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H2 ECONOMICS
MACROECONOMICS

Topics covered:
1
...
Fiscal policy

2
...
Monetary policy

3
...
Supply-side policy

4
...
Balance of payment

5
...
Exchange rate

6
...
International trade

7
...
Actual – Annual percentage increase in national output (Outward shift of point in PPC)
2
...
Cyclical – recession / economic downturn
2
...
Frictional – lack of perfect information concerning job availability
Unemployment rate =

Number of unemployed
Size of labour force

x 100%

INFLATION
Definition: Sustained increase in general price levels of a given basket of goods over period of time
Types of inflation:
1
...
Cost push – inflation due to increased cost of imports / wages / cost of production
Inflation rate =

CPI for Year 1 – CPI for Year 2
CPI for Year 1
~ END ~

!

x 100%

Chapter 2: NI Accounting and SOL
Definition: Value of nation’s output / goods and services produced by an economy over a given
period of time
• Note: Also known as National product OR National output
• Note: Indicators are GDP and GNP
Gross Domestic and National Product:
GDP
Market value of all final goods and services newly produced within the geographical boundaries of
an economy in a given period of time (~ 1 year)
GNP
Market value of all final goods and services newly produced anywhere in the world from resources
belonging to residents of a country in a given period of time (~ 1 year)
Conversion
GNP = GDP – NFIA
Note: Net Factor Income From Abroad = Factor Income From Abroad – Factor Income Paid
Abroad
Value of national income:
Y=PxQ
P: General Price Level;

Q: Quantity of physical output

1
...
Nominal GDP/GNP – Measured at current / prevailing market prices
Real GDP/GNP =

Nominal GDP/GNP x 100%
GDP Deflator

Note: CPI is used as an alternative measure if GDP deflator is not available
Growth in Real NI ≈ Growth in Nominal NI – Inflation Rate
Basic indicator of SOL is real national income per capita
• Reflects changes in economic welfare of average citizen
• Takes into account changes in population
Real GDP/GNP per capita =

!

Real GDP/GNP
Population

Difficulties in measuring NI:
1
...

•
•
3
...
Indicate overall Standard of Living
• Level of well-being / welfare enjoyed by an average person or resident
• Material
o Quantity and quality of goods and services for consumption
o Real GDP per capital to measure
• Non material
2
...
Households
• Consumers AND Resource owners – sell factor services to firms (land, labour, capital and
entrepreneurship)
2
...
Business investment expenditure
• Working capital
o Inventories – refers to stocks or unsold finished goods / semi-finished goods
o Fluctuations help track changes in state of economy
• Fixed Capital (plant and equipment)
2
...
Foreign Direct Investments (FDI)
• Foreign firms’ fixed capital when they build plants in another economy

!

Basis of Investment decisions:
Profitability: Incentive to invest if it is profitable
• Expected returns (MEI)
• Cost of funds (Interest rates ! r)
Marginal Efficiency of Investment (MEI)
Measures the expected profitability or rate of returns from an additional unit of invest on capital
goods
MEI =

Returns gotten
Investment

x 100%

Interest rates (r)
Refers to cost of borrowing and represents opportunity costs of using the funds for investment
Equilibrium / Optimal level of Investment:
Interest Rate / MEI (%)

r < MEI = 25%
r = 20%

r = MEI = 20%
r > MEI = 15%
Planned Investment

MEI < r
Investments fall from I2 to I1, where MEI = r

MEI > r
Investments raise from I3 to I1, where MEI = r

GOVERNMENT EXPENDITURE
Categories:
• Recurrent expenditure – salaries of civil servants and operating costs of running various
government services like healthcare and education
• Social capital or infrastructure expenditure – new roads, MRT, airports
Note: Government expenditure is autonomous (affected by various economic goals)
NET EXPORTS
Categories:
• Autonomous – export revenue (since amount country exports depends on spending decisions of
foreign countries)
• Induced – import revenue (depends on decisions of local consumers)
EQUILIBRIUM OF NATIONAL INCOME
!

Equilibrium in 4-sector economy:
NI is in equilibrium when planned aggregate expenditure = planned output
Y = AE

/

Y = C + I + G + (X – M)

Disequilibrium:
1
...

•
•
•
•

Planned output > Planned expenditure
Leads to unplanned increase in stocks or inventories
Thus firms decrease their output and hire less workers and factors of production
Results in an decrease of output, income and employment
NI will decrease until equilibrium position where planned AE equals planned output

Types of NI Equilibrium:
Full employment equilibrium
Economy operating at full capacity with full employment and no inflation
Y = AE
AEFE

YFE corresponds to points on
PPC
Also called full employment
output
45o

!

Deflationary Gap (Ye below full employment)
Y = AE
AEFE
AE1

DG

45o

Output gap

Output gap: Demand deficient in the economy has led to output gap, resulting in demand deficient
unemployment
Deflationary gap: indicates a shortfall of aggregate expenditure below that of national income at the
full-employment level
Inflationary Gap (Ye above full employment)
Y = AE
AE1
AEFE

IG

45o

Infationary gap: Excessive demand pulls up prices which will result in demand-pull inflation
Policies to resolve disequilibrium:
1
...
When IG appears - Decrease expenditure, Contractionary policy

!

FACTORS CAUSING PARALLEL SHIFT OF AE FUNCTION
Factors affecting Autonomous Consumption:
1
...
Wealth
Wealth includes real assets like houses, jewelry and financial assets like stocks and shares
• Wealth effect
• When a person’s wealth increases (value of stock increases), makes him feel rich
• Spends more
3
...
Interest rates (movement along MEI)
Interest Rate / MEI (%)

r = 25%
r = 20%
r = 15%
Planned Investment
Relationship: Fall in interest rates causes investment to increase

!

2
...
Marginal Propensity to Consume (MPC)
Recall the consumption function:
C = a + bY
Using this formula, where b = MPC, the greater the size of b, the steeper the slope
2
...
6
Stage 1 – Injection of autonomous expenditure
The multiplier process starts by injection of autonomous spending into the circular flow of
income
...
6bn

...


...


...

Total
10bn
25bn
Note: ΔY = k x ΔJ = (1/MPW) x ΔJ

Δ Induced C
6bn
3
...
16bn

...


...
4bn
1
...


...

10bn

Stage 2 – Stimulates a steam of income induced consumption
First group of individuals who received the $10 billion spends 60 cents per dollar (MPC = 0
...
6 of every
extra dollar of income on consumption, the multiplier effect will continue

!

Stage 3 – End of Multiplier effect
Ends when ΔJ = ΔW, since no more additional incomes are created to be passed on within the
circular flow
Stage 4 – Summing up Multiplier effect
Final effect of national income calculated by adding intial increase in injection with successive
rounds of induced spending where: ΔY = k x ΔJ
Illustration of multiplier on a graph:
Y = AE
AEFE
AE1

ΔG

ΔY

ΔY > ΔG due
to the
multiplier
effect!

45o

Succinct explanation of multiplier effect:
Given an autonomous increase in investment (or government expenditure), it will generate income
for households employed by firms in the capital goods industry
...
This further creates income for households employed in the consumer goods
industry who will further spend their additional income on consumption
...
The
eventual increase in national income is several times the initial increase in AE
...

Size of multiplier:
Formula
! =!

!
!
!!!!!!!!!!!!!!!!!!!!!!"!!!!!!!!!!!!!!!!!!!!!! = !
! − !"#
!"#

Hence, the greater the MPC or the smaller the MPW, the larger the k

!

Factors affecting size of multiplier:
The multiplier is made up of the components of MPW that are:
• MPS, MPT, MPM
• Thus any change in the above components will lead to a change in the size of the multiplier
1
...
Marginal Propensity to Tax (MPT)
(A) Progressiveness of the tax system
• Implies that as income rises, much more tax will have to be paid out
• Examples: GST
(B) Extent of government benefits and transfer payments
• Welfare states have high MPT
• Large amount of tax needed to finance welfare benefits
3
...
Size of multiplier
• If multipliers are large, most of increase in Nominal NI is real output, fiscal policy will be
effective
2
...
State of economy
• Must be presence of unused resources or excess capacity
• Else might result in inflationary pressures
~ END ~

!

Chapter 4: AD-AS Analysis
AGGEGATE DEMAND
Definition: Total level of expenditure on domestically produced goods and serves by households,
firms, government and foreigners at each general price level for a given period of time
AD = C + I + G + (X – M)
Movement along AD curve: Change in general price levels
Factors that shift AD curve:
Any change in non-price determinants will shift the AD curve:
• Consumption, Investment, Government expenditure, Net Export Revenue
• Policy options also shift the AD
Non-price determinants of AD

Component

Fiscal Policy
Government influences AD through spending and tax policies
• Expansionary policy
o Aim to increase AD by budgeting for a deficit (G > T)
o Reducing direct taxes
" Income – Increase disposable income
" Corporate – Increase expected rate of return on investment
• Contractionary policy
o Reduce AD by budgeting for a surplus (G < T)
Monetary Policy / Credit Conditions
Consumption can be financed by both income and by borrowing or incurring
debt
• Credit value
o Making credit cheaper or more easily available
o Increasing money supply (printing more money)
• Interest rates
o Lower interest rates ! lower cost of borrowing
" Households – purchase more consumer goods
" Firms – purchase more capital goods
• Exchange rates
o Causes a shift in quantity demanded for exports and imports
Trade Policy
Achieved through trade agreements
• Free Trade Agreements
o Reduces tariffs (tax on imports)
o Ease and facilitate investments
• Trade Barriers
!

C, I, G

C, I, X – M

I, X, M

AGGREGATE SUPPLY
Definition: Total output of foods and services that domestic firms would like to produce and seel at
each general price level for a given period of time
Shape of AS Curve:

Vertical range

Horizontal range
Intermediate
range
Segments of AS Curve:
Horizontal (Keynesian) Range
• Large amounts of unused or excess capacity
• Significant demand deficient unemployment
• Corresponds to point in PPC
Upward sloping (Intermediate) Range
• As NI increases, GPL increases
• As production levels are near full capacity, bottlenecks in resource supplies appear
• Increase in COP as firms use increasingly inefficient resources, thus GPL rises
• Corresponds to point close to PPC
Vertical (Classical) Range
• Economy has used up all available resources
• There is no excess capacity ! economy operating at full capacity
• Any increase in AD leads to demand-pull inflation
• Corresponds to point on PPC

!

Factors that shift the AS Curve:
Upward sloping Range

Vertical Range

Short run
Cost of production
• Change in input prices shifts upward
sloping range
o Wages, cost of resources
• Firms are now only willing to sell lower
quantities at same GPL
• Shifts leftwards if there is cost-push
inflation

Long run (productive capacity changes)
Change in quantity of resources
• Size of labour force
o Fertility rate / immigrants
• Land and natural resources
o Oil, minerals discovery
• Investment in private capital stock
o More plants, machines
• Investment in social capital

Supply shocks
• Temporary supply shocks causes
unanticipated shift
o Bumper harvests, natural
disasters

Change in productivity of resources
• Investment in human capital
o Education, skills training
upgrading
o Raises quality of workforce
o Also helps reduce costs
• Improvement in technology
• Entrepreneurship

Graph

Time
Factors

MACROECONOMIC EQUILIBRIUM
Equilibrium and state of economy:
E4

E3

E1
E2

!

E1: Under full-employment equilibrium (recession)
• Excess or unused idle capacity present
• Output is below full employment as AD is too weak
• Lay-offs and retrenchment occur
E2: Near full-employment equilibrium
• Spare capacity is limited
• Increase in AD outpaces the increase in real NI, causes inflationary pressures
• Thus the cost of production increases
• Start of demand-pull inflation
E3: Full-employment equilibrium
• No spare capacity
• Full employment is achieved
• Only frictional and structural unemployment present
E4: Over full-employment equilibrium (Inflation)
• Real NI cannot increase, competition amongst consumers
• Leads to increase in GPL without any increase in real NI
• Demand-pull inflation occurs
Shifts in AD and/or AS curve:
Involves a 5-step process when describing impact on AD and AS curve:
(1) Impact on AD
• How a component in AD changes causes it to shift left / right
(2) Impact on AS
• Short run AS: changes in COP ! shifting intermediate range
• Long run AS: changes in productivity ! shifting vertical range
(3) Impact on income, employment, output
• Fall in output leading to slow down in actual growth
• As NI falls, causes a fall in demand for factors of production
o Unemployment results
• Economy operates below YFE
• Income levels fall
(4) Impact on GPL
• Increases ! cost push inflation
(5) Evaluation
• Eventually the extent of shifts of AD and AS depends on
o Original state of the economy
o Size of multiplier
~ END ~

!

Chapter 5: Economic Growth
Definition: Expansion or increase in an economy’s level of output or GDP over time – usually
expressed as a percentage change in real output or GDP over time
MEASURING ECONOMIC GROWTH
There are two main types of economic growth, actual and potential
Actual – annual percentage increase in national output
Potential – annual percentage increase in the economy’s capacity
Economic growth is usually measured by rate of growth, where a common indicator is GDP – yet it
only measures actual growth
Illustrating economic growth:
Using the PPC

Using the AD-AS Curve
General Price Levels

Consumer goods

Capital
goods

Real NI

Actual growth is illustrated when one moves
from a point within the PPC to a point on it

Actual growth is illustrated when the AD shifts
to the right

Potential growth is illustrated when the PPC
moves outwards

Potential growth is illustrated when the LRAS
shifts to the right

CONSEQUENCES OF ECONOMIC GROWTH
Generally, most economies target non-inflationary economic growth
Benefits of economic growth:
1
...
Creates jobs, reduces unemployment and increase national income
• When the economy is growing, more output is produced and to increase production, more
factors of production are employed ! reducing cyclical unemployment
• Potential growth helps reduces structural unemployment (as they obtain new skills)
!

Costs of economic growth:
1
...
Structural unemployment (Macro problem)
• Rapid growth is accompanied by rapid innovation and technological changes
• Low skilled workers may not possess the required skills and knowledge and thus made
redundant
• Some are also replaced by technology and machines
3
...
Environmental pollution (Micro problem)
• Economic growth is often accompanied by industrialization which causes deterioration of the
environment by air and water pollution
5
...
Depletion of natural resources
• Economic growth brings about depletion of resources, which is generally non-renewable in
nature
NEGATIVE / SLOW ECONOMIC GROWTH
Causes:
Slow growth in any components of AD (C, I, G, X-M) will cause the AD to fall or increase slowly,
thus resulting in slow increase in real national output
Cures:
1
...
Expansionary monetary policy
3
...
Demand management policies – contractionary fiscal/monetary policy to reduce the AD
2
...
Cyclical – usually due to recession
2
...
Frictional – lack of perfect information
4
...
Unemployed do not report to the “Employment Registration Office”
2
...
Concept of employment / unemployment different in agricultural countries
• Where additional unit of labour does not contribute much to productivity
• Disguised unemployment – marginal product is rather small
4
...
Loss in Production and Income
• Results in reduction of purchasing power and standard of living
• Economy’s actual output < potential output
2
...
Loss in Social Stability
• Impact on non-material SOL: Linked to greater incidence of crime, violence, drug abuse etc
...
Loss in Human Capital
• Cause a person to lose touch of the skills and knowledge, lowering economy’s potential output
• Impact on non-material SOL: loss of self-esteem, stress, discouraged and demoralized
Benefits of low unemployment:
• More efficient use of human resources – leading to gain in actual output and material SOL
• Less drain on government revenues for unemployment benefits
• Allowing it to be used for other purposes to increase potential growth (education)
SECTION 1: CYCLICAL UNEMPLOYMENT
Related to business cycle / state of global economy
Causes of cyclical unemployment:
a recession, AD decreases ! firms are thus unable to sell at current output and resort to cutting
back on factors of production (workers)
• Referred to as demand-deficient unemployment OR Keynesian unemployment
In Singapore,
• Asian Financial Crisis in 1997/98
• Affected export trade with rest of the world, tourism and internal banking
• Affected export revenue (X) and investment (I)
o Singapore’s AD made up largely of the above two components
In USA,
• USA Subprime Crisis in 2008
• Crash of the property market resulted in damage of global economy

!

Cures for cyclical unemployment:
1
...
Expansionary Monetary Policy
How it works
Definition: deliberate attempt by Central bank to regulate money supply or manipulate the interest
rate or exchange rate to influence level of economic activity to achieve economic objectives (4
macroeconomic goals)
Method
• Open market operations: Government buys back bonds to increase liquidity (increase money
supply)
• Reduction in banks liquidity ratio: Encourage lending and approval of loans (increase money
supply)
Lowering interest rates
• Cost of borrowing for firms are reduced, increase expected rate of returns ! increase I
• Cost of borrowing for consumers reduced, increase in demand for consumer durables (cars) and
stimulates domestic consumption
• Results in short term capital outflows, increase supply of US$ in foreign exchange market
o Value of US$ lowered, exports encouraged & imports discouraged ! increase (X-M)
Explanation
• Increase in C, I and (X-M), causes AD to rise ! unplanned decrease in stocks
• Hires more factor of production (workers), reducing cyclical unemployment

Limitations
Responsiveness of C and I
• Depends on interest elasticity of C&I
• Changes in C&I are greatly influenced by consumers and investors expectations
o Interest elastic: Negative about future outlooks
o Interest inelastic: Positive about future outlooks
Willingness to give out loans
• Commercial banks that are saddled with bad debts are unwilling to give out loans to others
easily
Liquidity trap
• In the context of Japan, prevailing interest rates (near zero) are already the lowest possible rate
• Everyone expects interest rates to only increase
• Expansionary MP becomes ineffective to stimulate C&I

!

3
...
If PEDx>1, Qx will rise more than proportionately ! increases export revenue (X)
• Makes imports more expensive in terms of S$
2
...
Supply-side Policy
How it works
CPF System (slaughtering the sacred cow)
• Drives a wedge between (effective) wages and labour costs
• Reduce employer’s CPF contribution ! lowers labour cost without affecting disposable Y
• Allows to reduce COP and retain a large proportion of work force
Flexible Wage System (relies on tripartite relationship)
• Incorporated annual wage supplement (AWS) and monthly variable component (MVC) that
varied with the performance of the company
• Allowed firms to adjust labour costs by adjusting wages to avoid having to retrench workers
Limitations
Strong labour unions
• Present in some countries that will oppose wage adjustments, causing supply-side policies to be
hard to implement
Evaluation:
• CPF plan preferred over FWS as for FWS, if firms unilaterally cut wages, the good workers will
tend to leave, while the poor ones will stay
5
...
This stems from:
• Permanent fall in demand for product of particular industry
• Supply not forthcoming (due to depletion of natural resources)
• More capital is used to substitute for labour (automation) ! technological unemployment
Technological unemployment:
• From successful growth of new industries using labour saving technology
• Contrast with mechanization (people operating machines), now its automation (machines
operating independently)
E
...
Singapore’s shift to a knowledge-based industry and EU/USA losing out to low cost economies
Cures for structural unemployment:
1
...
Protectionism
Similar to that of Cyclical Unemployment
!

SECTION 3: FRICTIONAL UNEMPLOYMENT
Arises because of imperfect information in the labour market
Causes of frictional unemployment:
Workers take time to be matched with suitable jobs, largely because
• Workers leave declining industries for expanding ones
• Recurring stream of students graduate and start to look for new jobs
o Particularly serious in China
Cures for frictional unemployment:
Supply Side policies
How it works
Improving labour market information
• Websites to collate potential employees’ details and match them to needs of prospective
employers
• Job fairs which Community Development Councils (CDCs) organize to bring employers of
same industries together for mass recruitment exercise
• Countries with generous unemployment benefits, should cut down to raise opportunity cost of
being unemployed
Limitations
Attitude and mindset
• Depends largely on attitude, of job seekers, whether they are keen to be reemployed into the
workforce
• Job fairs might not help as workers have more choices of employers to choose from and vice
versa
• Lengthen period of job sourcing
Evaluation:
• Policy makers not overly concerned with frictional unemployment ! does not last long
• Might be good too as a better match between workers and jobs can be achieved, allowing
economy to be more efficient
SECTION 4: SEASONAL UNEMPLOYMENT
Varies with the season or weather
Causes of seasonal unemployment:
Predominantly happen in temperate countries
• Industries affected by seasonal trades: building, tourism and agriculture
Cures for seasonal unemployment:
Diversification of industries to reduce dependency on seasonal demand
~ END ~
!

Chapter 7: Inflation

Definition: Sustained increase in the general price level of a given basket of goods over a period of
time, usually a year
Consumer Price Index:
• General Price Levels – measured by means of index numbers with weights highlighting degree
of importance of items in a basket of goods
• Consumer Price Index – measures average level of prices of a basket of goods and services
consumed by a typical household using weights of each item
Rate of Inflation =

CPI for period (2) – CPI for period (1)
CPI for period (1)

x100

Types of inflation:
1
...
Creeping inflation – Persistent annual increase of 6% to 7% in GPL
3
...
Disinflation – price levels are still rising but at a decreasing rate (in contrast to deflation)
Inflation in Singapore:
Singapore’s annual inflation rate is around 2% till 2008, achieved by altering foreign exchange rate
...

•
•
•

Promotes business investment, employment and economic growth
Allows investors to make projections on costs and return of investments
If mild demand-pull inflation: Firms experience higher profits, encourage investments
Also encourages savings ! source of loanable funds

2
...
No “shoe-leather” and “menu costs” – wasteful / inefficient use of resources
• Shoe-leather: Inefficiency or waste from holding case whose value falls very fast
• Menu-costs: Constant need to update price lists, renegotiate contracts and wages
4
...
Distributive effects
• No undue hardship on fix income earners and those living on their savings
• Promotes sense of equity or social justice and fair play
Costs of HIGH Inflation:
1
...

•
•
•
•

Effects on Balance of Payments
Causes demand for its exports to fall, as partners switch to relatively cheaper alternatives
Increases demands for imports at home
Falling X and improving M worsens BOT and thus BOP
Might also result in capital flight as investors lose confidence in the local currency

3
...
variable income earners: Losers are those whose incomes are fixed in money terms,
as they suffer fall in real incomes if inflation is higher than increase in nominal wages
• Creditors vs
...
Firms: Consumers always lose, as real income (purchasing power) will fall, but
firms will gain if it is demand-pull inflation (higher profits) and lose if it is cost-push (higher
COP)

!

SECTION 1: DEMAND PULL INFLATION
Fundamentally happens when economy has AD above YFE
Causes of demand-pull inflation:
Can be attributed to two main views
• Keynesian view – caused by rise in AD with no or little increase in productive capacity of
the economy (supply bottleneck) due to excessive spending in economic boom
• Monetarist view – caused by excessive growth of money supply, causing people to spend
more and result in increase in AD
Note: In Singapore, demand-pull inflation largely comes from rising export demand
Cures for demand-pull inflation:
1
...
Contractionary Fiscal Policy
How it works
Reduction in government spending and/or increase in taxation
• Decrease in G directly reduces AD
• Increase in income tax decreases disposable incomes for consumers ! reduces consumption
• Increase in corporate tax rates reduces post-tax returns on investments, reducing level of
investment
Limitations
Relative inflexibility
• Hard for government to reduce spending, as they are tied down by long term contracts and
important social and political projects
Will not deter if economic outlook is positive (similar to monetary policy)
• Increasing direct taxes is also unfavorable as it has adverse long term supply-side effects on
incentive to work ! affects LRAS
3
...
Exchange rate policy
How it works
Appreciation of currency
• Adopts policy of gradual & modest appreciation, making imports relatively cheap in terms of S$
• Singapore has limited natural resources, heavily reliant on imports of necessities and raw
materials for consumption and production of exports
• Cheaper import prices lower COP and shift SRAS to right, lowering price levels
Limitations
Less price competitive
• Strong currency makes exports more expensive to others, thus less price competitive
• BOT worsens, leads to slower economic growth (assumes Marshall-Lerner condition holds)
• However this is partly mitigated by our high import content of goods
o Appreciation allows lower COP of exports, thus lowering export prices
Short term
• Does not solve root causes to high prices
• Should subsidize R&D for alternative energy sources to reduce dependency on oil and less
affected by rising oil prices
2
...
Find or develop cheaper alternatives
How it works
Cheaper alternatives
• Especially for small and open economies
• Need to source for cheaper alternatives or develop them through the use of R&D to reduce
dependency on imports
• Consider harnessing technology to develop high-yield crops or alternative energy sources
Limitations
R&D limitations
• Usually expensive and no guarantee of success
• Long gestation period
• Economy might incur opportunity costs as money could be spent on education, defense and
healthcare
• Also requires a mindset change to use alternatives
4
...
of workers
output per worker x total no
...
Incomes policy
How it works
Wage setting
• Direct or indirect intervention by government to freeze or reduce wages
• In Singapore: Works mainly on the tripartite relationship of government, trade unions and the
employers to determine appropriate wages
• National Wage Council also makes recommendations to ensure wage increases do not exceed
productivity gains ! maintaining unit labour cost in Singapore
Limitations
Interferes with allocative function of price system
• Effective wage controls prohibit the market system from making adjustments to ensure
allocative efficiency in the economy
• Thus firms cannot attract the labour they want through higher wages
• When demand for labour increases, there should be higher wages to attract higher quantity or
quality of labour, but this is prevented by wage controls
Evaluation:
• In Singapore, NWC only makes recommendations, thus not compulsory to follow
• With greater international mobility of Singaporeans, local talents are drawn to oversea
companies ! hence firms find it hard to follow NWCs recommendations
2
...
Price controls
Can adopt short-run policies that include price controls such as
• Marginal-cost pricing or Average-cost pricing
2
...
Price policy – price ceiling
2
...
Correct market failures related to negative externalities: discouraging consumption of
undesirable goods
2
...
Promote actual and potential growth: taxes raise revenue for government expenditure and giving
tax rebates/incentives is part of supply side policies to encourage investments
2
...
Direct tax – incidence of tax cannot be transferred to another party (Income tax, corporate tax
and property tax)
2
...

Effect on Distribution of Income
Direct tax: With tax being progressive, after-tax incomes will be more equally distributed
Indirect tax: Tax on commodities which the lower income groups spend on will be regressive (less
equitable) while that on higher income groups will be progressive (more equitable)
Effect on Incentive to Work
Income effect: People might work harder in an attempt to maintain their consumption of goods and
services since tax reduces incomes of people, thus it encourages people to work more
Substitution effect: An hour’s work buys less consumption than before while an extra hour in
leisure involves smaller sacrifice in consumption, thus it encourages people to work less
Hence if the substitution effect outweighs the income effect, it could cause people to work lesser
than before
Effect on Consumption
Direct taxes reduces disposable incomes and discourages consumption, however this depends on the
propensity to consumer and level of saving
High MPC: Causes a greater fall in consumption
Low Savings: Consumption will be reduced
Effect on Ability and Incentive to Save
A progressive income tax system will reduce a person’s ability to save
However if a person is saving for a particular reason, higher taxation might causes him to increase
his work rate
Effect on Ability and Incentive to Invest
Taxation may reduce the ability of individuals and firms to invest as taxation also discourages
investments when after-tax profits are reduced ! this hampers economic growth
Effect on Resource Allocation
If taxation affects consumer choice, the pattern of production will be altered accordingly
...
Provide for public goods and merit goods
2
...
Regulate economic activities and promote economic growth
4
...
Together with a progressive tax system, this will serve to reduce the extent of income
inequalities
Effect on Economic Growth
Expenditure on infrastructure, improvement and extension of transport improves productive
capacity and efficiency of a country
Thus this boosts output and employment and increases national income
Effect on Stability
It is used as a tool to influence the level of economic activity, such as increasing AD in times of
recession and lowering it in times of inflation
FISCAL POLICY
The aims of fiscal policy is to stimulate economy closer to full employment without inflation,
promote economic growth and maintain price stability
There are two main tools of fiscal policy: automatic stabilizers and discretionary fiscal policy
Automatic fiscal stabilizers:
They are built-in features of the economy that operate automatically where changes in aggregate
demand occur without any deliberate intervention by the government
They are thus known as counter-cyclical forces
• When times are good: contracts AD
• When times are bad: expands AD
They are beneficial as they avoid problems with time lags that include recognition lags and
legislative lags
!

Workings of automatic fiscal stabilizers:
Prevents Demand-Pull Inflation
• As NI increases, tax revenues automatically increase, especially under direct progressive tax
systems
• Hence people will face higher tax rates and reduce the effects of AD on national income
• Government expenditure on transfer payments such as unemployment benefits will also fall,
thus further dampening the AD
Lessens demand-deficient unemployment
• Fall in NI will trigger an automatic decrease in tax receipts while transfer payments will rise
during periods of recession
• This helps to maintain disposable incomes, partly countering downward multiplier effect
Limitations of automatic fiscal stabilizers:
The problem of fiscal drag arises, which is the tendency of automatic fiscal stabilizers to reduce the
recovery of an economy from recession
DISCRETIONARY FISCAL POLICY
Discretionary fiscal policy refers to the deliberate management of government spending and
taxation designed to influence the level of economic activity, inflation and economic growth of the
country
Balanced budget (G=T) Refers to a budget where estimated revenue just covers the estimated
expenditure
Deficit budget (G>T)
Refers to where estimated revenue falls short of estimated expenditure,
thus the government must finance its spending by other methods
(borrowing) and this is known as budget financing
Surplus budget (GRefers to a budget where estimated revenue exceeds estimated
expenditure
Note: Fiscal policy is primarily a form of demand management (AD) tool, which results in
conflicting goals of inflation and unemployment

!

Fiscal policy to solve slow/negative economic growth and cyclical unemployment:
(1) Stimulates AD as it is part of the components, resulting in unplanned decrease in stocks and
firms thus up production AND decrease T to increase disposable incomes and investments
(2) Briefly explain multiplier effect
(3) Draw Y-AE / AD-AS diagram and explain the diagram
(4) Limitations
(5) Conclusion
Limitations
1
...
Relative small size of government spending to other components of AD
• Fall in export revenue of 5% requires more than 20 times increase in G
• Makes fiscal policy less effective
3
...
Relative inflexibility to change government spending
• Difficult to reduce spending in times of inflation as they are tied to long term contracts which
cannot be easily switched
2
...
Income inelastic imports
• Fall in NI might not lead to a significant fall in import expenditure if demand for imports is
income inelastic
• Especially if large portion of imports comprise basic necessities such as clothes and food
2
...
In Singapore, exchange rate is the more
effective tool in maintaining price stability
DETERMINING EQUILIBRIUM INTEREST RATES
Nominal and real interest rate:
To a borrower, rate of interest is the payment which has to be made to obtain a loan – cost of
borrowing
...
Keynesian Liquidity Preference Theory
2
...
Poor Economic Outlook
• Ineffective when economic outlook is pessimistic as investors and consumers cannot be forced
to borrow if they do not wish to even if I/R is lowered
• Pessimistic business sentiments prevents firms from expanding (MEI falls, shifts leftwards)
• Fear of retrenchment reduces consumer confidence and causes withholding of spending
2
...
Commercial banks not lending
• Commercial banks are saddled with bad debts and scrutinize the borrowers and be unwilling to
give out loans easily
• For fear of defaulted loans
Conclusion
Business sentiments and consumer confidence will remain low in times of recession, thus lowering
interest rates might note help single I and C are interest-inelastic
• Monetary policy can at best solve cyclical unemployment but not structural unemployment
!

Using monetary policy (via I/R) to solve demand-pull inflation:
(1) Explain how increase in I/R serves to increase cost of borrowing, thus decreasing both
consumption (consumers) and investment (firms) [thus reducing AD]
(2) Draw AD-AS diagram and explain the diagram
(3) Limitations
(4) Conclusion
Limitations
Investment and consumption are both interest-inelastic – where consumers are willing to go into
debt to splurge, also known as “irrational exuberance”
• In periods of inflation, expected returns also alter upwards and cause the MEI to shift right
• Hence rise in I/R might not curb rising investments
Conclusion
Contractionary policies aim to bring down AD and might have conflicting goals with growth and
employment
• Might result in hard-landing
• Thus changes by Central Bank to increase I/R is usually meager
• A long term policy would be to increase productive capacity of economy to allow for noninflationary economic growth
Using monetary policy (via I/R) to solve BOT deficit:
(1) Explain as expenditure reducing method where a fall in AD causes fall in NI, thus fall in
purchasing power, lowering import expenditure
(2) Similarly, it reduces the GPL and thus lower prices of exports, thus increasing Qd for exports
(3) Draw AD-AS diagram and explain the diagram
(4) Limitations
(5) Conclusion
Limitations
1
...
Conflicting goals
• Expenditure reducing policy to reduce trade deficit is a double-edged sword
• It improves trade deficit but reduces country’s economic growth and an increase in demanddeficient unemployment
Conclusion
Expenditure reducing measures (contractionary fiscal policy) are particularly useful if root cause of
BOT deficit is due to excessive spending on imports due to high demand-pull inflation
• However government still needs to use long term measures to ensure competitiveness of
country’s exports in terms of price and quality
• Thus supply side policies and trade policies are more useful

!

Targeting money supply:
This is also known as quantitative easing, which is an unconventional monetary policy by central
banks to stimulate national economy when conventional monetary policy becomes ineffective
Central Bank buys financial assets of longer maturity from banks and other private sector
businesses to inject pre-determined quantity of money into the economy
• Increases excess reserves of banks and ability to create credit
• Thus this helps to increase money supply, allowing people to have more money than they are
required to hold ! spend on goods
Quantitative Easing has been known to reduce systematic risks and boost market confidence, which
contributes to increasing consumption
MONETARY POLICY (EXCHANGE RATE) – SINGAPORE
The primary objective of choosing exchange rate as the monetary instrument in Singapore is to
promote price stability as a sound basis for sustainable economic growth
Reason for exchange rate-centered policy:
Exchange rate has a strong effect on Singapore’s macroeconomic aims given her small and open
economy
• Singapore has to import the basics of our daily requirements & raw materials for production
• A small domestic market also means we have to export to pay for these
• Thus, Singapore’s total trade volume (X+M) makes up 3-4 times our GDP and trade becomes
the engine of growth to Singapore
Hence we need to main a stable exchange rate to keep our import-price-push inflation, to maintain
reasonable costs of living, keep costs of production low and instill confidence in the economy
During normal/good times:
Gradual and modest appreciation
(a) Helps to reduce imported inflation
• Singapore is a resource poor country and relies heavily on imported consumer goods
• Strong S$ will alleviate imported inflation as imports will be relatively cheaper in S$
• Keeps cost of living at bay
(b) Helps to lower cost of production for exports
• High import content of exports means strong S$ will lower COP in terms of imported raw
material
• This will help to mitigate any rise in export prices due to appreciation of S$
During bad times:
Maintain zero appreciation
• Prevents tarnishing of export competitiveness as exports are now more expensive in foreign
currency ! will wait and see before deciding to depreciate
Slight depreciation
• Pressure of high import prices (oil and food) will become less prominent, thus less need to
maintain strong currency
• Demand for exports also become more price elastic ! importers want cheap alternatives
• Based on ML, depreciation will improve the (X-M) and thus AD
!

Reasons why interest rate policy is not chosen:
Openness to Capital Flows
Due to the openness, it makes it very difficult to control money supply or interest rate
...
J-curve effect
• Depreciation will first worsen the BOT before eventually improving it
• Due to less responsiveness of both quantity of exports and imports to price change
• Time needed for people to adjust
2
...
Drive up cost of imported inputs
• Offsets advantage gained by exporters from the initial depreciation of S$
Conclusion
MAS stand is to slow-down gradual appreciation of S$ to mitigate effect on gradual appreciation
• Encourages exporters to improve product attractiveness by improving quality, productivity,
product innovation, marketing and branding
• Aim to make exports more price inelastic
~ END ~

!

Chapter 10: Supply-side Policies
Introduction:
Supply-side policies are mainly micro-economic policies designed to improve the supply-side
potential of an economy, make markets and industries operate more efficiency and thereby
contribute to a faster rate of growth of real national output
WORKINGS OF SUPPLY SIDE POLICIES
There are generally two main types of supply-side policies: short-run and long run
Short-Run Supply Side Policies:
They work primarily to reduce business costs, usually during situations such as recession or
inflation
...
CPF System
• Cutting CPF contribution is akin to slaughtering the sacred cow as CPF is meant to be a safety
net for people to finance housing/medical and savings for retirement
• It might causes lower income households to be unable to pay for their monthly housing loans
via CPF and end up having to use cash
2
...
Balance of Trade (X-M)
- Contains two components: goods account (tangible goods) as well as the services account
(invisible goods)
- Surplus occurs when X>M and deficit occurs when X2
...
Current transfers (unilateral transfers)
- Unilateral flows to and from abroad
- Include government contributions to and receipts from international organizations, and
transfer of money by private individuals (remittances of foreign workers)

!

Capital Account:
It records debt forgiveness (writing off a loan is a debit in our account), migrant transfers and
acquisition and disposal of non-financial assets such as patents and copyrights
For most countries it is recorded under the Financial Account
...
Direct Investment (Net)
- Involves purchase and sale of real assets such as manufacturing plants
- Involves investor acquiring a lasting interest and large degree of influence or control over
the management of an enterprise located in another economy
2
...
Other Investment (Net)
- Consists of primarily short-term financial investments or monetary flows
- It is also known as ‘hot money’
Net errors and omissions (balancing item):
It is a statistical adjustment to record the value of errors and omissions in calculations
The main reason for such errors is that the statistics are obtained from a number of sources, and
there are often delays before items are recorded and there might be omissions too
Overall balance:
If the overall balance is positive, there is BOP surplus – credit > debit, net currency inflow
If the overall balance is negative, there is BOP deficit – credit < debit, net currency outflow
Official Reserves Account (ORA):
It accommodates the surpluses or deficits in the overall balance
...
It could also lead to trade friction

!

Consequences of a Deterioration of BOP:
Deterioration in Current Account
Contractionary effect on the economy
• Assuming decrease in current account is due to decrease in (X-M), this will decrease the AD
• NI will decrease via the multiplier process
• Draw AD-AS diagram
However it is important to note that a worsening BOT is not necessarily bad as it depends on the
original state of the economy (cool inflation) and the impact on SOL (increase in material goods)
Deterioration in Financial Account
Outflow of FDI: less employment opportunities for domestic economy
• An outflow of FDI away from domestic economy towards lower labour cost countries
• Hence country will experience a decrease in the AD and even productive capacity
Outflow of hot money: increases funds for investment
• Leads to decrease in the supply of loanable funds, thus raising interest rates
• This discourages consumption and investment since the cost of borrowing is higher
Outflow of portfolio investment
• Government will have lesser funds to finance their spending
Consequences of an overall BOP deficit
Persistent BOP deficit will cause a country to draw down on its reserves as it needs to be financed
by government’s official reserve transactions
This reduces a country’s ability to intervene in the forex market and problematic for countries with
fixed exchange rate system as it reduces her ability to defend her currency
CAUSES OF DETERIORATION IN BOP
Worsening Current Account:
1
...
Increase in import expenditure
Affluence leading to high imports for consumption + Industrialization leading to higher imports for
machines and raw materials
• Higher growth rates and increasing consumerism leads to larger import expenditure on
consumer goods
• Emerging economies such as China and India have been enjoying high growth rates and thus
growing demand for imports
• These countries undergoing industrialization phase also have a huge appetite for imports
especially capital goods and raw materials to support production
• Assuming most imports are income elastic, the demand will increase more than proportionate
when income increases, thus worsening trade balance
Worsening Financial Account:
1
...
Changes in relative interest rates
• If interest rates fall relative to those in foreign countries, residents would be induced to deposit
their funds abroad to earn higher rate of interest
• This causes increase in outflow of hot money
• Foreigners are also discouraged to deposit their funds in the country, causing fall in inflow of
hot money

!

CURES FOR BOP DEFICIT
Expenditure Switching Measures:
These aim to help switch the locals from consuming imports to buying local goods and to switch
foreigners from buying local products to their exports
Depreciation: When market forces operate freely such that external value of currency decreases
Devaluation: When prevailing forex market conditions make it clear that pressure on exchange rate
is a long term matter and price is inappropriate, government can unilaterally declare lowering of
fixed exchange rate
1
...

• There might also be the J-Curve effect where the current account may worsen in the short run as
demand for exports and imports may not be price-sensitive and it takes time for consumers to
adjust their spending habits
• If major trading partners retaliate by devaluing their currency, the advantages of a cheaper
currency would be nullified
• The success of this policy also depends on the degree of import substitution – if CED is not
large, there is decreased likelihood of consumers purchasing domestically produced goods over
imported ones
• Might also lead to import-price push inflation
Note: Effectiveness of using exchange rate to attract foreign investors is limited as there are other
crucial considerations such as infrastructure, pool of labour with appropriate skills, corporate tax
rate and political stability

!

2
...
Hence the country can import as much steel as she wants at PW
• With free trade and at price Pw, consumers will demand 0Q2 of steep, where 0Q1 is supplied by
domestic producers and the rest is imported from other countries
• Free trade thus lowers domestic price of steel from PE to PW; consumers are better off as they
consumer more at lower prices
• However domestic producers sell fewer units at a lower price, causing them to lose profits and
result in unemployment
• The imposition of tariffs will raise the supply curve to (SW + tariff), price increases to P2
• At P2, domestic production increases from 0Q1 to 0Q3; domestic buyers buy less steel from 0Q2
to 0Q4
• Tariff caused fall in amounts of imports
• With higher local production, firms experience fall in inventories, higher more factors of
production, causing domestic unemployment to reduce

Negative implications
• Ultimate cost of protection borne by domestic consumers
• Referring to tariff diagram, as price is higher after tariff, consumers are worse off as consumer
surplus is reduced
• Loss in consumer surplus is areas A+B+C+D
• Producers gain in producer surplus A, government gain in tax revenue of C, but there is
deadweight loss of B+D
Limitations
• Harms trade position of major trading partners as their exports will fall, deemed as “beggar-thyneighbor” measure and might cause trading partners to retaliate as they set their own
protectionist measures – leading to fall in world wide trade
• Effectiveness of tariff depends on price elasticity of demand for imports, if it is price inelastic, it
will lead to less than proportionate fall in Qd for imports

!

Use of Quotas
• They are quantitative limits to imports
• A quota must limit imports to an amount that is less than what would otherwise be imported
under free trade
• In the case of quotas, foreigners may gain by raising their prices or importers may benefit when
they sell imported goods at higher prices
Limitation
• Similar to tariffs, trading partners may retaliate and country is not able to enjoy the benefits of
free trade
Hidden Export Subsidies and Import Restrictions
• Subsidy is an indirect form of protection to domestic producers to become more competitive
against more efficient foreign producers
• Subsidies allow home producers to market their goods at prices lower than actual COP
• With cheaper exports and assuming demand is price elastic, Qd will increase more than
proportionate, allowing export revenue to rise
• For exports – export credit guarantees (government-backed insurance against bad debts for
overseas sales), financial help and state assistance via Ministry of Trade
• For imports – complex import regulations and documentation & variety of technical and
administrative regulations imposed by government on imported goods (government health and
safety standards)
Limitation
• Subsidies cause a strain on the government budget and leads to opportunity cost of forgoing
spending on other development
• Money could be spent on healthcare and education
• Such subsidies might breed complacency and increase inefficiency
Voluntary Restraint Agreement (VRA) or Voluntary Exports Restraint (VER)
• VRAs are agreements to reduce volume of trade in a specific good
• Compared to a quota, the government asks foreign producers to voluntarily limit their exports
• Such as the VRA in 1981 by Japan when the USA automobile industry was threatened
• However since 1994, VRAs no longer existed as the WTO’s goal of eliminating trade barriers
Such agreements are negotiated rather than imposed, and they often include provisions for increase
in sales at some later date

!

Expenditure Reducing Measures:
Expenditure reducing measures are only useful if the root cause of the current account deficit is due
to excessive spending on imports or loss of export competitiveness due to high demand-pull
inflation in an overheated economy
Contractionary fiscal/monetary policy
•
•
•

•
•

Fiscal: Reducing government spending (G) or raising taxes (reduce disposable incomes)
Monetary: Increasing interest rates (reducing investment)
With the fall in national income, purchasing power falls and this reduces the level of import
expenditure and the ability to buy local products, leaving more for exports and thus improving
BOT position
It also reduces the GPL as AD falls, allowing price of domestically produced exports to fall,
raising quantity demanded for exports, thus improving export revenue
Consumers might also switch to local products instead, further reducing import expenditure

Limitations
• If demand for imports is income inelastic, it might not lead to a significant fall in import
expenditure, especially if a large portion of imports comprise basic necessities
• Double edged sword: While improving trade deficit, it reduces economic growth, and increases
demand deficient unemployment
Supply-side policies:
Supply-side policies are especially useful if the root cause of the current account deficit is due to
loss in comparative advantage
Strengthening comparative advantage
•
•
•
•

Encouraging further research and development (R&D), training of workers to increase
productivity and to help them fit into new expanding sectors
It also helps to reduce the unit cost of production and improve export competitiveness
It further results in the production of a wide range of high quality goods and thus help to further
improve export competitiveness and expand export market share
Productive workforce also attracts more inflow of FDIs of high capital intensive manufacturing
and high value added services and further improves the financial account

Limitations
• Take a long time to bear fruit and success is relatively less certain
• If it is done through retraining older workers, their reluctance to pick up training would reduce
the effectiveness of such supply side policies
Conclusion: Expenditure-switching and expenditure reducing policies are merely short-term
measures
...
Nominal exchange rate – exchange rate based on nominal value of currency, before making
adjustments to price changes
2
...
Nominal effective exchange rate – Measures value of currency against a ‘basket’ of currencies
of its major trading partners (based on relative importance of the country as a trading partner)
International trade and foreign exchange:
Foreign exchange is important as it facilitates international trade
...
5£

Market Equilibrium

Quantity of S$
10
!

Factors that change the equilibrium exchange rate:
Demand and supply of a currency are affected by changes in the (1) demands for exports and
imports and (2) the movement of speculative funds and remittances
Changes in relative income
• As the real income in UK rises faster than that in the Singapore, it causes UK’ demands for
Singapore’s goods and services to increase at each level of exchange rate
• Since demand for Singapore dollar is a derived demand for exports, a higher demand for exports
causes demand of the S$ to rise, resulting in a stronger S$ (appreciation)
APPRECIATION
Price
of S$
in £

DEPRECIATION
Price
of S$
in £

P2
P1

P1
P2
Quantity of
S$

Quantity of
S$

Changes in domestic prices relative to prices abroad
• A fall in the inflation of rate of Singapore relative to the UK will cause Singapore’s goods to be
relatively cheaper and UK goods to be relatively more expensive
• This will lead to a rise in demand for S$ as people buy S$ to purchase Singapore’s exports and a
fall in supply of S$ as people sell lesser S$ since they are buying less UK imports
• Results in appreciation of currency
APPRECIATION

DEPRECIATION

Price
of S$
in £

Price
of S$
in £

P2

P1

P1

P2
Quantity of
S$

Quantity of
S$

Changes in relative interest rates
• If interest rates in Singapore rise relative to those in foreign countries, Singapore residents
would be induced to deposit their funds locally to earn higher rate of interest
• This causes decrease in supply of domestic currency
• Foreigners are also encouraged to deposit their funds in Singapore, causing demand for S$ to
increase
• Hence the S$ will appreciate
!

Anticipation in Exchange Rate Movements
• When people expect or speculate that there will be a rise in the exchange rate of a country’s
currency in the near future, they will buy more of the currency before it actually rises
• The supply of the currency thus falls
• Also those who wish to buy the currency will quickly buy up the currency now, causing the
demand of the currency to rise
• Hence the S$ will appreciate
Other factors
• Exchange rate of a country can also be affected by changes in relative productivity among
counties, changes in taste and preferences for imports and exports and government intervention
Note: Problems might arise from the appreciation of a currency which include (1) worsening BOT,
increased unemployment, slow growth and also (2) discouraging FDI as it is more expensive to do
business
DETERMINING EXCHANGE RATE USING PURCHASING POWER PARITY THEORY
PPP Theory:
According to the PPP theory, the equilibrium rate of exchange between two currencies is
determined by the relative prices in the countries concerned (domestic purchasing power)
The PPP theory is based on the idea that if goods in one country are significantly cheaper in one
country, people will convert their money and buy the goods there, until equality is achieved
PPP explained:
Let the initial exchange rage between S$ and RM be S$1=RM1
• Assume both Singapore and Malaysia consumes apples only and in Singapore, S$1 can buy 3
apples but in Malaysia RM1 can buy 6 apples
• To obtain cheaper apples, Singaporeans sell S$1 for RM1 in the forex market
• This causes the S$ to depreciate due to increase in supply of S$, until the exchange rate become
S$0
...
This can help determine if a currency is under-valued or over-valued
Country
USA
China
Switzerland

Price of Big
Mac in local
currency
US$ 2
...
60
SFr 5
...
36
1
...
80

Implied
PPP of
the dollar
1
4
...
50

Actual US$
Local currency
exchange
under-valued (-) or
rate
over-valued (+) in %
--8
...
23
+103

Therefore we are able to conclude that Yuan is very under-valued while the Swiss dollar is very
over-valued
EXCHANGE RATE SYSTEMS
The determination of the exchange rate of a country’s currency depends on the system upon it
operates
...
Freely-Floating System
2
...
Managed Float System
Freely Floating Exchange Rate System:
It is a system in which the exchange rate of one country’s currency is determined freely by market
forces of demand and supply in the foreign exchange market
Appreciation/Depreciation
• When market forces operate freely such that the external value of a currency increases, the
currency is said to have appreciated in value
• Happens when demand for currency increases or when supply falls, or when demand increases
more than supply
• The converse occurs for depreciation
Fixed Exchange Rate System:
The government of the country fixes and guarantees the official price of its currency in terms of
other foreign currencies – hence the government is committed to maintain the currency by buying
or selling its currency in the forex market using its reserves
How the government intervenes to maintain pegged rate
When prevailing forex market conditions make it clear that pressure on exchange rate is a long-term
matter and price is inappropriate, government can unilaterally declare lowering of fixed exchange
rate (devaluation) or raising the fixed rate (revaluation)
Note: When government intentionally buys currency, it raises the demand for the currency
...
5£
A

Lower Limit
Quantity of S$
Referring to the above figure
• Initially the exchange rate was at point A
...
MAS also relies on
reducing business cost and improving labour productivity to manage our AD
During normal times, gradual and modest appreciation:
It helps to reduce imported inflation as well as lower the cost of production of our exports
...

However, too strong a currency might also deter them since they it increases their COP
...
Trade and
specialization are closely related, as the rationale for both is to specialize in producing goods and
services one is best suited to and use these to trade for other goods and services
COMPARATIVE ADVANTAGE
Definition: A country is said to have comparative advantage in the production of a good when she
can produce the good at a lower opportunity cost than another country
Law of comparative advantage: It states that trade can benefit all countries if they specialize in
the goods in which they have a comparative advantage in the production of the good
Assumptions:
The law of comparative advantage is based on the following assumptions
• Only 2 countries are involved in the production and exchange of 2 commodities
• Each country devotes half her resources among the production of the 2 goods
• There are constant opportunity costs of production
• There are no transport costs and restrictions to trade
• There is perfect factor mobility within each country and factor immobility between countries
• There are no emergence of political or strategic reasons for a country to produce at a higher
opportunity cost
Illustrations on the law of comparative advantage:
Production before specialization
Assuming that the levels of production of textiles and tablets are as follows for USA and Vietnam:
USA
Vietnam
Total world output

Tablets
40
5
45

Textile
10
10
20

Due to different factor endowments and by devoting half of their resources among production of
tablets and textile, USA produces 40 units of tablets, 10 units of textile while Vietnam produces 5
units of tablets and 10 units of textile

!

Area of comparative advantage
USA
Vietnam

1 unit of tablet
0
...
5C

For USA, to produce each unit of computer, she has to give up 0
...
But to produce
1 unit of textile, she has to give up 4 units of computer
...
The TOT
must lie within the limits of 0
...
5C, the more Vietnam
loses and the closer it is to 4C, the more USA loses
Assuming that the terms of trade is 1C for 1T, and they trade 10 units of computers, the
consumption levels will be as follows
USA
Vietnam
Total world output

Computer
80 - 10 = 70
0 + 10 = 10
80

Textile
0 + 10 = 10
20 - 10 = 10
20

Computer
70 - 40 = 30
10 - 5 = 5

Textile
10 - 10 = 0
10 - 10 = 0

Gains after trade
USA
Vietnam

Hence, by look at the above table, we realize that both countries are able to consume more than
before after complete specialization and trade
...


!

Sources of Comparative Advantage:
1
...
Differences in Technology
• Due to different intensities of R&D and speeds of absorption of new technologies
• Ability to keep ahead in technological race gives a country comparative advantage
3
...
Increasing opportunity costs
• Due to law of increasing opportunity costs, a country will lose her CA as she specializes further
in the production of a good
• This happens when an expansion of the industry drives up factor prices, or when industry
expands into less and less appropriate resources
• This explains why complete specialization is not possible in the real world
2
...
Protectionism
• In reality, there may often be trade barriers such as tariffs, quotas or restrictive rules and
regulations
• Hence a country might end up producing goods it does not have a CA in
4
...
Political and strategic reasons
• Countries may choose to be self-reliant in times of war and thus not dependent on insecure
sources
!

GAINS AND COST OF FREE TRADE
Benefits of Free Trade:
Higher Standard of Living
Gains in terms of higher consumption level
• Trade between two countries lead to higher level of welfare or living standards as they can
consume beyond a country’s production possibility
• Prior to specialization and trade, Singapore and China would be producing a point 1 on their
PPC – this point represents self-sufficiency
• However if countries specialize, Singapore in high-end manufacturing and China in low-end,
the would produce at point 2 on their PPC
• If they trade on mutually benefiting TOT, they can now consume more of both types of goods
which is point 3 on their consumption possibility curve (CPC)
• This is due to higher efficiency gains which are possible through specialization due to their
respective CA and better rate of exchange or favorable TOT
Low end

Low end
SINGAPORE

2

CHINA

CPC
PPC

1

CPC
3

PPC
2

3

1
High end

High end

Wider consumer choice and variety
• Consumers all over the world are also able to enjoy a greater variety of goods and services to
suit with every taste
Trade as an engine of growth (Cost and Revenue Advantages)
Increase in demands for exports
• In a growing world economy, demand for country’s exports is likely to grow, especially when
they have high YED, hence allows for growth for exporting country
Lower price of exports + PED>1 ! Increase in X
• More exports imply a larger scale of production and thus internal economies of scale
• The cost savings help to lower prices of goods and services
• It also allows importers to source for cheaper alternatives due to improved information,
allowing COP to fall and fall in prices
• Free trade also signals more competition and produces reduce prices to stay profitable and
discover more innovative methods of production
Thus, increase in X leads to increase in AD and thus NI via the multiplier effect

!

Innovation and Transfer of technology + increase in FDI
•
•
•
•
•

Fierce competition stimulates entrepreneurial efforts to lower costs, improve quality of outputs
and create new products
It also increases possibilities of firms from developed countries to relocate/offshore their
factories to low-cost economies
Results in inflow of FDI into these developing countries
Also leads to technology transfers from advanced nations to developing countries and leads to
faster economic growth
Leads to improvement in LRAS (Draw AD-AS diagram)

Improvement in BOP
•
•
•

Free trade helps to improve the BOP as increase in trade of goods and services improves the
current account of BOP
When relocation/offshoring occurs, there is also an inflow of long-term capital, improving their
financial account
When profits are remitted back to the developed countries, not only property income from
abroad increases and improves the GNP, the current account also improves

Increase competition and prevention of monopolies
•
•
•

By bringing more producers into the market, international trade increases competition and
promotes economic efficiency
Attempts by domestic producers to amalgamate to form monopolies to exploit consumers may
be checked by imports of cheaper products
Hence it keeps prices relatively low for the consumers

Factor price equalization
This explains how international trade would bring prices of factors of inputs closely together
• Using the example of Canada (land is plentiful) & Indonesia (labour is plentiful, low wage)
• With international trade, Canada exploits its cheap land by specializing and exporting grain to
Indonesia
• Indonesia utilizes labour to produce labor-intensive goods like textiles or furniture for the
Canadian market
• This exchange pushes up wages in Indonesia so it moves wages closer to that of Canada

!

Costs of Free Trade:
Unfair Competition and Dumping
Dumping: refers to the selling of the same good to a foreign country at a lower price than that
charged to the domestic buyers and below the marginal cost of production
•
•
•
•

The objective is to drive out rival producers in the importing country and thus monopolize the
market
Developed economies have often been perceived as victims of unfair trade practices like
dumping
It usually involves the use of state subsidies to sell their exports at artificially low prices,
resulting in depressed wages and job losses
Another example is currency manipulation where a country intentionally under-values its
currency to give their exporters an unfair advantage

Over-reliance on Foreign Countries
Susceptible to externally-induced cyclical unemployment
• Countries that are open to free trade and rely on it mainly for economic growth will be more
prone to other countries’ economic crisis
• Such as trade, financial or mechanical spillovers (e
...
USA subprime mortgage crisis affecting
trading partners Singapore and Vietnam)
• This is sometimes called the coupling effect
• To avoid the above from happening, countries can diversify products and trading partners as
well as increase domestic consumption to reduce dependency on exports
Susceptible to imported inflation
• Rising costs of imports is also a threat to the economic stability of the country
• Rising costs of imports such as energy (oil) and food create inflationary pressures and add
pressure to the cost of living for many individuals
• They can also translate to demands for higher wages
• At the same time rising costs of imported inputs is a threat to export competitiveness if there is
high import content
Structural Unemployment
•

•
•

!

The mismatch of skills and job requirements can arise from free trade as there are changes in
technology or international competition changing the skills needed to perform the jobs or the
location of the jobs
People made redundant in one sector of the economy cannot immediately find jobs elsewhere as
they do not have the skills
When firms from developed countries relocate their plants to low-cost developing countries, the
locals who are occupationally and geographically immobile will thus experience structural
unemployment

Worsening BOP
Developing Countries
• Countries exporting high tech capital goods and are more income elastic will experience an
increase of demand for their goods more than proportionately when global income increases
• Other less developing countries who export primary products which are income inelastic, will
increase less than proportionately with income
• Hence BOT of a developing country is likely to be worsened
• However, as more MNCs relocate their factories into these developing countries, they will
ultimately experience a rise in exports volume and inflow of FDI, improving their current and
financial account
Developed Countries
• Free trade increases the possibility of firms from developed countries to relocate/offshore their
manufacturing base to low-cost economies (India and China)
• Results in outflow of domestic investment from developed countries to developing countries,
worsening their financial account and thus BOP
• However in the long run, profits will be repatriated back via the current account
Widening Income Disparities
•
•
•

Free trade leading to rapid growth can cause widening income disparities, worsening income
gap between the rich and poor
Rapid growth provides opportunities for incomes of able, talented and entrepreneurial
individuals to surge ahead compared to workers with low skill and education
This could result in social tension and social conflicts

Note: The government can choose to tax the rich and provide subsidies for the poor
...

It also usually includes betters terms for investment in foreign countries (leads to increase in FDI)
It is commonly known to be a form of preferential trading agreement to give special preference or
trade concessions to member states
Singapore’s FTA:
Singapore is a highly trade-dependent economy (small and open) with the highest trade to GDP
ratio in the world
It must rely imports as her only source of food, energy and industrial raw materials and also rely on
overseas exports markets to absorb her outputs
• Singapore is thus a supporter of the WTO that provides stable framework for free trade
• Singapore also undertakes trade efforts in the region such as APEC, ASEM and ASEAN, and
bilateral FTAs
• FTAs thus enhances trade and investment flows by providing lower tariffs for exports of goods,
hassle-free custom procedures, improved market access for various commercial and
professional services, easier entry for businessmen and better terms of investment
• They help set a framework for business in a small country like Singapore to grow and expand
globally – allowing more employment opportunities
(B) Customs Union: Formed when member countries agree to remove all trade barriers amongst
themselves, and also adopt common external tariff for non-member countries
(C) Common Market: Over and above trade liberalization under a custom union, a common
market would also have lifted restrictions on trade in services, all capital and labour movements
They might also have common system of laws and regulations governing production, employment
and trade – such as the European Community
(D) Monetary Union: A group of countries that share a common currency and agree on a common
monetary policy – such as the European Union
(E) Fiscal Union: One that taxes a country to provide for expenditure in another country (helping
poorer states) – such as the United States of America

!

BENEFITS AND COSTS OF FTAS
Benefits of FTA:
Trade Creation
It occurs when consumption shifts from a high cost producer to a low cost producer
FTA results in welfare gain from trade when a country is able to import from the cheapest/most
efficient source; this efficient allocation of resources results in welfare gain (allocative efficiency)
• Assuming Vietnam is the most efficient producer of textile
• After signing FTAs, there will be lowering or removal of tariffs, thus it is now possible for USA
to import textile from Vietnam without the tariff
• This leads to efficiency gain to USA consumers and increased export revenue for Vietnam

Referring to the above figure,
• After an FTA is signed and the tariff is removed, price falls from P1 to P2, Qd increases to Q4,
local production drops to Q3 and imports from Vietnam increase to Q3Q4
• The American consumers are better off as they are able to consume more textile at a lower price
thus increasing consumer surplus by area A+B+C+D
• However there is also a reduction in the producer surplus for USA textile producers of area A
and loss in government tariff revenues of area C
• Hence there is a net gain of area B+D when trade creation occurs
Extended market and greater output levels – both actual and potential growth
FTA increases BOT and thus increasing NI via increase in AD, leading to more employment and
higher SOL
FTA also increases FDI, and thus increasing NI via rise in AD and LRAS
• Under free trade, inflow of FDI is a secondary impact, however it is a direct impact in FTA due
to relaxing rules for foreigners to invest
OTHER BENEFITS SAME AS FREE TRADE

!

Costs of FTA:
Trade Diversion
It occurs when consumption shifts from a lower cost producer outside the trading bloc to a higher
cost one within it
FTA results in welfare loss from trade when a country ends up importing from an inefficient source
• The distortion of resource allocation results in welfare loss
• Assume that most efficient producer of rice in the world is Thailand
...
For Singapore, there are typically two distinct patterns of trade, inter- and intraindustry trade
...
25 unit of R
1 unit of R

To produce 1 unit of M, Thailand gives up 1 unit of R while Singapore gives up 0
...
In international trade, the sellers are the exporting country and
the buyers are the importing ones

!

SECTION 2: GLOBALISATION
Definition: Refers to the integration or inter-connectedness of national economies through trade of
goods and services, foreign direct investment, capital flows, spread of technology and labor
migration
Hence, globalization is about the free movement of GOODS + RESOURCES and PEOPLE across
national boundaries
FEATURES OF GLOBALISATION
Economic integration refers to the inter-connectedness amongst different countries that goes beyond
trade and includes openness to international movement of both capital and labour
Openness to trade:
External trade – engine of growth
• Trade has become a major “engine of growth” for many economies that have embraced
globalization
• One sign of this greater dependence on trade is the rising trend of trade to GDP ratio
Trade liberalization
• Proliferation of different forms of FTA amongst different countries such as WTO, EU, NAFTA,
AFTA and FTAs
• It is a clear indication of trend towards greater trade liberalization in a globalized world
Outsourcing
• Foreign outsourcing refers to use of business-related services provided by foreign firms to
domestic firms such as Indian call centres
• This phenomenon represents the import of cheaper business services from abroad to cut down
business cost
• This is very popular due to increasing pressures and opportunity to cut costs in a globalized
world
Openness to international movement of capital:
Offshoring
• Today, China is said to be the ‘factory of the world’ for cheap low-end manufactured products
• Many international MNCs like American and Japan have relocated or off-shored their
manufacturing plants to China and other low-cost production centres
• Take advantage of availability of cheap labour
International supply chain
• Free movement of capital or business across countries has created an international supply chain
• Products are assembled in many different countries (such as iPhone)
• This is a form of international vertical specialization capitalizing different CAs around the
world

!

Financial flows
• Emergence of world-wide financial markets to provide funds for investment
• The openness of capital markets also allows investors and savers from all over the world to
transfer funds from one country to other to take advantage of differences in interest rates
• This has often resulted in short term inflow and outflow of ‘hot money’ and currency
fluctuations
Migration and international movement of labour:
There are two main categories of imported labour
• Those that choose to take up permanent residency are called immigrants
• Those who are transient workers on temporary work permits or employment pass
Many cities like Singapore have cosmopolitan population where the proportion of foreigners to
locals in the workforce is quite significant
CAUSES OF TREND TOWARDS GLOBALISATION
The trend towards globalization can be traced to the following economic, technological and political
factors
• Economic – Trade liberalization or promotion of free trade based on CA
• Technological – advancement in transportation and communication
• Political – collapse of former socialist or centrally planned economies
Economic factor:
According to Ricardo’s Law of Comparative Advantage, international specialization and trade
benefit both consumers and the economy as it leads to more efficient allocation of resources
A country is said to have CA in the production of a good when she can produce the good at a lower
opportunity cost than another country
Option A – Similar to inter-trade POT
• Assuming country A has to sacrifice 3 units of textile to produce an additional unit of computer
but B has to sacrifice 6 units
• Hence the opportunity cost of producing 1 computer is lower in country A, thus it has a CA in
the production of computers
• Law of CA states that trade can benefit all countries if they specialize in the goods which they
have a CA in
• With open trade countries need not be self-sufficient and can afford to specialize in exporting
goods they have a CA in and import or exchange goods they do not have a CA in
• Ability to produce at a lower opportunity cost is due to efficiency gains from devoting resources
to produce what they are best suited for
• For example, given differences in resource endowments countries like Singapore stand to gain
by specializing in high value add manufactures while countries like China stand to gain from
specializing in cheap low-end manufactures
• Trade between 2 countries result in higher level of welfare or living standards because they can
consume beyond their CPC

!

Option B – Consumption out of PPC
• Trade between two countries lead to higher level of welfare or living standards as they can
consume beyond a country’s production possibility
• Prior to specialization and trade, Singapore and China would be producing a point 1 on their
PPC – this point represents self-sufficiency
• However if countries specialize, Singapore in high-end manufacturing and China in low-end,
the would produce at point 2 on their PPC
• If they trade on mutually benefiting TOT, they can now consume more of both types of goods
which is point 3 on their consumption possibility curve (CPC)
• This is due to higher efficiency gains which are possible through specialization due to their
respective CA and better rate of exchange or favorable TOT
Low end

Low end
SINGAPORE

2

CHINA

CPC
PPC

1

CPC
3

PPC
2

3

1
High end

High end

Technological factor:
A major limitation to free trade is high/prohibitive transaction/transportation costs
Geographical distances and poor communication are potential hindrances or limitations to free trade
• In international trade, countries have to factor in transaction costs such as freight costs for
shipping or airlifting goods from one country to another
• According to the Law of CA, too high or prohibitive transportation costs can wipe out gains
from trade arising from difference in CA
• If difference in opportunity cost was $100, but transportation costs alone is higher than that,
then potential gains from trade are wiped out by too high/prohibitive transaction costs
• Hence technological advancements have facilitated trade by reducing transportation or
transaction costs
• Communication is now cheaper and more efficient such as the growth of e-commerce via the
internet
• It enhanced the flow of information and facilitated cross border business transactions
• It is a very cost efficient way for countries to reach out to a huge global market using on-line
marketing tools like the internet (Amazon to sell books)
• Transportation of goods, resources and people is cheaper and more efficient
• This has enhanced global trade and investment as well as tourism (use of giant container ships
to transport bulky goods)

!

BENEFITS AND COSTS OF GLOBALISATION
Benefits of Globalization:
Exports as an engine of actual growth
• Boosts AD: Provide access to foreign markets (enlarged/bigger markets), allowing aggregate
level of spending to increase
• Similarly, domestic producers are also provided access to large/huge global markets allowing
growth to be driven by exports
Access to Foreign resources
• Boosts AS: Provides access to foreign resources to drive growth (increased resources)
• Economic growth is dependent on the availability of resources or what is called potential output
or productive capacity (maximum output of an economy)
• Foreign raw materials and inputs: Globalization enables countries with resource constraints
to tap on foreign resources such as Singapore relying on imported inputs to produce goods for
exports – For every $1 of exports about $0
...
However
globalization can affect or alter the underlying factors behind Law of CA
Composition of Trade
Globalization has impact on comparative advantage (gain/loss)
Loss in CA
• Trade liberalization led to emergence of new rivals causing countries like Singapore to lose her
CA in production of cheap low-end labour intensive products
• Many MNCs have taken advantage of globalization to cut costs and be more efficient in
production via offshoring or relocation, outsourcing to cheaper production centres
Gain in CA
• Mobility of resources or productive factors across national boundaries have allowed Singapore
to acquire new CA in producing high value add, capital and knowledge intensive products
• Capital mobility takes the form of FDI inflows whilst labour mobility takes the form of influx of
foreign talent / skilled workers
Trade partners
• Globalization has also altered composition of trade partners – in the past it used to be advanced
economies like US, EU and regional economies like ASEAN
• Due to growing network of FTAs, trade has extended to emerging economies like China, India
and non-traditional trade partners like Peru, Panama and Russia
• Forging of FTAs is prompted by the need to diversify our markets to cushion the economy
against the threat of contagion and protectionism in a globalized world

!

Singapore’s Pro-Globalization policy:
Being a small and open economy with no natural resources, Singapore has much to gain from
globalization
...

•
•
•

Strategic Industries
Strong political and strategic reasons for protecting an industry which has no CA
Such as the need to be self-sufficient in times of war and not dependent on insecure sources
Some industries are indispensable to any war effort such as steel, transportation equipment,
aircraft and mining of strategic materials

2
...
Protection to achieve political objectives
• Used as a weapon of foreign policy to achieve political objectives
• Embargoes and other import controls are often imposed on trade in armaments and military
goods
~ END ~

!



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Title: A Level Economics
Description: Macroeconomics

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