Economics Model Essay 12

Discuss whether fiscal policy is the best policy for decreasing inflation in Singapore. [25]

Introduction

Inflation is a sustained rise in the general price level. Fiscal policy is a demand-side policy that is used to control government expenditure or taxation to influence aggregate demand. The question on whether fiscal policy is the best policy for decreasing inflation in Singapore can be discussed with reference to the effectiveness of contractionary fiscal policy, exchange rate policy and supply-side policies.

Body

Contractionary fiscal policy can be used to decrease inflation in Singapore. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. To reduce inflation, the Singapore government can decrease expenditure on goods and services. For example, many European governments reduced expenditure on goods and services in the early 1980s to reduce inflation caused by the sharp rise in oil prices. It can also decrease disposable income to decrease consumption expenditure by increasing direct taxes such as personal income tax and corporate income tax or decreasing transfer payments. In addition to a decrease in consumption expenditure, an increase in corporate income tax will lead to lower expected after-tax returns on planned investments resulting in a decrease in investment expenditure. A decrease in consumption expenditure, investment expenditure and government expenditure on goods and services will lead to a decrease in aggregate demand. Assuming aggregate demand and hence the general price level is rising rapidly, this will reduce the growth of aggregate demand which will lead to a slower rise in the general price level resulting in lower inflation. However, the use of contractionary fiscal policy to decrease inflation is subject to several limitations. It is difficult to decrease government expenditure on goods and services significantly as a large part of it is made on important areas such as education, healthcare, infrastructure and national defence. This is particularly true in Singapore due to the small government expenditure on goods and services as a result of the prudent fiscal policy adopted by the government. Furthermore, an increase in personal income tax in Singapore which will lead to lower after-tax personal income will make the economy less attractive to foreign talents, and an increase in corporate income tax in Singapore which will lead to lower expected after-tax returns on planned investments will make the economy less attractive to foreign direct investments. As the Singapore economy is highly dependent on foreign talents and foreign direct investments, this can be rather detrimental to the economy. An economy with high income taxes, high savings and high imports will have a small multiplier. Singapore has a small multiplier due to the high savings and high imports. The savings rate in Singapore is high due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. The level of imports in Singapore is high due to lack of factor endowments and the embracement of free trade. If the multiplier is small, the initial decrease in aggregate demand due to the decrease in consumption expenditure, investment expenditure and government expenditure on goods and services may not lead to a significant fall in inflation.

Exchange rate policy may be better than contractionary fiscal policy for decreasing inflation in Singapore. Exchange rate policy is a policy that is used to control the exchange rate through central bank intervention in the foreign exchange market. In times of high external price pressures, the prices of imports will rise substantially which will lead to high imported inflation. To reduce imported inflation, the Monetary Authority of Singapore (MAS) can revalue the Singapore dollar by raising the exchange rate policy band and simultaneously buying domestic currency and selling foreign currency in the foreign exchange market. A rise in the exchange rate will reduce the increase in the prices of imports in domestic currency resulting in lower imported inflation. In addition, a rise in the exchange rate will make domestic goods and services relatively more expensive than foreign goods and services. When this happens, net exports will fall which will lead to a decrease in aggregate demand. Assuming aggregate demand and hence the general price level is rising rapidly, this will reduce the growth of aggregate demand which will lead to a slower rise in the general price level resulting in lower demand-pull inflation. Exchange rate policy may be better than contractionary fiscal policy for decreasing inflation in Singapore due to several reasons. Unlike contractionary fiscal policy, exchange rate policy does not work through decreasing government expenditure on goods and services or increasing income taxes. Furthermore, although contractionary fiscal policy can only decrease demand-pull inflation, exchange rate policy can decrease both demand-pull inflation and imported inflation. In addition, as demand-pull inflation in Singapore is mainly due to an increase in external demand, contractionary fiscal policy which can only reduce the extent of an increase in domestic demand is unlikely to be more effective for decreasing demand-pull inflation compared to exchange rate policy which can reduce the extent of an increase in external demand.

Exchange rate policy may not be better than contractionary fiscal policy for decreasing inflation in Singapore. The use of contractionary fiscal policy to decrease inflation may lead to a budget surplus which may translate into an increase in government reserves. If this happens, the government reserves can be put to good uses such as increasing expenditure on infrastructure to attract foreign direct investments. In contrast, the use of exchange rate policy to decrease inflation will not lead to a budget surplus. The use of exchange rate policy to decrease inflation involves selling foreign currency in the foreign exchange market and this is unsustainable as a long-term policy as it will lead to the depletion of foreign exchange reserves in time to come. In contrast, the use of contractionary fiscal policy to decrease inflation does not involve selling foreign currency in the foreign exchange market.

Supply-side policies may be better than contractionary fiscal policy for decreasing inflation in Singapore. Aggregate supply is the total supply of goods and services in the economy over a period of time and is determined by the production capacity and the cost of production in the economy. Supply-side policies are policies that are used to increase the production capacity in the economy and hence aggregate supply. For example, education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy. The government can provide education and training directly, by setting up educational institutes, or indirectly, by giving subsidies or tax incentives to firms to encourage them to send their workers for education and training. A case in point is the setting up of the Institute of Technical Education, polytechnics and Continuing Education and Training campuses by the Singapore government to provide education and training. Research and development will lead to technological advancement which will increase the efficiency of capital in the economy. 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. A case in point is the setting up of the Biomedical Research Council (BMRC) and the Science and Engineering Research Council (SERC) under the Agency for Science, Technology and Research (A*STAR) by the Singapore government to engage in research and development. To decrease inflation, the Singapore government can use supply-side policies to increase aggregate supply. Assuming aggregate demand in Singapore is rising which is the normal state of the economy, an increase in aggregate supply will lead to a smaller rise in the general price level resulting in lower inflation. Supply-side policies may be better than contractionary fiscal policy for decreasing inflation in Singapore due to several reasons. Although a small multiplier limits the effectiveness of fiscal policy, it does not limit the effectiveness of supply-side policies. Furthermore, although the use of contractionary fiscal policy to decrease inflation will lead to lower economic growth, the use of supply-side policies to decrease inflation will lead to higher economic growth. In addition, the use of supply-side policies to decrease inflation will lead to potential economic growth which is essential for achieving sustained economic growth. In contrast, the use of contractionary fiscal policy to decrease inflation will not lead to potential economic growth.

Supply-side policies may not be better than contractionary fiscal policy for decreasing inflation in Singapore. The effects of supply-side policies will be realised only in the long run and this long effectiveness time lag makes them ineffective in the short run. For example, it takes time for education and training to increase the skills and knowledge of labour in the economy. Furthermore, the use of supply-side policies to decrease inflation may lead to an increase in aggregate demand and hence the general price level resulting in higher inflation. For example, to increase the skills and knowledge of labour in the economy, the government may provide education and training directly by setting up educational institutes. An increase in government expenditure on goods and services will lead to an increase in aggregate demand. In contrast, the effectiveness time lag of contractionary fiscal policy is shorter and it will not lead to higher inflation.

Evaluation

In the final analysis, contractionary fiscal policy is unlikely to be more effective than exchange rate policy for decreasing inflation in Singapore. In addition to demand-pull inflation in Singapore being mainly due to an increase in external demand, cost-push inflation in Singapore is mainly imported in nature. As the world economy is generally expanding, the world demand for intermediate goods and hence the prices are generally rising. Due to lack of factor endowments, Singapore imports a large amount of intermediate goods and hence a rise in the prices leads to a rise in the cost of production in the economy to a larger extent. For example, the increase in the prices of imported intermediate goods in Singapore in 2010 due to the global economic recovery led to a substantial rise in the cost of production in the economy. Therefore, exchange rate policy is likely to be effective for reducing both demand-pull inflation and cost-push inflation in Singapore. Although there are several policies to decrease inflation in Singapore, they are all subject to limitations, despite their strengths. To overcome this problem, the government should adopt a policy mix. The use of a policy mix allows the strengths of some policies to compensate for the limitations of other policies. This will reduce their limitations and improve on their strengths resulting in greater effectiveness. Therefore, the use of a policy mix to decrease inflation in Singapore is likely to be more effective than the use of any single policy. For example, the use of supply-side policies in conjunction with exchange rate policy to decrease inflation in Singapore will help reduce the negative effect on economic growth.

The question will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

Click to Read Next Model Essay

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Economics tutors and teachers who wish to use the materials for teaching may submit a request to Economics Cafe.

 

economics tuition, back to homepage

Economics Tuition Singapore @ Economics Cafe
Principal Economics Tutor: Mr. Edmund Quek