chapter 19-macroeconomic-policies
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Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 1
CHAPTER 19
MACROECONOMIC POLICIES
LECTURE OUTLINE
1 DEMAND-SIDE POLICIES: FISCAL POLICY
1.1 The objective of fiscal policy
1.2 The limitations of fiscal policy
1.3 The supply-side effect of fiscal policy
1.4 Fiscal policy in Singapore
2 DEMAND-SIDE POLICIES: MONETARY POLICY
2.1 The objective of monetary policy
2.2 The limitations of monetary policy
2.3 The supply-side effect of monetary policy
2.4 Monetary policy in Singapore
3 EXCHANGE RATE POLICY
3.1 The objective of exchange rate policy
3.2 The limitations of exchange rate policy
3.3 Exchange rate policy in Singapore
4 SUPPLY-SIDE POLICIES
5 PRICES AND INCOME POLICIES (optional)
References
John Sloman, Economics
William A. McEachern, Economics
Richard G. Lipsey and K. Alec Chrystal, Positive Economics
G. F. Stanlake and Susan Grant, Introductory Economics
Michael Parkin, Economics
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 2
1 DEMAND-SIDE POLICIES: FISCAL POLICY
1.1 The objective of fiscal policy
Demand-side policies are policies that are used to influence aggregate demand.
Fiscal policy is a demand-side policy that is used to control government expenditure or
taxation to influence aggregate demand.
Expansionary fiscal policy
To increase economic growth or reduce unemployment, the government can increase
aggregate demand by increasing expenditure on goods and services or by increasing
consumption expenditure through decreasing direct taxes or through increasing transfer
payments. In addition to increasing consumption expenditure, a decrease in corporate
income tax will also increase investment expenditure and hence aggregate demand.
Contractionary fiscal policy
To reduce inflation, the government can decrease aggregate demand by decreasing
expenditure on goods and services or by decreasing consumption expenditure through
increasing direct taxes or through decreasing transfer payments. In addition to decreasing
consumption expenditure, an increase in corporate income tax will also decrease
investment expenditure and hence aggregate demand. In reality, contractionary
demand-side policies are more commonly used to reduce the growth of aggregate demand.
1.2 The limitations of fiscal policy
Inflexibility of government expenditure and taxation
Increasing government expenditure and changing taxation involve a high degree of
inflexibility because fiscal budgets are subject to parliamentary debates and approvals,
which may take weeks, if not months. This is commonly known as the decision time lag. It
is also difficult to decrease government expenditure significantly as a large part of it is
made in important areas such as education, healthcare, infrastructure and national defence.
Crowding-out effect (not applicable to contractionary fiscal policy)
An increase in government expenditure not financed by increasing taxes will lead to a
budget deficit. When the government runs a budget deficit, it will need to raise funds by
issuing securities (i.e. bonds and bills) to finance the deficit, assuming it does not have
sufficient reserves. If this happens, the supply of loanable funds will fall which will lead to
a rise in interest rates. Higher interest rates will reduce investment expenditure and
consumption expenditure which will partially offset the initial increase in government
expenditure. This is known as the crowding-out effect.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 3
Consumption expenditure depends on permanent income (optional)
Permanent income is the average annual income that people expect to receive over a period
of years in the future. If consumption expenditure depends more on permanent income than
on current income, a change in direct taxes will not have a significant effect on
consumption expenditure if permanent income is little affected.
Small multiplier
An economy with high income taxes, high savings and high imports will have a small
multiplier which will limit the effect of fiscal policy on the national income and hence
unemployment and inflation in the economy.
Effectiveness time lag
The effect of fiscal policy is spread out over time and hence the full effect will be realised
only after a period of at least several months.
Note: It is important to note that some of the limitations of fiscal policy do not apply in
Singapore which will become obvious by the end of this chapter.
1.3 The supply-side effect of expansionary fiscal policy
Fiscal policy is referred to as a demand-side policy because it is used to influence aggregate
demand. However, it may also have an effect on aggregate supply in the long run. For
instance, an increase in government expenditure on education and training will increase the
productivity of the labour force. An increase in government expenditure on research and
development will increase the productivity of the capital stock. An increase in government
expenditure on infrastructure will increase investment expenditure and hence the size of
the capital stock. An increase in government expenditure on capital goods will increase the
size of the capital stock. A decrease in corporate income tax will increase expected
after-tax returns on planned investments and hence investment expenditure resulting in an
increase in the size of the capital stock. A decrease in personal income tax will increase the
incentive to work and hence the size of the labour force. However, when economists talk
about fiscal policy, they are normally referring to the use of it to influence aggregate
demand.
1.4 Fiscal policy in Singapore
The Singapore government has adopted a prudent fiscal policy to provide mainly essential
goods and services. Therefore, the government expenditure in Singapore is only about 10
per cent of the national income compared to about 20 per cent in the US. As a result, the
Singapore government has consistently achieved modest budget surpluses in normal years
and has hence built up a large amount of reserves.
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Due to the small multiplier in Singapore and the small government expenditure relative to
the exports, fiscal policy is used for its supply-side effect to increase the aggregate supply.
This is commonly known as fiscal policy with a supply-side intent and it involves an
increase in government expenditure on education and training, research and development
or infrastructure, or a decrease in corporate income tax, or to a lesser extent, personal
income tax. Assuming the aggregate demand in Singapore is rising, which is the normal
state of the Singapore economy, an increase in the aggregate supply will lead to higher
economic growth and lower inflation.
Expansionary fiscal policy is used in Singapore in recession years such as the Subprime
Mortgage Crisis. However, unlike many other economies where expansionary fiscal policy
is used to increase aggregate demand in times of recession, due to the small government
expenditure in Singapore relative to the exports, it is used mainly to cushion hardship in
recession years in Singapore in the form of giving transfer payments to households and
firms.
Contractionary fiscal policy is not used in Singapore in times of high inflationary pressures.
Due to the small size of the government expenditure in Singapore, there is limited room for
decreasing government expenditure. Further, the Singapore government does not favour
increasing direct taxes as this will have an adverse effect on inward FDI and immigration
of foreign talents.
2 DEMAND-SIDE POLICIES: MONETARY POLICY
2.1 The objective of monetary policy
Demand-side policies are policies that are used to influence aggregate demand.
Monetary policy is a demand-side policy that is used to control the money supply and
hence interest rates to influence aggregate demand.
Expansionary monetary policy
To increase economic growth or reduce unemployment, the central bank can increase
aggregate demand by increasing the money supply. If the central bank increases the money
supply, interest rates will fall which will lead to an increase in aggregate demand due to
three reasons. First, lower interest rates will reduce the incentive to save which will lead to
an increase in consumption expenditure. Second, lower interest rates will lead to more
profitable planned investments resulting in an increase in investment expenditure. Third,
lower interest rates will lead to a decrease in hot money inflows and an increase in hot
money outflows and the resultant fall in the exchange rate of domestic currency will make
domestic goods and services relatively cheaper than foreign goods and services resulting in
an increase in net exports. The combined increases in consumption expenditure,
investment expenditure and net exports will lead to an increase in aggregate demand.
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© 2011 Economics Cafe All rights reserved. Page 5
Contractionary monetary policy
To reduce inflation, the central bank can decrease aggregate demand by decreasing the
money supply. If the central bank decreases the money supply, interest rates will rise which
will lead to a decrease in aggregate demand due to three reasons. First, higher interest rates
will increase the incentive to save which will lead to a decrease in consumption
expenditure. Second, higher interest rates will lead to less profitable planned investments
resulting in a decrease in investment expenditure. Third, higher interest rates will lead to an
increase in hot money inflows and a decrease in hot money outflows and the resultant rise
in the exchange rate of domestic currency will make domestic goods and services relatively
more expensive than foreign goods and services resulting in a decrease in net exports. The
combined decreases in consumption expenditure, investment expenditure and net exports
will lead to a decrease in aggregate demand. In reality, contractionary demand-side
policies are more commonly used to reduce the growth of aggregate demand.
Note: Hot money refers to money that moves quickly between countries in search of the
highest short-term returns. For simplicity, students can think of hot money inflows as
the money that foreigners deposit in the economy and think of hot money outflows as
the money that domestic residents deposit overseas.
2.2 The limitations of monetary policy
The demand for money is interest elastic (not applicable to contractionary monetary
policy)
If the demand for money is interest elastic, which is likely to occur at low interest rates, an
increase in the money supply will not lead to a significant fall in interest rates.
In the above diagram, an increase in the money supply (M) from M0 to M1 leads to only a
small fall in the interest rate (r) from r0 to r1. An example is Japan where the interbank
overnight rate has not exceeded one per cent since 1995.
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© 2011 Economics Cafe All rights reserved. Page 6
The demand for investment is interest inelastic
If the demand for investment is interest inelastic, a change in interest rates will not lead to a
significant change in investment.
In the above diagram, a fall in the interest rate (r) from r0 to r1 leads to only a small increase
in investment (I) from I0 to I1. An example is Singapore where most of the investments are
made by foreign firms with foreign sources of funds.
Credit crunch (not applicable to contractionary monetary policy)
Sometimes, although households and firms are willing to borrow, banks are unwilling to
lend due to pessimism about the economic outlook which results in a credit crunch.
Small multiplier
An economy with high income taxes, high savings and high imports will have a small
multiplier which will limit the effect of monetary policy on the national income and hence
unemployment and inflation in the economy.
Effectiveness time lag
The effect of monetary policy is spread out over time and hence the full effect will be
realised only after a period of at least several months.
2.3 The supply-side effect of expansionary monetary policy
Monetary policy is referred to as demand-side policy because it is used to influence
aggregate demand. However, it also has an effect on aggregate supply in the long run.
Expansionary monetary policy will lead to an increase in investment and hence the size of
the capital stock. However, when economists talk about monetary policy, they are
normally referring to the use of it to influence aggregate demand.
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© 2011 Economics Cafe All rights reserved. Page 7
2.4 Monetary policy in Singapore
Monetary policy is not used in Singapore due to four reasons: the choice of a managed float
exchange rate, the role of an interest rate-taker, the small consumption expenditure and
investment expenditure relative to the exports and the low degree of responsiveness of the
consumption expenditure and investment expenditure to a change in interest rates (this will
be explained in section 3.3).
Although monetary policy is not used in the conventional way in Singapore, it is used to
ensure adequate liquidity in the banking system to meet banks’ demand for reserves. This
is to maintain the exchange rate of the Singapore dollar in the policy band and is commonly
known as the exchange rate-centred monetary policy. For instance, when the Singapore
government runs a budget surplus, it will deposit the money with the MAS. When this
happens, the supply of reserves and hence the money supply in the banking system in
Singapore will fall and the resultant rise in the interbank overnight rate will lead to a rise in
interest rates. Higher interest rates in Singapore will lead to an increase in hot money
inflows and a decrease in hot money outflows which will result in a rise in the exchange
rate of the Singapore dollar. To maintain the exchange rate of the Singapore dollar in the
policy band, the MAS will increase and hence restore the money supply.
Note: It is important to note that unlike the conventional monetary policy, an increase in the
money supply under exchange rate-centred monetary policy will not lead to a fall in
interest rates. Rather, the objective is to prevent interest rates from rising.
3 EXCHANGE RATE POLICY
3.1 The objective of exchange rate policy
Exchange rate policy is a policy that is used to control the exchange rate to influence
aggregate demand or aggregate supply.
To increase economic growth or reduce unemployment, the central bank can increase
aggregate demand by devaluing domestic currency through selling domestic currency and
buying foreign currency. A depreciation of domestic currency will make domestic goods
and services relatively cheaper than foreign goods and services which will lead to an
increase in net exports and hence aggregate demand.
To reduce inflation, the central bank can decrease aggregate demand by revaluing domestic
currency through buying domestic currency and selling foreign currency. An appreciation
of domestic currency will make domestic goods and services relatively more expensive
than foreign goods and services which will lead to a decrease in net exports and hence
aggregate demand.
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3.2 The limitations of exchange rate policy
A weaker domestic currency will lead to a rise in the prices of imported goods and services,
which include both consumer and intermediate goods, which may lead to high imported
inflation. The rise in the prices of imported intermediate goods may also lead to high
cost-push inflation. If the Marshall-Lerner condition does not hold, which may happen in
the short run, a devaluation of domestic currency will lead to a deterioration in the current
account and hence the balance of payments. A continual devaluation of domestic currency
may lead to currency instability. If this happens, inward foreign direct investments and
hence aggregate demand may fall.
A stronger domestic currency will lead to an increase in the costs of investing in the
economy in foreign currency which will lead to a decrease in inward foreign direct
investments. Further, if the central bank does not have sufficient foreign exchange reserves,
it will not be able to revalue domestic currency. If the Marshall-Lerner condition holds, a
revaluation of domestic currency will lead to a deterioration in the current account and
hence the balance of payments.
3.3 Exchange rate policy in Singapore
Singapore operates under the managed float exchange rate system due to the small and
open nature of the economy. As a small and open economy, the exports and imports of
Singapore are high relative to the national income. Therefore, the MAS holds the view that
the exchange rate is the most effective policy instrument for achieving low inflation in
Singapore. Further, due to 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, also known as the nominal
effective exchange rate of the Singapore dollar (S$NEER), is a trade-weighted average of
the bilateral exchange rates between the Singapore dollar and the currencies of 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.
Monetary 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
stance for the following six months.
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When its external economic environment is strong, Singapore will experience high
inflation in the absence of central bank intervention. When Singapore’s trading partners
expand rapidly, their national income and general price level will rise rapidly. When this
happens, the prices of imported goods and services in Singapore, which include both
consumer and intermediate goods, will rise rapidly which will lead to high imported
inflation. The rapid rise in the prices of imported intermediate goods in Singapore will also
lead to high cost-push inflation. Further, the external demand for Singapore’s goods and
services will increase rapidly which will lead to high demand-pull inflation in Singapore.
When the MAS predicts a strong external economic environment, it will raise the policy
band gradually and modestly to allow a gradual and modest appreciation of the Singapore
dollar in a pre-emptive strike against inflation. When the Singapore dollar becomes
stronger, the rise in the prices of imported goods and services in Singapore will be smaller
which will lead to lower imported inflation. The smaller rise in the prices of imported
intermediate goods in Singapore will also lead to lower cost-push inflation. Further, a
stronger Singapore dollar will lead to a smaller increase in the external demand for
Singapore’s goods and services which will lead to lower demand-pull inflation in
Singapore.
When the MAS predicts a weak external economic environment, it will keep the policy
band unchanged. In other words, it will adopt a neutral exchange rate policy stance with a
policy band centred on a zero per cent appreciation of the S$NEER.
When the MAS predicts a very weak external economic environment, it will lower the
policy band to allow the Singapore dollar more room to depreciate. A weaker Singapore
dollar will make Singapore’s goods and services relatively cheaper than foreign goods and
services which will lead to a smaller decrease in the exports and hence the aggregate
demand in Singapore resulting in a smaller decrease in the national income. However, the
MAS will not devalue the Singapore dollar dramatically to prevent high imported inflation
and high cost-push inflation in Singapore.
Over the last few decades, due to the strong external economic environment of Singapore,
the Singapore dollar has been on an appreciating trend and this has helped achieve low
inflation in Singapore.
Monetary policy is not used in Singapore because of its inability to control interest rates
due to the choice of a managed float exchange rate and the role of an interest rate-taker.
According to the Impossible Trinity or the Open-Economy Trilemma, an economy cannot
have simultaneously a fixed exchange rate, free capital mobility and an independent
monetary policy. Therefore, due to the larger external sector of the Singapore economy and
hence the choice of a managed float exchange rate, the MAS cannot use monetary policy.
For instance, if the MAS increases the money supply to lower interest rates, hot money
inflows will decrease and hot money outflows will increase which will cause the exchange
rate of the Singapore dollar to fall below the policy band. To bring the exchange rate of the
Singapore dollar back into the policy band, there are two measures that the MAS can take.
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First, it can reverse the policy by decreasing the money supply to increase hot money
inflows and decrease hot money outflows but this will negate the effect of the initial
increase in the money supply. Second, it can buy Singapore dollars and sell foreign
currency but this will also lead to a decrease in the money supply and hence negate the
effect of the initial increase in the money supply.
As a small and open economy, interest rates in Singapore are largely determined by foreign
interest rates, particularly interest rates in the US. Therefore, Singapore is an interest
rate-taker in the sense that it cannot change interest rates independently of foreign interest
rates. For instance, 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 supply of loanable funds. Due to the small and open nature of the Singapore
economy, interest rates will rise back to the initial level.
In addition to the inability to control interest rates, monetary policy is not used in
Singapore due to the small consumption expenditure and investment expenditure relative
to the exports and their low degree of responsiveness to a change in interest rates. The
exports of Singapore are over 300 per cent of the sum of the consumption expenditure and
investment expenditure. Therefore, it is more effective to manage the Singapore economy
by controlling the exports rather than the consumption expenditure and investment
expenditure. Further, a fall in interest rates in Singapore will not lead to a significant
increase in the consumption expenditure due to the culture of thrift, and it will not lead to a
significant increase in the investment expenditure as most of the investments are made by
foreign firms with foreign sources of funds.
Note: Interest rates in Singapore usually change due to a change in interest rates in the US.
For instance, when interest rates in the US rise, interest rates in Singapore will
become relatively lower and these will lead to a decrease in hot money inflows and
an increase in hot money outflows, 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 US. However, they have typically been below interest rates in the
US due to market expectations of an appreciation of the Singapore dollar against the
US dollar.
4 SUPPLY-SIDE POLICIES
Supply-side policies are policies that are used to increase the production capacity in the
economy and hence aggregate supply. They are often used to increase economic growth,
reduce unemployment or reduce inflation. The production capacity in the economy and
hence aggregate supply will rise when there is an increase in the size of the capital stock,
the productivity of the capital stock, the size of the labour force or the productivity of the
labour force.
Supply-side policies are often classified into market-oriented policies and interventionist
policies.
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Education and training (Interventionist policy)
Human capital is the skills and knowledge that workers acquire through education and
training. Education and training will increase human capital and hence the productivity of
the labour force. The government can provide education and training directly, by setting up
educational institutes, or indirectly, by giving subsidies or tax incentives to firms to induce
them to send their workers for education and training.
Research and development (Interventionist policy)
Research and development will lead to technological advancement and hence increase the
productivity of the capital stock. The government can engage in research and development
directly, by setting up research institutes, or indirectly, by giving subsidies or tax
incentives to firms to encourage them to engage in research and development.
Deregulation (Market-oriented policy)
Deregulation is the removal of regulations that restrict competition. Deregulation will lead
to an increase in the number of firms and hence greater competition which will induce
firms to engage in research and development. Research and development will lead to
technological advancement and hence increase the productivity of the capital stock.
Privatisation (Market-oriented policy)
Privatisation is the conversion of a state-owned industry to a private industry. Privatisation
will lead to an increase in the number of firms and hence greater competition which will
induce firms to engage in research and development. Research and development will lead
to technological advancement and hence increase the productivity of the capital stock.
Foreign worker policy (Interventionist policy)
If the government allows more foreign workers into the country through changing the
dependency ceiling or the foreign worker levy, the size of the labour force will increase.
Immigration policy (Interventionist policy)
If the government allows more foreigners to migrate to the country, the size of the labour
force will increase.
Government expenditure on capital goods (Interventionist policy)
An increase in government expenditure on capital goods will increase the size of the capital
stock.
Free trade (Market-oriented policy)
A reduction in tariffs and non-tariff barriers will lead to greater competition which will
induce firms to engage in research and development. Research and development will lead
to technological advancement and hence increase the productivity of the capital stock. The
government can promote free trade by entering into more free trade agreements with other
economies in the international community or by reducing tariffs and non-tariff barriers
unilaterally.
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Personal income tax (Market-oriented policy)
A decrease in personal income tax will increase the incentive to work and hence the size of
the labour force. Further, it will reduce the extent of the unemployment trap. The
unemployment trap occurs when the pay that will be received by the unemployed are not
significantly higher than the unemployment benefits that they are currently receiving. This
discourages movement into work and affects particularly low-skilled workers.
Corporate income tax (Market-oriented policy)
A decrease in corporate income tax will increase expected after-tax returns on planned
investments and hence investment expenditure resulting in an increase in the size of the
capital stock.
Capital gains tax (Market-oriented policy)
A capital gain is a profit that is made from the sale of certain types of asset that include both
physical assets and financial assets. A decrease in capital gains tax will increase the
incentive to invest and hence investment expenditure resulting in an increase in the size of
the capital stock.
Trade union reforms (Market-oriented policy)
The government can implement trade union reforms to reduce the power of trade unions
such as making industrial action without a ballot unlawful. This has the effects of reducing
wage rates and increasing the productivity of the labour force.
A major limitation of supply-side policies is the long period of time it takes for the effects
to be realised.
The supply-side policies that are used in Singapore are education and training, research and
development, immigration policy and foreign worker policy. Further, in times of recession,
the Singapore government also uses short-term supply-side measures such as reducing the
employers’ CPF contribution and helps firms pay a certain percentage of their workers’
salaries to reduce the labour cost and hence the cost of production in Singapore to achieve
an increase in the aggregate supply and hence higher economic growth.
Note: The classification of market-oriented policies and interventionist polices is not
important for the examination.
5 PRICES AND INCOME POLICIES (optional)
Prices and income policies are wage and price controls used to fight inflation. Such policies
were widely used in the 1960s and 1970s as a method of fighting stagflation. They may be
in the form of a voluntary agreement with firms and/or trade unions, or there may be
statutory limits imposed. There are, however, problems with such policies. First, income
policy may lead to strikes. This was exactly what happened in the UK in the late 1960s and
1970s. Second, by arbitrarily interfering with price signals, prices policies provide an
additional bar to achieve economic efficiency, potentially leading to shortages and declines
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in the quality of goods on the market, while requiring large government bureaucracies for
their enforcement. These shortages may lead to black markets.
Note: Some economics teachers discuss prices and income policies as supply-side policies.
However, although this can be done for income policy, it is inappropriate to do so for
prices policy.
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