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Written by: Edmund Quek

CHAPTER 19 MACROECONOMIC POLICIES

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

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

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a decrease in corporate income tax will also increase investment expenditure and hence aggregate demand. © 2011 Economics Cafe All rights reserved. In addition to decreasing consumption expenditure. This is known as the crowding-out effect. the demand for loanable funds will rise which will lead to a rise in interest rates. Higher interest rates will reduce investment expenditure and consumption expenditure which will partially offset the initial increase in government expenditure. In reality.Written by: Edmund Quek 1 1. Crowding-out effect (only for expansionary fiscal policy) An increase in government expenditure not financed by taxes will lead to a budget deficit. It is also difficult to decrease government expenditure significantly as a large part of it is made in important areas such as education. Page 2 . Fiscal policy is a demand-side policy that is used to control government expenditure or taxation to influence aggregate demand. This is commonly known as the decision time lag. When this happens. if not months. bonds and bills) to finance the deficit. which may take weeks. it will issue securities (i. contractionary demand-side policies are more commonly used to reduce the growth of aggregate demand. 1. healthcare.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. When the government runs a budget deficit. an increase in corporate income tax will also decrease investment expenditure and hence aggregate demand. 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.1 DEMAND-SIDE POLICIES: FISCAL POLICY The objective of fiscal policy Demand-side policies are policies that are used to influence aggregate demand. 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.e. assuming it does not have sufficient reserves. Contractionary fiscal policy To reduce inflation. In addition to increasing consumption expenditure. There are two demand-side policies: fiscal policy and monetary policy. Expansionary fiscal policy To increase economic growth or reduce unemployment. infrastructure and national defence.

4 Fiscal policy in Singapore The Singapore government has adopted a prudent fiscal policy to provide mainly essential goods and services. 1. Note: Loanable funds can be defined as funds available for loan in the form of bank loans or funds available for loan in general. 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. By the second definition. 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. In either case. I use the second definition. A decrease in personal income tax will increase the incentive to work and hence the size of the labour force. 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. the demand for loanable funds will rise. high savings and high imports will have a small multiplier which will limit the effect of fiscal policy on the national income. An increase in government expenditure on infrastructure will increase investment expenditure and hence the size of the capital stock. interest rates will rise. As a result. An increase in government expenditure on research and development will increase the productivity of the capital stock. By the first definition. However. they are normally referring to the use of it to influence aggregate demand. © 2011 Economics Cafe All rights reserved.Written by: Edmund Quek Small multiplier An economy with high income taxes. when economists talk about fiscal policy. the Singapore government has consistently achieved modest budget surpluses in normal years and has hence built up a large amount of reserves. An increase in government expenditure on capital goods will increase the size of the capital stock. 1. Page 3 . unemployment and inflation. it may also have an effect on aggregate supply in the long run. However. the supply of loanable funds will fall when the government issues securities to finance a deficit. an increase in government expenditure on education and training will increase the productivity of the labour force. For instance. the government expenditure in Singapore is only about 10 per cent of the national income compared to about 20 per cent in the US. Therefore.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.

Monetary policy is a demand-side policy that is used to control the money supply and hence interest rates to influence aggregate demand. However. 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. The increase in consumption expenditure. lower interest rates will lead to a decrease in hot money inflows and an increase in hot money outflows and hence a decrease in the demand for domestic currency and an increase in the supply of domestic currency resulting in a fall in the exchange rate. Expansionary monetary policy To increase economic growth or reduce unemployment. Assuming aggregate demand in Singapore is rising. Page 4 . or to a lesser extent. due to the small government expenditure in Singapore relative to the exports. Expansionary fiscal policy is used in Singapore in recession years such as the 2008-2009 global financial crisis. lower interest rates will lead to more profitable planned investments resulting in an increase in investment expenditure. Second. Third.1 DEMAND-SIDE POLICIES: MONETARY POLICY The objective of monetary policy Demand-side policies are policies that are used to influence aggregate demand. Due to the small size of the government expenditure in Singapore. it is used mainly to cushion hardship in recession years in Singapore in the form of giving transfer payments to households and firms. investment expenditure and net exports will lead to an increase in aggregate demand. personal income tax. interest rates will fall which will lead to an increase in aggregate demand due to three reasons. When domestic currency depreciates. © 2011 Economics Cafe All rights reserved. the fiscal policy is used for its supply-side effect to increase aggregate supply and this is commonly known as fiscal policy with a supply-side intent which involves an increase in government expenditure on education and training. the central bank can increase aggregate demand by increasing the money supply. an increase in the aggregate supply will lead to higher economic growth and lower inflation. there is limited room for decreasing government expenditure. First. 2 2. lower interest rates will reduce the incentive to save which will lead to an increase in consumption expenditure. Contractionary fiscal policy is not used in Singapore in times of high inflationary pressures. or a decrease in corporate income tax. unlike many other economies where expansionary fiscal policy is used to increase aggregate demand in times of recession. which is the normal state of the economy. domestic goods and services will become relatively cheaper than foreign goods and services which will lead to an increase in net exports. If the central bank increases the money supply.Written by: Edmund Quek Due to the small multiplier in Singapore and the small government expenditure relative to the exports. research and development or infrastructure.

If the central bank decreases the money supply. 2. In the above diagram. higher interest rates will lead to an increase in hot money inflows and a decrease in hot money outflows and hence an increase in the demand for domestic currency and a decrease in the supply of domestic currency resulting in a rise in the exchange rate. higher interest rates will lead to less profitable planned investments resulting in a decrease in investment expenditure. Page 5 . interest rates will rise which will lead to a decrease in aggregate demand due to three reasons.Written by: Edmund Quek Contractionary monetary policy To reduce inflation. © 2011 Economics Cafe All rights reserved. domestic goods and services will become relatively more expensive than foreign goods and services which will lead to a decrease in net exports.2 The limitations of monetary policy The demand for money is interest elastic (only for expansionary monetary policy) If the demand for money is interest elastic. an increase in the money supply will not lead to a significant fall in interest rates. higher interest rates will increase the incentive to save which will lead to a decrease in consumption expenditure. which is likely to occur at low interest rates. 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. The decrease in consumption expenditure. In reality. investment expenditure and net exports will lead to a decrease in aggregate demand. contractionary demand-side policies are more commonly used to reduce the growth of aggregate demand. For simplicity. the central bank can decrease aggregate demand by decreasing the money supply. Note: Hot money refers to money that moves quickly between countries in search of the highest short-term returns. Second. students can think of hot money inflows as bank deposits that flow into the economy and hot money outflows as bank deposits that flow out of the economy. Examples include Japan and the US where the interest rates are very low. When domestic currency appreciates. First. Third.

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. Expansionary monetary policy will lead to an increase in investment and hence the size of the capital stock. 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. they are normally referring to the use of it to influence aggregate demand. 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. Small multiplier An economy with high income taxes. In the above diagram. it also has an effect on aggregate supply in the long run. However. However. Credit crunch (only for expansionary monetary policy) Sometimes. An example is Singapore where most of the investments are made by foreign firms with foreign sources of funds. a fall in the interest rate (r) from r0 to r1 leads to only a small increase in investment (I) from I0 to I1. banks are unwilling to lend due to pessimism about the economic outlook which results in a credit crunch. 2. although households and firms are willing to borrow. when economists talk about monetary policy. Page 6 . © 2011 Economics Cafe All rights reserved. a change in interest rates will not lead to a significant change in investment.Written by: Edmund Quek Investment is interest inelastic If investment is interest inelastic.

the supply of reserves and hence the money supply in the banking system in Singapore will fall and the resultant rise in the interbank overnight rate will lead to a rise in the interest rates. an increase in the money supply under exchange rate-centred monetary policy will not lead to a fall in interest rates. the objective is to prevent interest rates from rising. the role of an interest rate-taker. the MAS will increase and hence restore the money supply. it will deposit the money with the MAS. Higher interest rates in Singapore will lead to an increase in the hot money inflows and a decrease in the hot money outflows which will result in a rise in the exchange rate of the Singapore dollar. Page 7 . Rather. 3 3.3). To reduce inflation. 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. the small consumption expenditure and investment expenditure relative to the exports and the low interest elasticity of consumption and investment (this will be explained in section 3. Although monetary policy is not used in the conventional way in Singapore. 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. 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. it is used to ensure adequate liquidity in the banking system to meet banks’ demand for reserves. To increase economic growth or reduce unemployment. To maintain the exchange rate of the Singapore dollar in the policy band. the central bank can increase aggregate demand by devaluing domestic currency through selling domestic currency and buying foreign currency. when the Singapore government runs a budget surplus.Written by: Edmund Quek 2. For instance. Note: It is important to note that unlike the conventional monetary policy. the central bank can decrease aggregate demand by revaluing domestic currency through buying domestic currency and selling foreign currency. When this happens. © 2011 Economics Cafe All rights reserved.4 Monetary policy in Singapore Monetary policy is not used in Singapore due to four reasons: the choice of a managed float exchange rate.1 EXCHANGE RATE POLICY The objective of exchange rate policy Exchange rate policy is a policy that is used to control the exchange rate to influence aggregate demand or aggregate supply.

Further. © 2011 Economics Cafe All rights reserved. The composition of the basket is revised periodically to take into account changes in Singapore’s trade patterns. As a small and open economy. Therefore. 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. The rise in the prices of imported intermediate goods may also lead to high cost-push inflation. which the MAS calls the monetary policy. Further. a revaluation of domestic currency will lead to a deterioration in the current account and hence the balance of payments. which include both consumer and intermediate goods. if the central bank does not have sufficient foreign exchange reserves. A continual devaluation of domestic currency may lead to currency instability. thereby ensuring non-inflationary sustained economic growth over the medium term. and sets out its monetary stance for the following six months. The various currencies are given different weights depending on the extent of Singapore’s trade dependence with that particular economy. it will not be able to revalue domestic currency. inward foreign direct investments and hence aggregate demand may fall. 3. 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.2 The limitations of exchange rate policy A weaker domestic currency will lead to a rise in the prices of imported goods and services. 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. If this happens. 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. If the Marshall-Lerner condition does not hold. the MAS holds the view that the exchange rate is the most effective policy instrument for achieving low inflation in Singapore.Written by: Edmund Quek 3. Exchange rate policy in Singapore. which may lead to high imported inflation. a devaluation of domestic currency will lead to a deterioration in the current account and hence the balance of payments. also known as the nominal effective exchange rate of the Singapore dollar (S$NEER).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. 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. which may happen in the short run. the exports and imports of Singapore are high relative to the national income. If the Marshall-Lerner condition holds. Page 8 . The trade-weighted exchange rate of the Singapore dollar.

Further. their national incomes and general price levels will rise rapidly. due to the strong external economic environment of Singapore. To bring the exchange rate of the Singapore dollar back into the policy band.Written by: Edmund Quek When its external economic environment is strong. When the MAS predicts a weak external economic environment. Over the last few decades. it will lower the policy band to allow the Singapore dollar more room to depreciate. 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 this happens. due to the larger external demand of the Singapore economy and hence the choice of a managed float exchange rate. Therefore. the Singapore dollar has been on an appreciating trend and this has helped achieve low inflation in Singapore. the rise in the prices of imported goods and services in Singapore will be smaller which will lead to lower imported inflation. The rapid rise in the prices of imported intermediate goods in Singapore will also lead to high cost-push inflation. Further. an economy cannot have simultaneously a fixed exchange rate. it will keep the policy band unchanged. the prices of imported goods and services in Singapore. if the MAS increases the money supply to lower interest rates. 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 exports and hence aggregate demand in Singapore resulting in a smaller decrease in the national income. 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. the MAS cannot use monetary policy. According to the Impossible Trinity or the Open-Economy Trilemma. Singapore will experience high inflation in the absence of central bank intervention. 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 Singapore’s trading partners expand rapidly. will rise rapidly which will lead to high imported inflation. In other words. Page 9 . When the Singapore dollar becomes stronger. 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. free capital mobility and an independent monetary policy. which include both consumer and intermediate goods. However. For instance. When the MAS predicts a very weak external economic environment. the hot money inflows will decrease and the hot money outflows will increase which will cause the exchange rate of the Singapore dollar to fall below the policy band. there are two measures that the MAS © 2011 Economics Cafe All rights reserved. The smaller rise in the prices of imported intermediate goods in Singapore will also lead to lower cost-push inflation. 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. the MAS will not devalue the Singapore dollar dramatically to prevent high imported inflation and high cost-push inflation in Singapore.

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 exports of Singapore are over 300 per cent of the sum of the consumption expenditure and investment expenditure. interest rates in Singapore will become relatively lower and these will lead to a decrease in the hot money inflows and an increase in the hot money outflows. Interest rates in Singapore are largely determined by foreign interest rates. the productivity of the capital stock. a fall in interest rates in Singapore will not lead to a significant increase in the consumption expenditure due to the culture of thrift. Second. if the MAS increases the money supply to lower interest rates. Due to the small and open nature of the Singapore economy. reduce unemployment or reduce inflation. Empirically. First. it can intervene in the forex market to prevent the Singapore dollar from depreciating by buying Singapore dollars and selling foreign currency but this will also reduce the money supply. Therefore. For instance. Singapore is an interest rate-taker in the sense that it cannot change the money supply to influence interest rates. 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. the money supply will fall back and hence the interest rates will rise back to the initial levels. In addition to the inability to control interest rates. © 2011 Economics Cafe All rights reserved. the hot money inflows will decrease and the hot money outflows will increase which will lead to a decrease in the money supply. 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. resulting in a decrease in the supply of loanable funds (or a decrease in the money supply) and hence a rise in the interest rates. the size of the labour force or the productivity of the labour force. Page 10 . Supply-side policies are often classified into market-oriented policies and interventionist policies. For instance. As a small and open economy. They are often used to increase economic growth. it can reverse the monetary policy which will make it ineffective. monetary policy is not used in Singapore due to the small consumption expenditure and investment expenditure relative to the exports and the low interest elasticity of consumption and investment. 4 SUPPLY-SIDE POLICIES Supply-side policies are policies that are used to increase the production capacity in the economy and hence aggregate supply. particularly interest rates in the US. it is more effective to manage the Singapore economy by controlling the exports rather than the consumption expenditure and investment expenditure. However. when interest rates in the US rise. Further.Written by: Edmund Quek can use. interest rates in Singapore follow interest rates in the US.

Research and development will lead to technological advancement and hence increase the productivity of the capital stock. firms will engage in education and training and research and development. firms will engage in education and training and research and development. by giving subsidies or tax incentives to firms to induce them to send their workers for education and training. To increase labour productivity. by giving subsidies or tax incentives to firms to encourage them to engage in research and development. Education and training will increase human capital and hence the productivity of the labour force.Written by: Edmund Quek Education and training (Interventionist policy) Human capital is the skills and knowledge that workers acquire through education and training. Deregulation (Market-oriented policy) Deregulation refers to the removal of restrictive regulations. which is output per hour of labour. © 2011 Economics Cafe All rights reserved. Research and development (Interventionist policy) Research and development will lead to technological advancement and hence increase the productivity of the capital stock. Privatisation (Market-oriented policy) Privatisation refers to the conversion of a state-owned industry to a private industry. 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. by setting up research institutes. Government expenditure on infrastructure (Interventionist policy) An increase in government expenditure on infrastructure will increase investment expenditure and hence the size of the capital stock. by setting up educational institutes. to reduce costs. Education and training will increase human capital and hence the productivity of the labour force. which is output per hour of labour. The government can provide education and training directly. Page 11 . Immigration policy (Interventionist policy) If the government allows more foreigners to migrate to the country. or indirectly. Research and development will lead to technological advancement and hence increase the productivity of the capital stock. to reduce costs. the size of the labour force will increase. Education and training will increase human capital and hence the productivity of the labour force. To increase labour productivity. 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. Privatisation will lead to an increase in the number of firms in the market and hence greater competition which will induce firms to increase labour productivity. the size of the labour force will increase. The government can engage in research and development directly. or indirectly.

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. A major limitation of supply-side policies is the long period of time it takes for the effects to be realised. 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. 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. it will reduce the extent of the unemployment trap. However. This will reduce wages and hence the cost of production in the economy. 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. supply-side policies are a policy option in a recession. Therefore. When the cost of production in Singapore falls. 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. they include reducing the employers’ CPF contribution and helping firms pay a certain proportion of wages to reduce labour cost. 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. Nevertheless. Page 12 . In Singapore. Unlike other supply-side policies. such measures may lead to an increase the profits of firms resulting in a less equitable distribution of income. the Singapore government does use short-term supply-side measures in a recession. 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. the aggregate supply and hence the national income will rise.Written by: Edmund Quek Government expenditure on capital goods (Interventionist policy) An increase in government expenditure on capital goods will increase the size of the capital stock. This discourages movement into work and affects particularly low-skilled workers. Further. trade union reforms do not increase the production capacity in the economy. Short-term supply-side measures are measures that are used to reduce the cost of production in the economy and hence increase aggregate supply. Research and development will lead to technological advancement and hence increase the productivity of the capital stock. © 2011 Economics Cafe All rights reserved. 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.

Second. while requiring large government bureaucracies for their enforcement. Note: Some economics teachers discuss prices and income policies as supply-side policies.Written by: Edmund Quek 5 PRICES AND INCOME POLICIES (optional) Prices and income policies are wage and price controls used to fight inflation. by arbitrarily interfering with price signals. These shortages may lead to black markets. Page 13 . prices policies provide an additional bar to achieve economic efficiency. although this can be done for income policy. it is inappropriate to do so for prices policy. however. Such policies were widely used in the 1960s and 1970s as a method of fighting stagflation. or there may be statutory limits imposed. © 2011 Economics Cafe All rights reserved. They may be in the form of a voluntary agreement with firms and/or trade unions. First. problems with such policies. This was exactly what happened in the UK in the late 1960s and 1970s. income policy may lead to strikes. potentially leading to shortages and declines in the quality of goods on the market. There are. However.