CHAPTER-19-MACROECONOMIC-POLICIES.pdf

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



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.

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: Loanable funds can be defined as funds available for loan in the form of bank loans

or funds available for loan in general. By the first definition, the supply of loanable

funds will fall when the government issues securities to finance a deficit. By the

second definition, the demand for loanable funds will rise. In either case, interest

rates will rise. I use the first definition.

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.



Due to the small multiplier in Singapore and the small government expenditure relative to

the exports, 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, 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 increase in consumption expenditure, investment

expenditure and net exports will lead to an increase in aggregate demand.



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

decrease 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.



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.



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 interest elasticity of

consumption and investment (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

the interest rates. 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. 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.



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 Singapores diverse trade links, the MAS manages the exchange rate of the Singapore dollar against a trade-weighted basket of currencies of Singapores 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 Singapores major trading partners and competitors. The various currencies are given different weights

depending on the extent of Singapores trade dependence with that particular economy. The composition of the basket is revised periodically to take into account changes in

Singapores 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.



When its external economic environment is strong, Singapore will experience high

inflation in the absence of central bank intervention. When Singapores 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 Singapores 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

Singapores 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 Singapores 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. 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, 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. 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 make it ineffective. Second, 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.

As a small and open economy, Singapore is an interest rate-taker in the sense that it cannot

change the money supply to influence interest rates. For instance, if the MAS increases the

money supply to lower interest rates, the hot money inflows will decrease and the 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 money supply will fall back and

hence the interest rates will rise back to the initial levels. Interest rates in Singapore are

largely determined by foreign interest rates, particularly 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 the hot money inflows and an increase

in the hot money outflows, 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. 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.

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 the low interest elasticity of consumption and investment. 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.

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.



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 infrastructure (Interventionist policy)

An increase in government expenditure on infrastructure will increase investment

expenditure and hence the size of the capital stock.

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.

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 will reduce wages and

hence the cost of production in the economy. Unlike other supply-side policies, trade union

reforms do not increase the production capacity in the economy.

A major limitation of supply-side policies is the long period of time it takes for the effects

to be realised. Therefore, supply-side policies are not used in Singapore in a recession.

Nevertheless, in a recession, the Singapore government uses short-term supply-side

measures such as reducing the employers CPF contribution and helping 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

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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