FBAH:13-

14
SG: 12

TOPIC 2: FIGHTING RECESSION

Zhang Xuyao
Asia Competitiveness Institute
LKY School Of Public Policy

Prepared by
Dr. Xu Le
NUS Business School
US RESESSIONS BEFORE 2009
GLOBAL RECESSION IN 2020
1. Due to the widespread adoption of travel restriction and border closing, it had
an impact on airlines and tourism-related activities in many countries. (Recent
news: SIA, Alpa-S agree on pilot pay cut, change to compulsory no pay leave
scheme
https://www.businesstimes.com.sg/companies-markets/sia-alpa-s-agree-on-pilot-
pay-cut-change-to-compulsory-no-pay-leave-
scheme)
2. Department stores and other retailers experienced immediate setback.
3. In particular, small companies faced the crisis with less financial and operational
resources. Harvard Business School (HBS) Senior Fellow Karen Mill noted that
small businesses, which accounted for half of U.S. jobs, had only about 27 days
of “cash buffers” to handle disruptions.
QUESTIONS
• If the citizens are not spending enough, the companies receive insufficient sale
revenues to cover costs, they close shops, workers retrenched and have even less
money to spend, creating a vicious cycle and deepening recession.

 Can government spend its past reserves (savings) and jump start the economy?

 Can the same be achieved by cutting income taxes?

RECESSION AND UNEMPLOYMENT
• A common characteristic of a recession is the rising number of people loosing their jobs,
and the unemployment rate increases. How is this measured?

•Labor force = employed + unemployed

•Unemployment rate = unemployed / labor force
•Participation rate = labor force / population 16+
U.S. EMPLOYMENT DATA, JUNE 2013
SINGAPRE UNEMPLOYMENT RATE 2017 -2020
COSTS OF UNEMPLOYMENT
• Economic costs
 Lost wages and production
 Decreased taxes and increased transfers
 Depreciation of skill especially for long duration out of work
 Discourage workers : permanent loss of human resource
• Psychological costs
 Individual self-esteem
 Family stress of decreased income and increased uncertainty
• Social costs
 Potential increases in crimes and social problems
• Social resources spent to address these costs
 A reason for income inequality
TYPES OF UNEMPLOYMENT

• Full employment does not mean that unemployment rate = 0. Even when
output is at its potential Y*, there is natural unemployment allowing for
skill-job matching.
• Cyclical unemployment is the increase in unemployment during economic
slow-downs
–Usually short duration
–Economic cost is the decline in real GDP
TYPES OF UNEMPLOYMENT
• Frictional unemployment occurs in the process of matching workers with jobs. It
occurs because
(a) workers quit jobs due to financial or personal reasons
(b) employers fire workers and look for better ones to replace them
(c) people spend more time looking for work in order to find better jobs
• Short duration, low economic cost
• May increase economic efficiency
STRUCTURAL UNEMPLOYMENT
• Structural unemployment arises from lack of skills or a mismatch of skills with
available jobs.
 A perpetual source of unemployment, reflecting structural feature of labor markets,
industrial structure and labour legislations.
• Factors contributing to structural unemployment:
 Lack of skills, language barriers, or discrimination;
 Sectoral shifts in the economy, where new industries grow and old industries die
off. (e.g. textile industries being replaced by electronic industries);
 Structural features of labour markets that impede labour employment:
 Minimum wage laws;
Unemployment benefits and legislations that raise reservation wage of workers;
High firing cost which may be related to labour union activities;
Lethargic information system: slow dissemination of information about job
vacancies and manpower requirement to potential job seekers.
OKUN’S LAW:
Linking Potential Output(Y*) & Natural Rate of Unemployment(u*)
RECESSIONARY GAP
• Great Depression (1929 –1933)
 Available resources are unemployed
 Public’s willingness or ability to spend declines
• A decrease in spending leads to lower production
 Laid-off workers reduce their spending
 Insufficient spending to support the normal level of
production
• Conventional economic policy of the 1920s and 1930s
would not solve this problem
 Classical economists, price flexibility, shifting of AS
curves will restore full employment.
 Keynesian theory views that price is not flexible
enough, actions have to be taken to shift the AD curve
to get back to full employment.
RECESSION AND THE ADAS DIAGRAM

• Keynesian
economists will
consider shifting
B AD curve to AD1
to restore full
employment
P
output.
AD1

Y Y
*
HEY! PRICE MECHANISM IS NOT THAT PERFECT
KEYNESIAN MODEL
• Growing unemployment during the Great Depression: Demand-side problem.
• People were not able and willing to buy all the goods and services the economy was
capable of producing.
• Government Intervention is necessary: Fiscal policy (by the government) and
monetary policy (by the central bank), can help stabilise economic output, inflation,
and unemployment over the business cycle.
PLANNED AGGREGATE EXPENDITURE
• Planned aggregate expenditure (PAE) is total planned spending on final goods and
services.
• Four components of planned aggregate expenditure: C, IP, G and NX.
• The general equation for planned aggregate expenditures is
PLANNED INVESTMENT
• Actual spending equals planned spending for
 Consumption
 Government purchases of final goods and services
 Net exports
• Difference between actual and planned spending: accomplished with changes in
inventories
PLANNED INVESTMENT EXAMPLE
• Fly-by-Night Kite produces $5 million of kites per year
 Expected sales are $4.8 million and planned inventory increase is $0.2
million
 Capital expenditure of $1 million is planned
 Total planned investment is $1.2 million
• If actual sales are only $4.6 million
 Unplanned inventory investment of $0.2 million
 Actual investment is $1.4 million
• If actual sales are $5.0 million
 Unplanned inventory decrease of $0.2 million
 Actual investment is $1.0 million
CONSUMPTION FUNCTION
• The consumption function is an equation relating planned consumption (C) to its
determinants, notably disposable income (Y –T)
ˇ + ( 𝑚𝑝𝑐 ) (𝑌 −𝑇 )
𝐶 =𝐶
Where is autonomous consumption spending, mpc (i.e. 0<mpc<1) is the
change in consumption for a given change in disposable income and
• Autonomous consumption is spending not related to the level of
disposable income

• Autonomous consumption,𝐶 ˇ captures the wealth effect (W/P) and the

effects of interest rates on consumption. Higher rates increase the cost of
using credit to purchase, leading to lower autonomous consumption.

• A change in (intercept) shifts the consumption function

CONSUMPTION FUNCTION
GOVERNMENT EXPENDITURE – MULTIPLIER
EFFECT
Keynesian Income-expenditure multiplier for government purchase:

The larger the mpc, the larger the multiplier. For example, when mpc=0.9,
k=1/0.1=10
Similarly, we can derive the income-expenditure multiplier for taxation:

For example, when mpc =0.8, the tax multiplier =-0.8/0.2=-4

PLANNED AGGREGATE EXPENDITURE: AN
EXAMPLE
GRAPH OF PLANNED AGGREGATE
EXPENDITURE
SHORT-RUN EQUILIBRIUM: NUMERICAL EXAMPLE
• Short-run equilibrium is the level of output at which planned spending is equal to output. In
other words, during the SR period in which prices are preset, firms produce an amount that
is equal to PAE (i.e. Y = PAE )
• Using our previous example, PAE = 960 + 0.8 Y.
• In equilibrium, Y = PAE, hence
Y = 960 + 0.8 Y
0.2 Y = 960
Ye= $4,800
• Graphical illustration of the solution in the next slide…
SHORT-RUN EQUILIBRIUM GRAPH
OUTPUT GREATER THAN EQUILIBRIUM
Suppose output reaches 5,000
• Planned spending is less than total
output
• Unplanned inventory increases
• Businesses slow down production
• Output goes down to 4,800
OUTPUT LESS THAN EQUILIBRIUM
Suppose output is only 4,500
 Planned spending is more than total
output
 Unplanned inventory decreases
 Businesses speed up production
 Output goes up to 4,800

Y=4,800 is a stable equilibrium:

any output deviation will
eventually come back to 4,800
SHORT-RUN EQUILIBRIUM GRAPH
•If equilibrium output is
below potential output (say,
Y*=5,000); there is a
recessionary gap.
•Note that the equilibrium
(below potential) is
stable…
•That explains why
unemployment can last for
a long period…
 STABILIZATION POLICY
• How to cover the recessionary gap?
• Stabilization policies are government policies that are used to affect planned
aggregate expenditure, with the objective of eliminating output gaps
• Expansionary policies increase planned expenditure
• Contractionary policies decrease planned expenditure
• Fiscal policy uses changes in government spending, transfers, or taxes
• Monetary policy uses changes in the money supply or interest rates
EXPANSIONARY FISCAL POLICY (G )&
RECESSIONARY GAP
• The potential output is 5,000.
• The current equilibrium is at E
with GDP = 4,800.
• There is a recessionary gap of 200.
• Govt may remove gap by
Expansionary fiscal policy:
• Increasing government purchase (G↑)
mpc = 0.8
EXPANSIONARY FISCAL POLICY(T )&
RECESSIONARY GAP
• Cutting Tax to increase
disposable income & boost economy
• Can also remove the gap by decreasing tax.
• mpc = 0.8
FISCAL POLICY IN THE AD-AS DIAGRAM
• Economy is initially in equilibrium at A
with a recessionary gap.
• Fiscal Policy is used to restore full
employment equilibrium Y*.
• Expansionary fiscal policy (G or Tax ) will shift AD
to the right.
• Note: Higher prices lead to higher interest rates which will have the effect of
crowding out private investments before potential output is realized.
• To get the appropriate magnitude of the fiscal instruments (G or Tax ) to attain Y*
is no trivial matter.
U.S. FISCAL POLICY DURING THE 2007 –2009
RECESSION
• Economic Stimulus Act of 2008
 $100 billion in tax cuts
 $60 billion government spending increase
• American Recovery and Reinvestment Act of 2009
 $200 billion in tax cuts
 $600 billion government spending increase
• Both were effective at raising consumption spending
• Real GDP higher than it would have been otherwise
JAPAN'S RECESSION AND EAST ASIA
• Japanese recession in 1990s reduced Japanese imports
• East Asian economies developed by promoting exports
 The decrease in exports to Japan decreased planned aggregate expenditure in these
countries (e.g. Thailand,…)
 Export Multiplier:
 The decrease in planned spending caused the East Asian economies to contract to a
new, lower level of planned spending and output
• Japan exported its recession to its neighbours
• U.S. recessions have similar effects on our major trading partners
SINGAPORE’S RECOVERY IN 2020 AND 2021
• Singapore’s economy grew by a modest 0.7% in 2019 . This is the weakest
growth since the 2008 Financial Crisis. Just as the global economy was
beginning to recover, the Coronavirus Disease 2019, or COVID-19, outbreak hit
us.

• $53.7 billion from its reserves to fund Covid support measures in 2020 and
2021.

https://www.cnbc.com/2021/02/16/singapore-announces-2021-government-
budget-to-support-covid-recovery.html
FISCAL POLICY CAN BE EFFECTIVE
• Automatic stabilizers increase government spending or decrease taxes when real
output declines
• Built into laws so no decision is required
• Unemployment compensation, proportional tax; progressive income tax; negative
income tax;
• Fiscal policy may be useful to address prolonged periods of recession (e.g. to embark
on structural reform)
• Monetary policy is more often used to stabilize the economy.
BUT
• Fiscal policy is usually slower in implementation relative to monetary policy as
parliamentary debate and legislative approval that takes time is required.
• Persistent government budget deficits can be harmful.
• Unless the government spending is productive (e.g. infrastructure)
SUMMARY
APPENDIX: THE MULTIPLIER (PROOF IS
OPTIONAL)
Recall the short run equilibrium condition:
SUPPLY-SIDE EFFECTS OF FISCAL POLICY
• Fiscal policy may shift AS curve; impact more pronounced than shifting AD curve. A
reduction in corporate tax and removal of levy or import duties on imported inputs
may shift the short run AS curve down and stimulate output expansion. {Refer to
discussion on Shifting of AS curve in Lecture Notes 01}
• Fiscal policy may also affect potential output (LRAS)
 Investment in infrastructure increases Y*
 Taxes and transfers affect incentives and can change potential output, Y*
• Current thinking is more moderate
 Demand-side effects of spending matter
 Supply-side effects also matter
• Supply side fiscal policies in Singapore : rental rebate; tax rebates to business; R&D
grants; labour cost reduction (CPF cut); PIC; . . .