rapid increase in the quantity of capital in the economy. A decrease in corporate income tax will increase expected after-tax returns on planned investments and hence investment expenditure resulting in a more rapid increase in the quantity of capital in the economy. A decrease in personal income tax will increase after-tax personal income resulting in an increase in the quantity of labour in the economy. An increase in the quantity of capital, the quantity of labour, the efficiency of capital and the skills and knowledge of labour in the economy will lead to an increase in the production capacity in the economy. In addition, an increase in the efficiency of capital and the skills and knowledge of labour in the economy will lead to an increase in labour productivity resulting in a fall in the cost of production in the economy. An increase in the production capacity and a fall in the cost of production in the economy will lead to an increase in aggregate supply. However, when economists talk about fiscal policy, unless otherwise stated, they are normally referring to the use of it to influence aggregate demand.

2.4       Fiscal Policy in Singapore

The Singapore government adopts a prudent fiscal policy which is mainly used to provide essential goods and services. Therefore, the government expenditure on domestic goods and services in Singapore accounts for only a small proportion of the national income. As a result, the Singapore government has consistently achieved modest budget surpluses with the exception of recession years when it ran budget deficits due to the implementation of fiscal stimulus. This has enabled the Singapore government to build up a large amount of reserves over the last few decades.

In non-recession years, expansionary fiscal policy is generally not used to increase economic growth in Singapore due to the low marginal propensity to consume, the small consumption expenditure, investment expenditure and government expenditure on domestic goods and services as components of aggregate demand, and the small multiplier. The marginal propensity to consume in Singapore is low due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. Therefore, an increase in disposable income is likely to lead to only a small increase in consumption expenditure. As consumption expenditure, investment expenditure and government expenditure on domestic goods and services are small components of aggregate demand in Singapore, an increase in consumption expenditure, investment expenditure and government expenditure on domestic goods and services is likely to lead to only a small increase in aggregate demand. The multiplier in Singapore is small due to the high savings and the high imports. The savings rate in Singapore is high due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. The level of imports in Singapore is high due to lack of factor endowments and the embracement of free trade. Therefore, the initial increase in aggregate demand due to the increase in consumption expenditure, investment expenditure and government expenditure on goods and services is likely to lead to only a small increase in national output and hence national income.

In a recession, which is caused by a fall in exports in Singapore due to the high dependence on external demand with the domestic exports accounting for a large proportion of the aggregate demand, the government will use expansionary fiscal policy to increase economic growth, as part of a policy mix. For example, it implemented the Resilience Package which included an increase in expenditure on infrastructure to increase aggregate demand in the 2008-2009 Global Financial Crisis. However, an increase in disposable income in Singapore is likely to lead to only a small increase in consumption expenditure due to the low marginal propensity to consume which is a result of the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. Furthermore, the consumption expenditure, investment expenditure and government expenditure on domestic goods and services in Singapore are small relative to the domestic exports. Therefore, the increase in consumption expenditure, investment expenditure and government expenditure on domestic goods and services is likely to only partially offset the decrease in domestic exports resulting in a smaller decrease in aggregate demand and hence lower negative economic growth.

Contractionary fiscal policy is not used to reduce inflation in Singapore. Due to the prudent fiscal policy in Singapore which is mainly used to provide essential goods and services, the government expenditure on goods and services is small. Therefore, it is difficult for the government to reduce expenditure on goods and services significantly. Similarly, as Singapore is not a welfare state, it is difficult for the government to reduce transfer payments significantly. Furthermore, an increase in personal income tax in Singapore which will lead to lower after-tax personal income will make the economy less attractive to foreign talents, and an increase in corporate income tax in Singapore which will lead to lower expected after-tax returns on planned investments will make the economy less attractive to foreign direct investments. As Singapore is highly dependent on foreign talents and foreign direct investments, this is very undesirable for the economy and hence the government does not favour increasing income taxes.

Fiscal policy is mainly used for its supply-side effect in Singapore to increase the production capacity in the economy and hence aggregate supply, which is known as fiscal policy with a supply-side intent. For example, the Singapore government spends on education and training which will lead to greater human capital and hence increase the skills and knowledge of labour in the economy. It has set up the Institute of Technical Education, polytechnics and Continuing Education and Training campuses to provide education and training. The Singapore government also spends on research and development which will lead to technological advancement and hence increase the efficiency of capital in the economy. It has set up the Singapore Institute of Manufacturing Technology (SIMTech) under the Agency for Science, Technology and Research (A*STAR) to engage in research and development. In addition to an increase in aggregate supply through increasing the production capacity in the economy, an increase in the skills and knowledge of labour and the efficiency of capital in the economy will lead to an increase in aggregate supply through increasing labour productivity and hence decreasing the cost of production in the economy. An increase in the production capacity in the economy and hence aggregate supply will lead to potential economic growth which is essential for achieving sustained economic growth. In addition, assuming aggregate demand is rising which is the normal state of the economy, an increase in aggregate supply will lead to higher actual economic growth and lower inflation.

As stated in Section 2.2, some of the limitations of fiscal policy do not apply in Singapore. The decision time lag of fiscal policy in Singapore is short due to the absence of a strong opposition party in the parliament. For example, the Resilience Package was readily approved by the Singapore parliament in January 2009 in response to 2008-2009 Global Financial Crisis. The Singapore government does not need to issue securities to finance a budget deficit due to its large amount of reserves. Furthermore, when interest rates rise, hot money inflows will increase and hot money outflows will decrease which will lead to an increase in the supply of loanable funds. Due to the small and open nature of the Singapore economy, the effect of the changes in hot money flows on the supply of loanable funds will be substantial. Therefore, the increase in the supply of loanable funds will lead to a fall in interest rates back to the initial level. Therefore, the crowding-out effect will not happen in Singapore.

Note:   The small multiplier in Singapore is a limitation of fiscal policy in non-recession years. However, in a recession, as expansionary fiscal policy will only cushion the decrease in aggregate demand generally caused by a fall in exports, the small multiplier is desirable for the economy as it will reduce the severity of the recession. 

Supply-side policies are policies that are used to increase the production capacity in the economy and hence aggregate supply. Fiscal policy with a supply-side intent is a supply-side policy which involves using government expenditure or taxation to increase the production capacity in the economy and hence aggregate supply. However, not all supply-side policies involve using government expenditure or taxation to increase the production capacity in the economy and hence aggregate supply. Therefore, fiscal policy with a supply-side intent is a subset of supply-side policies. Supply-side policies will be explained in greater detail in Section 5.

The Principal Economics Tutor will discuss fiscal policy in Singapore in greater detail in the economics tuition class.

2.5       Automatic Fiscal Stabilisers

Expansionary fiscal policy and contractionary fiscal policy are known as discretionary fiscal policies as the policies involve deliberate government policy action. However, apart from discretionary fiscal policies, there are also non-discretionary fiscal policies which are commonly known as automatic fiscal stabilisers. Automatic fiscal stabilisers are government expenditure and taxation which reduce economic fluctuations without involving any deliberate government policy action. Examples of automatic fiscal stabilisers include income taxes and unemployment benefits. Income taxes and unemployment benefits reduce economic fluctuations by decreasing the size of the multiplier and hence the multiplier effect and the reverse multiplier effect.

Assume that the economy is at or near the full-employment equilibrium. Further assume that autonomous expenditure decreases which will lead to a decrease in aggregate demand resulting in a decrease in national output and hence national income. When firms decrease production in response to a decrease in aggregate demand due to a decrease in autonomous expenditure, they will employ less factor inputs from households and hence will pay them less factor income resulting in a decrease in national income. When national income falls which will lead to a decrease in disposable income, households will decrease consumption expenditure which will lead to a further decrease in aggregate demand and this will induce firms to further decrease production. When this happens, firms will employ even less factor inputs from households and hence will pay them even less factor income. The further decrease in national income and hence disposable income will induce households to further decrease consumption expenditure resulting in a further decrease in aggregate demand. Therefore, the initial decrease in aggregate demand due to the decrease in autonomous expenditure will lead to decreases in consumption expenditure and hence further decreases in aggregate demand resulting in a larger decrease in national output and hence national income. This is commonly known as the reverse multiplier effect. If the size of the multiplier and hence the reverse multiplier effect is large, the initial decrease in aggregate demand due to the decrease in autonomous expenditure will lead to a large decrease in national output and hence national income, causing the economy to fall into a severe recession. Income taxes and unemployment benefits will reduce the severity of the recession by decreasing the size of the multiplier and hence the reverse multiplier effect. When national income falls, households will pay less income taxes and this is particularly true in view of the progressive nature of income taxes. Furthermore, the decrease in national output will lead to a decrease in the demand for labour in the economy resulting in a rise in unemployment and this will increase the amount of unemployment benefits received by households. Given any decrease in national income, a decrease in income taxes paid by households and an increase in unemployment benefits received by them will reduce the extent of the decrease in disposable income and hence the extent of the decrease in consumption expenditure resulting in a smaller decrease in national output and hence national income, given any decrease in aggregate demand due to a decrease in autonomous expenditure.

Similarly, an increase in aggregate demand due to an increase in autonomous expenditure will lead to increases in consumption expenditure and hence further increases in aggregate demand resulting in a larger increase in national output and hence national income. This is commonly known as the multiplier effect. In addition to an increase in national output and hence national income, an increase in aggregate demand will lead to a rise in the general price level resulting in higher inflation. If the size of the multiplier and hence the multiplier effect is large, the cumulative increase in aggregate demand will be large which will lead to a substantial rise in the general price level resulting in high inflation. Income taxes and unemployment benefits will reduce inflation by decreasing the size of the multiplier and hence the multiplier effect. When national income rises, households will pay more income taxes and this is particularly true in view of the progressive nature of income taxes. Furthermore, the increase in national output will lead to an increase in the demand for labour in the economy resulting in a fall in unemployment and this will decrease unemployment benefits received by households. Given any increase in national income, an increase in income taxes paid by households and a decrease in unemployment benefits received by them will reduce the extent of the increase in disposable income and hence the extent of the increase in consumption expenditure resulting in a smaller cumulative increase in aggregate demand and hence lower inflation, given any increase in aggregate demand due to an increase in autonomous expenditure.

Advantages of Automatic Fiscal Stabilisers over Discretionary Fiscal Policies

Automatic fiscal stabilisers may be better than discretionary fiscal policies due to several reasons. First, as automatic fiscal stabilisers do not involve any deliberate government policy action, they are not subject to parliamentary debates and approvals which may take months, which is known as the decision time lag. In contrast, discretionary fiscal policies involve deliberate government policy action and are therefore subject to parliamentary debates and approvals and hence the decision time lag. Second, when national output and hence national income change, income taxes paid by households and unemployment benefits received by them will change instantly. In other words, automatic fiscal stabilisers are not subject to the effectiveness time lag. In contrast, the full effects of discretionary fiscal policies will be realised only after some time as it takes time for the government to change expenditure and taxation. Therefore, discretionary fiscal policies are subject to the effectiveness time lag. Third, automatic fiscal stabilisers are not subject to some other limitations of expansionary fiscal policy which include the crowding-out effect and the high public debt-to-GDP ratio.

Advantages of Discretionary Fiscal Policies over Automatic Fiscal Stabilisers

Discretionary fiscal policies may be better than automatic fiscal stabilisers due to several reasons. First, when the economy falls into a recession, although automatic fiscal stabilisers will reduce the severity of the recession by decreasing the size of the multiplier and hence the reverse multiplier effect, they will not steer the economy back onto the path of expansion as they will not produce any expansionary effect on the economy. In contrast, in a recession, as expansionary fiscal policy works through increasing aggregate demand which will boost the economy, it may steer the economy back onto the path of expansion. This is particularly true if the economy is highly dependent on domestic demand. Second, income taxes and unemployment benefits are known as automatic fiscal stabilisers when the economy is at or near the full-employment equilibrium. However, when the economy is at a below full-employment equilibrium which means the existence of a negative output gap, income taxes and unemployment benefits are called fiscal drags. This is because in such a state of the economy, income taxes and unemployment benefits which will decrease the size of the multiplier and hence the multiplier effect will create a drag on the expansion of the economy in the event of an increase in autonomous expenditure which may occur due to government policy action, making it harder for the economy to move to the full-employment equilibrium. Third, the higher the income taxes and unemployment benefits, the more effective the automatic fiscal stabilisers. However, high income taxes will reduce the ability of the economy to attract foreign direct investments and foreign talents, the incentive to work and the incentive for skills upgrading. Furthermore, high unemployment benefits which will reduce the hardship of unemployment will induce workers who are frictionally unemployed to spend more time looking for a job which will lead to a rise in frictional unemployment resulting in a rise in the natural rate of unemployment.

Note:   Although income taxes are progressive, the progressive nature of these taxes is not a requisite for the automatic fiscal stabilisers to work. 

Unless otherwise stated, fiscal policy refers to discretionary fiscal policy.

3          DEMAND-SIDE POLICIES: MONETARY POLICY

3.1       Objectives of Monetary Policy

Monetary policy is a demand-side policy that is used to control the money supply and interest rates to influence aggregate demand.

Recall that the money supply consists of currency in active circulation and deposits. Currency in active circulation refers to currency held by the public and excludes currency held in bank vaults and currency held at the central bank. Deposits refer to the financial records of deposits kept by financial institutions. In order to understand the transmission mechanism of monetary policy, one has to understand the concepts of open market operations, interbank rates and the bank rate. Open market operations, which include open market purchases and open market sales, refer to purchases and sales of securities by the central bank to control the money supply. Interbank rates refer to interest rates charged on loans made between banks which are determined by the amount of reserves in the banking system. The bank rate refers to the interest rate charged on loans made by the central bank to banks. In an economy where interbank rates are lower than the bank rate and hence banks borrow from each other, such as the United States and Japan, the level of interest rates in the economy varies directly with interbank rates, particularly the interbank overnight rate which is known as the federal funds rate in the United States and the uncollateralised overnight call rate in Japan, as the bulk of the loans between banks are made on an overnight basis. In an economy where the bank rate is lower than interbank rates and hence banks borrow from the central bank, such as the United Kingdom and the euro area which consists of 19 economies where the euro is adopted as the official currency, the level of interest rates in the economy varies directly with the bank rate, which is known as the base rate in the United Kingdom and the refinancing rate in the euro area.

Expansionary Monetary Policy

To increase economic growth or decrease unemployment in an economy where interbank rates are lower than the bank rate and hence banks borrow from each other, such as the United States and Japan, the central bank can increase the money supply by conducting an open market purchase. When the money supply increases, the amount of reserves in the banking system will rise. When this happens, interbank rates will fall which will lead to a fall in the level of interest rates in the economy. For example, the Federal Reserve increased the money supply to lower the federal funds rate from 5.25 per cent in September 2007 to 0-0.25 per cent in December 2008 to boost the economy. To increase economic growth or decrease unemployment in an economy where the bank rate is lower than interbank rates and hence banks borrow from the central bank, such as the United Kingdom and the euro area, the central bank can lower the bank rate to decrease the level of interest rates in the economy. For example, the Bank of England cut the base rate from 5.75 per cent in December 2007 to 0.5 per cent in March 2009 to boost the economy. Lower interest rates will decrease the incentive to save and the costs of borrowing and this will lead to an increase in consumption expenditure. Furthermore, a decrease in the costs of borrowing will lead to more profitable planned investments resulting in an increase in investment expenditure. An increase in consumption expenditure and investment expenditure will lead to an increase in aggregate demand which will induce firms to increase production resulting in an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

Contractionary Monetary Policy

To reduce inflation in an economy where interbank rates are lower than the bank rate and hence banks borrow from each other, such as the United States and Japan, the central bank can decrease the money supply by conducting an open market sale. When the money supply decreases, the amount of reserves in the banking system will fall. When this happens, interbank rates will rise which will lead to a rise in the level of interest rates in the economy. For example, the Federal Reserve decreased the money supply to raise the federal funds rate in the 1979 oil crisis to combat inflation. To reduce inflation in an economy where the bank rate is lower than interbank rates and hence banks borrow from the central bank, such as the United Kingdom and the euro area, the central bank can raise the bank rate to increase the level of interest rates in the economy. For example, the Bank of England raised the base rate in the 1979 oil crisis to combat inflation. Higher interest rates will increase the incentive to save and the costs of borrowing and this will lead to a decrease in consumption expenditure. Furthermore, an increase in the costs of borrowing will lead to fewer profitable planned investments resulting in a decrease in investment expenditure. A decrease in consumption expenditure and investment expenditure will lead to a decrease in aggregate demand. Assuming aggregate demand and hence the general price level is rising rapidly, this will reduce the growth of aggregate demand which will lead to a slower rise in the general price level resulting in lower inflation.

Note:   Expansionary monetary policy will not only increase aggregate demand through increasing consumption expenditure and investment expenditure, it will also increase aggregate demand through increasing net exports. Hot money refers to money that moves quickly between countries in search of the highest short-term returns. A major source of hot money is bank deposits which are highly responsive to changes in interest rates. Lower interest rates will lead to a decrease in hot money inflows and an increase in hot money outflows and hence a decrease in the demand for domestic currency and an increase in the supply resulting in a fall in the exchange rate. When this happens, domestic goods and services will become relatively cheaper than foreign goods and services which will lead to an increase in net exports and hence aggregate demand. However, students are not required to explain this in the examination unless the question specifically asks for it. 

3.2       Limitations of Monetary Policy

Liquidity Trap

In the United States and Japan, the central banks decrease the level of interest rates in the economy through decreasing interbank rates by increasing the money supply and hence the amount of reserves in the banking system. Therefore, when interbank rates are near zero, an increase in the money supply and hence the amount of reserves in the banking system will not lead to a fall in interbank rates and hence the level of interest rates in the economy, as least not significantly. When this happens, consumption expenditure and investment expenditure will not rise, at least not significantly. This is known as the liquidity trap. An example is the United States where the federal funds rate was 0-0.25 per cent between December 2008 and December 2015. In the United Kingdom and the euro area, a liquidity trap occurs when the bank rate is near zero. For example, the Bank of England cut the base rate to 0.1 per cent in March 2020 in response to the pandemic of COVID-19.

Low Interest Elasticity of Investment and Consumption

If investment is interest inelastic, a change in interest rates is likely to lead to a small change in investment. In the case of expansionary monetary policy, investment may be interest inelastic due to weak business sentiment which may occur when the economy is weak. Similarly, if consumption is interest inelastic, a change in interest rates is likely to lead to a small change in consumption. In the case of expansionary monetary policy, consumption may be interest inelastic due to weak consumer sentiment which may occur when the economy is weak.

Credit Crunch

A credit crunch is a situation where it is difficult to obtain credit due to a substantial decrease in the availability of credit from banks. Due to factors such as a rise in the default rate, banks may reduce lending which may lead to a credit crunch. If a credit crunch occurs in the United States or Japan, an increase in the money supply and hence the amount of reserves in the banking system may not lead to a fall in interbank rates. Even if interbank rates do fall as a result of the increase in the money supply and hence the amount of reserves in the banking system, the level of interest rates in the economy may not fall due to the decrease in the supply of loanable funds as banks tighten credit. Therefore, consumption expenditure and investment expenditure may not rise. In the event of a credit crunch in the United Kingdom or the euro area, a cut in the bank rate may not lead to a fall in the level of interest rates in the economy.

Small Multiplier

Recall that an economy with high income taxes, high savings and high imports will have a small multiplier. For example, Singapore has a small multiplier due to the high savings and the high imports. The savings rate in Singapore is high due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. The level of imports in Singapore is high due to lack of factor endowments and the embracement of free trade. If the multiplier is small, the initial change in aggregate demand due to the change in consumption expenditure and investment expenditure may not lead to a significant change in national output and hence national income, unemployment and inflation.

Changing Sentiment

When interest rates fall due to an increase in the money supply, consumption expenditure may not increase if households are less optimistic about the economic outlook. A fall in interest rates may not lead to an increase in investment expenditure if business sentiment falls. Similarly, when interest rates rise due to a decrease in the money supply, consumption expenditure may not decrease if households are more optimistic about the economic outlook. A rise in interest rates may not lead to a decrease in investment expenditure if business sentiment rises.

3.3       Supply-side Effect of Monetary Policy

Monetary policy is referred to as demand-side policy because it is used to influence aggregate demand. However, apart from aggregate demand, monetary policy also has an effect on aggregate supply. Expansionary monetary policy will lead to an increase in investment expenditure resulting in a more rapid increase in the quantity of capital in the economy, assuming net investment is initially positive. When this happens, the production capacity in the economy will increase at a faster rate which will lead to a more rapid increase in aggregate supply. Conversely, contractionary monetary policy will lead to a decrease in investment expenditure resulting in a less rapid increase in the quantity of capital in the economy, assuming net investment remains positive. When this happens, the production capacity in the economy will increase at a slower rate which will lead to a less rapid increase in aggregate supply. However, when economists talk about monetary policy, unless otherwise stated, they are referring to the use of it to influence aggregate demand.

3.4       Quantitative Easing

As discussed earlier, expansionary monetary policy is subject to the limitation of liquidity trap which occurs when interbank rates are near zero in the United States or Japan or the bank rate is near zero in the United Kingdom or the euro area. An example is the United States where the federal funds rate was 0-0.25 per cent between December 2008 and December 2015. However, in the event of a liquidity trap, monetary policy can still be effective for boosting the economy, albeit in a different way from the conventional monetary policy explained in Section 3.1. Such unconventional monetary policy is called quantitative easing.

Quantitative easing is an unconventional monetary policy where the central bank increases the money supply substantially when the economy is in a liquidity trap. Unlike conventional monetary policy which involves purchasing short-term government securities, quantitative easing generally involves purchasing asset-backed securities in addition to purchasing short-term government securities. Economists have put forward several reasons why a substantial increase in the money supply by the central bank when the economy is in a liquidity trap can have an expansionary effect on the economy.

Reduce Interest Rates

As quantitative easing will increase the amount of reserves in the banking system substantially, it will induce banks to increase lending. When this happens, the supply of loanable funds will increase which will lead to a fall in interest rates. Lower interest rates will decrease the incentive to save and the costs of borrowing and this will lead to an increase in consumption expenditure. Furthermore, a decrease in the costs of borrowing will lead to more profitable planned investments resulting in an increase in investment expenditure. An increase in consumption expenditure and investment expenditure will lead to an increase in aggregate demand which will induce firms to increase production resulting in an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

Reduce the Exchange Rate

When interest rates fall due to an increase in the supply of loanable funds as a result of quantitative easing, hot money inflows will fall and hot money outflows will rise. When this happens, the demand for domestic currency will fall and the supply will rise which will lead to a fall in the exchange rate. A depreciation of domestic currency will make domestic goods and services relatively cheaper than foreign goods and services which will lead to an increase in net exports. When this happens, aggregate demand will rise which will lead to an increase in national output and hence national income resulting in a fall in unemployment.

Reduce Long-term Interest Rates (Optional but good to know)

Instead of purchasing government bills or short-term government bonds which is typically done with conventional expansionary monetary policy, the central bank can conduct quantitative easing through purchasing long-term government bonds. An example is the United States where the Federal Reserve purchased 10-year US Treasury bonds for its three quantitative easing programmes. When the central bank purchases long-term government bonds and hence increase the demand, the prices will rise. When this happens, the effective coupon rates on long-term government bonds will fall which will reduce interest rates on long-term loans such as housing loans. When this happens, the demand for housing will rise which will lead to an increase in aggregate demand. This will lead to an increase in national output and hence national income resulting in a fall in unemployment.

Limitations of Quantitative Easing

As the central bank will increase the money supply substantially under quantitative easing, this may lead to a situation of ‘too much money chasing too few goods’. If this happens, high inflation may ensue.

Note:   In the 2008-2009 Global Financial Crisis, the Federal Reserve was aggressive in the use of quantitative easing. In contrast, the European Central Bank started using quantitative easing much later. This could explain why the U.S. economy started recovering from the 2008-2009 Global Financial Crisis before the European economies did.

3.5       Monetary Policy in Singapore

In Singapore, monetary policy is not used in the way explained in Section 3.1 which is sometimes called interest rate-centred monetary policy, due to four reasons: the choice of a managed float exchange rate, the fact that Singapore is an interest rate-taker, the higher dependence on external demand and the low interest elasticity of consumption and investment.

According to the Impossible Trinity, also known as the Open-Economy Trilemma, an economy cannot have simultaneously a fixed exchange rate, free capital mobility and an independent monetary policy. Therefore, due to the high exports and the high imports in Singapore and hence the choice of a managed float exchange rate, the Monetary Authority of Singapore (MAS) cannot use monetary policy. For example, if the MAS increases the money supply to lower interest rates, hot money inflows will decrease and hot money outflows will increase. When this happens, the demand for Singapore dollars will fall and the supply will rise which will cause the exchange rate to fall below the policy band. To bring the exchange rate of the Singapore dollar back into the policy band, there are two measures that the MAS can use. First, it can reverse the monetary policy which will render it ineffective. Second, it can intervene in the foreign exchange market to prevent the Singapore dollar from depreciating by buying Singapore dollars and selling foreign currency but this will also cause the money supply to fall back.

As a small and open economy, Singapore is an interest rate-taker in the sense that it is unable to change the money supply to influence interest rates which are determined by foreign interest rates. For example, if the MAS increases the money supply to lower interest rates, hot money inflows will decrease and hot money outflows will increase which will lead to a decrease in the money supply. Due to the small and open nature of the Singapore economy, the effect of the changes in hot money flows on the money supply will be substantial. Therefore, the decrease in the money supply will lead to a rise in interest rates back to the initial level. Interest rates in Singapore are largely determined by foreign interest rates, particularly interest rates in the United States. For example, when interest rates in the United States rise, interest rates in Singapore will become relatively lower which will lead to a decrease in hot money inflows and an increase in hot money outflows in Singapore resulting in a decrease in the supply of loanable funds and hence a rise in interest rates. Empirically, interest rates in Singapore follow interest rates in the United States. However, they have typically been below interest rates in the United States due to market expectations of an appreciation of the Singapore dollar against the U.S. dollar.

In addition to the inability to control interest rates, monetary policy is not used in Singapore due to the higher dependence on external demand and the low interest elasticity of consumption and investment. Singapore is a small economy that is more dependent on external demand with the domestic exports accounting for a large proportion of the aggregate demand. In contrast, consumption expenditure and investment expenditure on domestic goods and services are small components of aggregate demand. Therefore, it is more effective to manage the economy by controlling exports rather than consumption expenditure and investment expenditure. Furthermore, consumption and investment are interest inelastic in Singapore. A change in interest rates in Singapore is likely to lead to a small change in consumption due to the culture of thrift, and it is likely to lead to a small change in investment as a large proportion of it is foreign direct investment which is made by foreign firms with foreign sources of funds.

Although monetary policy is not used to control interest rates in Singapore, it is used to control the exchange rate which is called exchange rate-centred monetary policy in Singapore. Exchange rate-centred monetary policy in Singapore, which is more commonly called exchange rate policy, will be explained in greater detail in Section 4.

Note:    As exchange rate-centred monetary policy in Singapore is more commonly called exchange rate policy, unless otherwise stated, monetary policy refers to interest rate-centred monetary policy. Therefore, in the examination, if the question is asking about monetary policy in a general context, students should discuss interest rate-centred monetary policy. However, if the question is asking about monetary policy in the Singapore context, students should discuss exchange rate-centred monetary policy which is more commonly called exchange rate policy.

The Principal Economics Tutor will discuss monetary policy in Singapore in greater detail in the economics tuition class.

4          EXCHANGE RATE POLICY

4.1       Objectives of Exchange Rate Policy

Exchange rate policy is a policy that is used to control the exchange rate through central bank intervention in the foreign exchange market.

Devaluation

To increase economic growth or decrease unemployment, the central bank can devalue domestic currency by selling domestic currency and buying foreign currency in the foreign exchange market. A fall in the exchange rate will make domestic goods and services relatively cheaper than foreign goods and services. When this happens, net exports will rise which will lead to an increase in aggregate demand. This will induce firms to increase production resulting in an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

Revaluation

To reduce inflation, the central bank can revalue domestic currency by buying domestic currency and selling foreign currency in the foreign exchange market. A rise in the exchange rate will make domestic goods and services relatively more expensive than foreign goods and services. When this happens, net exports will fall which will lead to a decrease in aggregate demand. Assuming aggregate demand and hence the general price level is rising rapidly, this will reduce the growth of aggregate demand which will lead to a slower rise in the general price level resulting in lower demand-pull inflation. In the face of strong external price pressures, a rise in the exchange rate will also reduce the rise in the prices of imports in domestic currency resulting in lower imported inflation.

Note:   The Principal Economics Tutor will discuss exchange rate policy in greater detail in the economics tuition class.

4.2       Limitations of Exchange Rate Policy

Devaluation

Devaluation is subject to several limitations. First, a devaluation of domestic currency will lead to a rise in the prices of imported intermediate goods in domestic currency. When this happens, the cost of production in the economy will rise which will lead to a decrease in aggregate supply resulting in a decrease in national output and hence national income. Therefore, the increase in aggregate demand due to the increase in net exports may not lead to a significant increase in national output and hence national income. Second, a continual devaluation of domestic currency may induce people to sell the currency in anticipation of further falls in the exchange rate. This may lead to currency instability which will result in capital flight and a fall in foreign direct investments. Capital flight will lead to a fall in asset prices resulting in a fall in the wealth of households and hence consumption expenditure. A fall in consumption expenditure and investment expenditure will lead to a decrease in aggregate demand resulting in a decrease in national output and hence national income. Third, if the sum of the price elasticities of demand for exports and imports is less than one, which may happen in the short run, a devaluation of domestic currency will lead to a deterioration in the current account and hence the balance of payments.

Revaluation

Revaluation is subject to several limitations. First, a revaluation of domestic currency to reduce imported inflation may lead to a decrease in net exports which will lead to a decrease in aggregate demand, and this is particularly true if the external demand is weak. This will lead to a decrease in national output and hence national income resulting a rise in unemployment Second, if the sum of the price elasticities of demand for exports and imports is greater than one, a revaluation of domestic currency will lead to a deterioration in the current account and hence the balance of payments. Third, if the central bank does not have foreign exchange reserves, it may not be able to revalue domestic currency.

Note:   The Principal Economics Tutor will discuss the limitations of exchange rate policy in greater detail in the economics tuition class.

4.3       Exchange Rate Policy in Singapore

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

When the external economic environment is strong, Singapore will experience high inflation in the absence of central bank intervention. When Singapore’s trading partners expand rapidly, their national incomes and hence imports will rise rapidly. When this happens, exports in Singapore will rise substantially which will lead to a large increase in aggregate demand resulting in high demand-pull inflation. Furthermore, when Singapore’s trading partners expand rapidly, their demand for intermediate goods will increase rapidly which will lead to a sharp rise in the prices. When this happens, the prices of imported intermediate goods and hence the cost of production in Singapore will rise substantially which will lead to a large decrease in aggregate supply and hence a substantial rise in the general price level resulting in high indirect imported inflation or imported cost-push inflation. When Singapore’s trading partners expand rapidly, their prices of consumer goods and services will also rise rapidly. When this happens, the prices of imported consumer goods and services and hence the general price level in Singapore will rise substantially which will lead to high direct imported inflation. Therefore, when the MAS predicts a strong external economic environment and hence high inflationary pressures, it will revalue the Singapore dollar by raising the exchange rate policy band modestly and gradually to allow a modest and gradual appreciation of the currency in a pre-emptive strike against inflation. When the Singapore dollar becomes stronger, Singapore’s goods and services will become relatively more expensive than foreign goods and services which will reduce the increase in exports resulting in lower demand-pull inflation. Furthermore, a stronger Singapore dollar will reduce the rise in the prices of imports in Singapore in domestic currency resulting in lower imported inflation. When the MAS predicts a weak external economic environment and hence a weak export growth, it will keep the exchange rate policy band constant. In other words, it will adopt a neutral exchange rate policy stance with the exchange rate policy band centred on a zero per cent appreciation of the S$NEER. When the MAS predicts a very weak external economic environment and hence a decrease in exports, it will devalue the Singapore dollar by lowering the exchange rate policy band to allow the currency more room to depreciate when the demand falls due to the decrease in exports. For example, in April 2009 in the midst of the 2008-2009 Global Financial Crisis, the MAS lowered the exchange rate policy band when it re-centred it to the prevailing S$NEER which was in the lower half of the policy band to allow it more room to fall. A weaker Singapore dollar will make Singapore’s goods and services relatively cheaper than foreign goods and services which will cushion the decrease in exports and hence aggregate demand resulting in a smaller decrease in national output and hence national income. However, a fall in the exchange rate will increase the prices of imports in domestic currency resulting in higher imported inflation. As the imports in Singapore are high due to lack of factor endowments and the embracement of free trade, the MAS will not devalue the Singapore dollar dramatically to prevent high imported inflation.

Note:   In non-recession years, the MAS does not devalue the Singapore dollar to boost exports as a devaluation of the Singapore dollar in the face of external price pressures is likely to lead to high imported inflation. In a recession, however, there are likely to be no or low external price pressures. Therefore, a modest devaluation of the Singapore dollar to cushion a fall in exports is unlikely to lead to high imported inflation. 

Over the last few decades, due to the strong external economic environment of Singapore, the MAS has been revaluing the Singapore dollar by raising the exchange rate policy band modestly and gradually to allow a modest and gradual appreciation of the currency in order to achieve low inflation. The modest and gradual appreciation of the Singapore dollar has also instilled confidence in the currency resulting in an increase in foreign direct investments in Singapore.

The Principal Economics Tutor will discuss exchange rate policy in Singapore in greater detail in the economics tuition class.

5          SUPPLY-SIDE POLICIES

5.1       Objectives of Supply-side Policies

Supply-side policies are policies that are used to increase the production capacity in the economy and hence aggregate supply. The production capacity in the economy can be increased through increasing the quantity or the quality of the factors of production in the economy. Although supply-side policies are used to increase the production capacity in the economy, they may also decrease the cost of production in the economy. For example, in addition to an increase in the production capacity in the economy, an increase in the quality of labour or the quality of capital in the economy will lead to an increase in labour productivity and hence a fall in the cost of production in the economy resulting in an increase in aggregate supply. As discussed in Chapter 11, potential economic growth is an increase in potential output and actual economic growth is an increase in actual output. An increase in the production capacity in the economy and hence aggregate supply will lead to potential economic growth. Potential economic growth per se will not lead to a rise in the standard of living. However, as actual economic growth is constrained by potential economic growth, potential economic growth is essential for achieving sustained economic growth. Apart from potential economic growth, an increase in the production capacity in the economy and hence aggregate supply will also lead to actual economic growth, although to a lesser extent. In addition, assuming aggregate demand is rising which is the normal state of the economy, an increase in the production capacity in the economy and hence aggregate supply will lead to lower inflation.

Supply-side policies can be classified into interventionist supply-side policies and market-oriented supply-side policies. Interventionist supply-side policies are policies that are used to increase the production capacity in the economy and hence aggregate supply through government intervention that reduces the deficiencies of the market. Market-oriented supply-side policies are policies that are used to increase the production capacity in the economy and hence aggregate supply by freeing up the market. The following is a list of supply-side policies that are useful for the examination.

Interventionist Supply-side Policies

Education and Training

Education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy. The government can provide education and training directly, by setting up educational institutes, or indirectly, by giving subsidies or tax incentives to firms to encourage them to send their workers for education and training. For example, the Singapore government has set up the Institute of Technical Education, polytechnics and Continuing Education and Training campuses to provide education and training.

Research and Development

Research and development will lead to technological advancement which will increase the efficiency of capital in the economy. The government can engage in research and development directly, by setting up research institutes, or indirectly, by giving subsidies or tax incentives to firms to encourage them to engage in research and development. For example, the Singapore government has set up the Biomedical Research Council (BMRC) and the Science and Engineering Research Council (SERC) under the Agency for Science, Technology and Research (A*STAR) to engage in research and development.

Infrastructural Development

Government expenditure on infrastructure will increase investment expenditure which will lead to a more rapid increase in the quantity of capital in the economy. For example, the Singapore government has provided infrastructures such as Jurong Island for high-end chemical manufacturing and Biopolis for pharmaceutical manufacturing which have attracted many foreign high-end chemical firms and pharmaceutical firms to invest in Singapore.

Market-oriented Supply-side Policies

Privatisation

Privatisation refers to the conversion of a state-owned firm to a private firm. Unlike state-owned firms, private firms need to consider factors such as profitability and survival. Therefore, privatisation will induce firms to increase labour productivity to reduce costs. It may also lead to an increase in the number of firms in the market and hence greater competition which will induce firms to increase labour productivity to reduce costs. To increase labour productivity, firms will engage in research and development, adopt better production technologies or engage in education and training. Research and development will lead to technological advancement. Technological advancement and adoption of better production technologies will increase the efficiency of capital in the economy. Education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy.

Deregulation

Deregulation refers to the removal of restrictive regulations. Deregulation will lead to an increase in the number of firms in the market and hence greater competition which will induce firms to increase labour productivity to reduce costs. To increase labour productivity, firms will engage in research and development, adopt better production technologies or engage in education and training. Research and development will lead to technological advancement. Technological advancement and adoption of better production technologies will increase the efficiency of capital in the economy. Education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy.

Cuts in Income Taxes and Capital Gains Tax

A decrease in personal income tax will increase after-tax personal income resulting in an increase in the quantity of labour in the economy. A decrease in corporate income tax will increase expected after-tax returns on planned investments and hence investment expenditure resulting in a more rapid increase in the quantity of capital in the economy. A capital gains tax is a tax imposed on the profit from the sale of a certain type of asset. For example, many governments impose a capital gains tax on the profit from the sale of properties. A decrease in capital gains tax on properties will increase the incentive to invest and hence investment expenditure resulting in a more rapid increase in the quantity of capital in the economy.

Labour Market Reforms

The government can implement labour market reforms to increase the quantity of labour in the economy. For example, it can increase retirement age and incentivise firms to employ older workers through subsidies or tax incentives. It can encourage firms to provide flexible work arrangements which will encourage non-working mothers to enter the labour force. It can loosen restrictions on foreign workers through increasing the dependency ratio ceiling, reducing the foreign worker levy or lowering the eligibility criteria for the application of work pass, which will increase the number of foreign workers. It can loosen restrictions on immigrants through lowering the eligibility criteria for the application of citizenship or permanent residence, which will increase the number of immigrants.

Trade Liberalisation

A reduction in tariffs and non-tariff barriers will lead to greater competition which will induce firms to increase labour productivity to reduce costs. To increase labour productivity, firms will engage in research and development, adopt better production technologies or engage in education and training. Research and development will lead to technological advancement. Technological advancement and adoption of better production technologies will increase the efficiency of capital in the economy. Education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy.

The Singapore government has been using supply-side policies to increase the production capacity in the economy and hence aggregate supply in order to achieve potential economic growth. As actual economic growth is constrained by potential economic growth, potential economic growth is essential for achieving sustained economic growth. The Singapore government has been using interventionist supply-side policies extensively which include education and training, research and development and infrastructural development. It has also been using market-oriented supply-side policies which include cuts in income taxes and labour market reforms, and to a lesser extent, privatisation and deregulation. In recent years, however, in an attempt to induce firms to increase labour productivity, the Singapore government has been tightening restrictions on foreign workers by decreasing the dependency ratio ceiling, increasing the foreign worker levy and raising the eligibility criteria for the application of work pass. This has led to a slower growth of the labour force resulting in a tighter labour market and hence an upward pressure on wages.

Note:   Although supply-side policies are mainly used to increase the production capacity in the economy, many supply-side policies will also lead to a decrease in the cost of production in the economy. For example, education and training will lead to an increase in labour productivity resulting in a fall in the cost of production in the economy. Nevertheless, the main objective of supply-side policies is to increase the production capacity rather than to decrease the cost of production in the economy. In the examination, students are often required to explain how supply-side policies can be used to increase the production capacity in the economy to achieve potential economic growth. 

The effect of supply-side policies will fall more on potential output than on actual output. Indeed, if the economy is far from the full-employment equilibrium¸ actual output may not rise, at least not significantly.

The Principal Economics Tutor will discuss supply-side policies in greater detail in the economics tuition class.

5.2       Limitations of Supply-side Policies

The effects of supply-side policies will be realised only in the long run and this long effectiveness time lag makes them ineffective in the short run. For example, it takes time for education and training to increase the skills and knowledge of labour in the economy. Furthermore, although supply-side policies can be used to increase actual output, the effect will fall more on potential output than on actual output. Indeed, if the economy is far from the full-employment equilibrium¸ actual output may not rise, at least not significantly. Therefore, supply-side policies may not be effective for increasing actual economic growth.

5.3       Demand-side Effect of Supply-side Policies

Although supply-side policies are used to increase aggregate supply, they may also lead to an increase in aggregate demand. This is particularly true for interventionist supply-side policies, although some market-oriented supply-side policies will also increase aggregate demand. For example, to increase the skills and knowledge of labour in the economy, the government may increase expenditure on education and training directly. Similarly, the government may increase expenditure on research and development directly to increase the efficiency of capital in the economy. An increase in government expenditure on goods and services will lead to an increase in aggregate demand. A decrease in personal income tax to increase the quantity of labour in the economy will lead to an increase in disposable income resulting in an increase in consumption expenditure. Similarly, a decrease in corporate income tax to achieve a more rapid increase in the quantity of capital in the economy will lead to an increase in investment expenditure, apart from an increase in consumption expenditure. An increase in consumption expenditure and investment expenditure will lead to an increase in aggregate demand.

6          SHORT-TERM SUPPLY-SIDE POLICIES

6.1       Objectives of Short-term Supply-side Policies

Short-term supply-side policies are policies that are used to decrease the cost of production in the economy in the short term and hence increase aggregate supply.

As explained earlier, the effects of supply-side policies will be realised only in the long run and this long effectiveness time lag makes them ineffective in the short run. For example, it takes time for education and training to increase the skills and knowledge of labour in the economy. Therefore, supply-side policies are generally not used to deal with a recession. However, unlike supply-side policies, short-term supply-side policies are often used to deal with a recession, as part of a policy mix. In a recession, the government can increase economic growth by using short-term supply-side policies to reduce the cost of production in the economy in the short term. When the cost of production in the economy falls, aggregate supply will rise which will lead to an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

Short-term supply-side policies are used in Singapore. To increase economic growth in a recession, the Singapore government may reduce the employers’ CPF contribution rate in the short term to decrease the labour cost in the economy. For example, it reduced the employers’ CPF contribution rate from 20 per cent to 10 per cent in the 1997-1998 Asian Financial Crisis. The Singapore government may also help firms pay a certain proportion of wages in the short term to decrease the labour cost in the economy. For example, it implemented the Jobs Credit Scheme which helped firms pay 12 per cent of the wages of a worker up to the first $2500 in the 2008-2009 Global Financial Crisis.

Note:   Unlike supply-side policies, short-term supply-side policies will not increase the production capacity in the economy. Rather, they will only decrease the cost of production in the economy. Furthermore, although the cost of production in the economy will fall in the short term, it will not stay at the lower level in the long term. For example, the Jobs Credit Scheme which was implemented by the Singapore government to decrease the cost of production in the economy in the 2008-2009 Global Financial Crisis was designed to last only one year. 

In theory, the Singapore government can use short-term supply-side policies to reduce inflation, although this has not been done in reality. As discussed in Chapter 11, this is because inflation in Singapore is mainly due to external factors and hence exchange rate policy is generally effective for reducing inflation. 

6.2       Limitations of Short-term Supply-side Policies

As Singapore is a small economy that is highly dependent on external demand with the domestic exports accounting for a large proportion of the aggregate demand, a fall in exports is likely to lead to a substantial decrease in aggregate demand. Therefore, unless the fall in the cost of production in the economy is large, the increase in aggregate supply is likely to only partially offset the decrease in aggregate demand resulting in a smaller decrease in national output and hence national income. Furthermore, these policies will lead to an increase in the profits of firms which are generally owned by high income individuals and this may result in a less equitable distribution of income.

7          TRADE POLICY

7.1       Objectives of Trade Policy

A free trade agreement (FTA) is an agreement between two or more economies to remove or reduce barriers to trade with the objective of increasing the cross-border movement of goods and services between the economies. Singapore has signed over 20 FTAs which is one of the highest numbers in the world.

To increase economic growth or reduce unemployment, the Singapore government can sign FTAs. When tariffs on Singapore’s goods are removed or reduced in the FTA member countries, firms in the FTA member countries that import and sell Singapore’s goods will experience a fall in their costs of production which will induce them to decrease prices to maintain competitiveness. When this happens, Singapore’s goods will become cheaper in the FTA member countries. Therefore, signing FTAs in Singapore will lead to an increase in exports which will lead to an increase in aggregate demand. For example, the USSFTA which came into effect in 2004 led to an increase in Singapore’s exports. Furthermore, firms in the non-FTA member countries that export goods to the FTA member countries and want to circumvent the tariffs will invest in Singapore. By setting up production facilities in Singapore, the goods that they produce in Singapore and export to the FTA member countries, which will be subject to lower or no tariffs, will be cheaper than those that they produce in the non-FTA member countries and export to the FTA member countries, other factors aside. This will lead to an increase in their sales and hence their profits. Therefore, signing FTAs in Singapore will lead to an increase in foreign direct investments which will lead to an increase in aggregate demand. For example, apart from an increase in exports, the USSFTA also led to an increase in foreign direct investments in Singapore. An increase in exports and investment expenditure in Singapore will lead to an increase in aggregate demand which will induce firms to increase production resulting in an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

Note:   Students are required to discuss trade policy in the examination only if the question is asked in the Singapore context.

7.2       Limitations of Trade Policy

A major limitation of trade policy in the form of signing FTAs is the long period of time it takes to negotiate FTAs with the potential partners. For example, the USSFTA was only concluded in May 2003, about two and a half years after negotiations began in November 2000.

8          CONFLICTS BETWEEN MACROECONOMIC GOALS

Although the government has four macroeconomic goals, conflicts between the goals may occur. In other words, when the government uses a policy to achieve a macroeconomic goal, this may conflict with another macroeconomic goal. As the government has four macroeconomic goals, there are 12 potential conflicts. The following are some examples of the potential conflicts between the macroeconomic goals of the government.

Example 1

Suppose that the government decreases unemployment to achieve the macroeconomic goal of low unemployment. Further suppose that it does so through the use of expansionary demand-side policies. An increase in aggregate demand will induce firms to increase production resulting in an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment. However, an increase in aggregate demand will lead to a shortage of goods and services resulting in a rise in the general price level and hence higher inflation. Furthermore, when aggregate demand rises which will induce firms to increase production, the resultant increase in the demand for factor inputs in the economy will lead to a rise in the prices. When this happens, the cost of production in the economy will rise which will induce firms to increase prices to maintain profitability resulting in a rise in the general price level and hence higher inflation. If there are moderate to high inflationary pressures in the economy, a rise in inflation is likely to lead to high inflation. Therefore, achieving the macroeconomic goal of low unemployment may conflict with the macroeconomic goal of low inflation. When national income rises, imports will increase which will worsen the current account and hence the balance of payments. Furthermore, if a rise in inflation makes domestic goods and services relatively more expensive than foreign goods and services, net exports will fall which will lead to a deterioration in the current account and hence the balance of payments, assuming the demand for exports is price elastic. If the economy has a balance of payments equilibrium, a deterioration in the balance of payments will lead to a balance of payments deficit. Under the fixed exchange rate system, the balance of payments deficit will be persistent, other things being equal. Therefore, achieving the macroeconomic goal of low unemployment may conflict with the macroeconomic goal of a balance of payments equilibrium.

If there are no or low inflationary pressures in the economy, a rise in inflation may not lead to high inflation. Indeed, if there are deflationary pressures in the economy, a rise in inflation is likely to lead to low inflation which is desirable for the economy. Furthermore, the use of expansionary demand-side policies to achieve low unemployment may lead to an increase in aggregate supply in the long run. For example, an increase in government expenditure on education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy. An increase in the skills and knowledge of labour in the economy will lead to an increase in the production capacity in the economy resulting in an increase in aggregate supply. In addition, it will lead to an increase in labour productivity and hence a fall in the cost of production in the economy resulting in an increase in aggregate supply. If this happens, assuming aggregate demand is rising which is the normal state of the economy, the general price level will rise at a slower rate resulting in lower inflation. Therefore, achieving the macroeconomic goal of low unemployment may not conflict with the macroeconomic goal of low inflation. When national income rises, imports will increase which will worsen the current account and hence the balance of payments. However, if the economy has a persistent balance of payments surplus, a deterioration may help correct the surplus and hence achieve an equilibrium. Furthermore, if inflation falls due to an increase in aggregate supply, domestic goods and services may become relatively cheaper than foreign goods and services. If this happens, net exports will rise which will lead to an improvement in the current account and hence the balance of payments. If the economy has a persistent balance of payments deficit, an improvement may help correct the deficit and hence achieve an equilibrium. Therefore, achieving the macroeconomic goal of low unemployment may not conflict with the macroeconomic goal of a balance of payments equilibrium. Expansionary demand-side policies decrease unemployment through increasing aggregate demand and hence national output. Therefore, achieving the macroeconomic goal of low unemployment may help achieve the macroeconomic goal of high economic growth.

Example 2

Suppose that the government decreases inflation to achieve the macroeconomic goal of low inflation. Further suppose that it does so through the use of contractionary demand-side policies. Assuming aggregate demand and hence the general price level is rising rapidly, contractionary demand-side policies will reduce the growth of aggregate demand which will lead to a slower rise in the general price level resulting in lower inflation. However, a slower growth of aggregate demand will lead to a less rapid increase in national output and hence national income. Therefore, achieving the macroeconomic goal of low inflation may conflict with the macroeconomic goal of high economic growth. When economic growth falls, the demand for labour in the economy will rise at a slower rate. As the labour force in the economy is generally expanding, a less rapid increase in the demand for labour in the economy may not create sufficient new jobs for the new entrants in the labour force. If this happens, unemployment will rise. Therefore, achieving the macroeconomic goal of low inflation may conflict with the macroeconomic goal of low unemployment.

Apart from contractionary demand-side policies, supply-side policies can also be used to reduce inflation. When the production capacity in the economy and hence aggregate supply rises, assuming aggregate demand is rising which is the normal state of the economy, the general price level will rise at a slower rate resulting in lower inflation. In addition to a fall in inflation, an increase in the production capacity in the economy and hence aggregate supply will lead to a more rapid increase in national output and hence national income, assuming aggregate demand is rising which is the normal state of the economy. Therefore, achieving the macroeconomic goal of low inflation may not conflict with the macroeconomic goal of high economic growth. When economic growth rises, the demand for labour in the economy will rise at a faster rate. As the labour force in the economy is generally expanding, a more rapid increase in the demand for labour in the economy may create sufficient new jobs for the new entrants in the labour force which may lead to low unemployment. Therefore, achieving the macroeconomic goal of low inflation may not conflict with the macroeconomic goal of low unemployment. A fall in inflation may make domestic goods and services relatively cheaper than foreign goods and services. If this happens, net exports will rise which will lead to an improvement in the current account and hence the balance of payments. Furthermore, when economic growth falls due to the use of contractionary demand-side policies to reduce inflation, import growth will fall. Assuming export growth remains constant, a decrease in import growth may improve the current account and hence the balance of payments. If the economy has a persistent balance of payments deficit, an improvement may help correct the deficit and hence achieve an equilibrium. Therefore, achieving the macroeconomic goal of low inflation may help achieve the macroeconomic goal of a balance of payments equilibrium.

Example 3

Suppose that the government increases potential economic growth in order to achieve the macroeconomic goal of high economic growth. Further suppose that it does so through research and development. Research and development will lead to technological advancement which will increase the efficiency of capital in the economy. When this happens, the production capacity in the economy and hence aggregate supply will increase which will lead to higher potential economic growth. Given that actual economic growth is constrained by potential economic growth, higher potential economic growth will allow higher actual economic growth resulting in a more rapid rise in the standard of living. However, technological advancement will lead to losses of low-skilled jobs which will result in a rise in structural unemployment. Therefore, achieving the macroeconomic goal of high economic growth may conflict with the macroeconomic goal of low unemployment.

Apart from research and development, education and training can also be used to increase potential economic growth in order to achieve the macroeconomic goal of high economic growth. Education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy. When this happens, the production capacity in the economy and hence aggregate supply will increase which will lead to higher potential economic growth. In addition to an increase in potential economic growth, education and training may equip the low-skilled workers who have been displaced with the relevant skills and knowledge to find jobs in the expanding industries which are typically high value-added industries and hence require high skills. If this happens, structural unemployment will fall. Furthermore, if higher potential economic growth leads to higher actual economic growth, the demand for labour in the economy will rise at a faster rate. As the labour force in the economy is generally expanding, a more rapid increase in the demand for labour in the economy may create sufficient new jobs for the new entrants in the labour force which may lead to low unemployment. Therefore, achieving the macroeconomic goal of high economic growth may not conflict with the macroeconomic goal of low unemployment.

Example 4

Suppose that the government corrects a persistent balance of payments deficit to achieve the macroeconomic goal of a balance of payments equilibrium. Further suppose that it does so through the use of contractionary demand-side policies. A decrease in aggregate demand will induce firms to decrease production resulting in a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income. When national income falls, imports will fall which will lead to an improvement in the current account and hence the balance of payments. A decrease in aggregate demand will also lead to a fall in the general price level which may make domestic goods and services relatively cheaper than foreign goods and services resulting in an increase in net exports. If this happens, assuming the demand for exports is price elastic, the current account and hence the balance of payments will improve. However, contractionary demand-side policies correct a persistent balance of payments deficit through decreasing aggregate demand which will lead to a decrease in national output and hence national income. Therefore, achieving the macroeconomic goal of a balance of payments equilibrium may conflict with the macroeconomic goal of high economic growth. When national output falls, the demand for labour in the economy will fall which will lead to a rise in unemployment. Therefore, achieving the macroeconomic goal of a balance of payments equilibrium may conflict with the macroeconomic goal of low unemployment.

Apart from contractionary demand-side policies, exchange rate policy can also be used to correct a persistent balance of payments deficit to achieve the macroeconomic goal of a balance of payments equilibrium. A devaluation of domestic currency will make domestic goods and services relatively cheaper than foreign goods and services. When this happens, net exports will rise which may lead to an improvement in the current account and hence the balance of payments, assuming the sum of the price elasticities of demand for exports and imports is greater than one. In addition to an improvement in the balance of payments, an increase in net exports will lead to an increase in aggregate demand resulting in an increase in national output and hence national income. Therefore, achieving the macroeconomic goal of a balance of payments equilibrium may not conflict with the macroeconomic goal of high economic growth. When national output rises, the demand for labour in the economy will rise which will lead to a fall in unemployment. Therefore, achieving the macroeconomic goal of a balance of payments equilibrium may not conflict with the macroeconomic goal of low unemployment. If aggregate demand and hence the general price level is rising rapidly, the use of contractionary demand-side policies to correct a persistent balance of payments deficit will reduce the growth of aggregate demand which will lead to a slower rise in the general price level resulting in lower inflation. Therefore, achieving the macroeconomic goal of a balance of payments equilibrium may help achieve the macroeconomic goal of low inflation.

Example 5

Suppose that the government decreases inflation to achieve the macroeconomic goal of low inflation. Further suppose that it does so through the use of exchange rate policy. In times of high external price pressures, the prices of imports will rise substantially which will lead to high imported inflation. A revaluation of domestic currency will reduce the increase in the prices of imports in domestic currency resulting in lower imported inflation. In addition, a rise in the exchange rate will make domestic goods and services relatively more expensive than foreign goods and services. When this happens, net exports will fall which will lead to a decrease in aggregate demand. Assuming aggregate demand and hence the general price level is rising rapidly, this will reduce the growth of aggregate demand which will lead to a slower rise in the general price level resulting in lower demand-pull inflation. However, a decrease in net exports may lead to a deterioration in the current account and hence the balance of payments, assuming the sum of the price elasticities of demand for exports and imports is greater than one. Therefore, achieving the macroeconomic goal of low inflation may conflict with the macroeconomic goal of a balance of payments equilibrium. A decrease in net exports will also lead to a decrease in aggregate demand which will induce firms to decrease production resulting in a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income. Therefore, achieving the macroeconomic goal of low inflation may conflict with the macroeconomic goal of high economic growth. When national output falls, the demand for labour in the economy will fall which will lead to a rise in unemployment. Therefore, achieving the macroeconomic goal of low inflation may conflict with the macroeconomic goal of low unemployment.

If the economy has a persistent balance of payments surplus, a deterioration may help correct the surplus and hence achieve an equilibrium. Therefore, achieving the macroeconomic goal of low inflation may not conflict with the macroeconomic goal of a balance of payments equilibrium. A stronger domestic currency may induce exporters to increase labour productivity to maintain competitiveness. For example, the revaluation of the yuan against the major currencies in the world including the U.S dollar from July 2005 to July 2008 led to a rise in labour productivity in China. If this happens, the cost of production in the economy will fall which will lead to an increase in aggregate supply resulting in an increase in national output and hence national income. Therefore, achieving the macroeconomic goal of low inflation may not conflict with the macroeconomic goal of high economic growth. When national output rises, the demand for labour in the economy will rise which will lead to a fall in unemployment. Therefore, achieving the macroeconomic goal of low inflation may not conflict with the macroeconomic goal of low unemployment.

Note:   The list of examples of the potential conflicts between the macroeconomic goals of the government discussed in this section is by no means comprehensive. Nevertheless, students need not discuss all the potential conflicts in the examination.

The Principal Economics Tutor will discuss conflicts between macroeconomic goals in greater detail in the economics tuition class.

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