Economics Model Essay 17

Discuss whether austerity measures in the European Union would adversely affect the Singapore economy. [25]

Introduction

Austerity measures refer to the measures used by the government to reduce a budget deficit which include spending cuts and tax increases. The effects of austerity measures in the European Union on the Singapore economy can be discussed in terms of the effects on the balance of payments, national output and hence national income, unemployment and inflation.

Body

Austerity measures in the European Union may lead to a deterioration in the balance of payments of Singapore. The balance of payments is a record of all the transactions between the residents of the economy and the rest of the world over a period of time and is made up of the current account and the capital and financial account. Austerity measures in the European Union may include an increase in direct taxes such as personal income tax and corporate income tax. If this happens, disposable income will fall which will lead to a decrease in consumption expenditure. Even in the absence of an increase in direct taxes, austerity measures in the European Union will still lead to a fall in disposable income resulting in a decrease in consumption expenditure due to the contractionary effect of the measures on the economy. When households in the European Union decrease consumption expenditure, not only will they purchase less domestic goods and services, they will also buy less imports including those produced in Singapore. When this happens, exports in Singapore will fall which will lead to a deterioration in the current account and hence the balance of payments. Furthermore, as austerity measures in the European Union will have a contractionary effect on the trading bloc which is the largest in the world, they will have a contractionary effect on the world economy. Therefore, austerity measures in the European Union may lead to a fall in global business sentiment resulting in a decrease in global investment. If this happens, foreign direct investments in Singapore will fall which will lead to a deterioration in the capital and financial account and hence the balance of payments. As austerity measures in the European Union will have a contractionary effect on the trading bloc, they may lead to a capital flight due to factors such as expectations of a fall in asset prices and a cut in interest rates. If this happens, as some of the capital will flee to Singapore, hot money inflows will increase which will lead to an increase in the demand for Singapore dollars resulting in a rise in the exchange rate. When the Singapore dollar appreciates, Singaporeโ€™s goods and services will become relatively more expensive than foreign goods and services which will lead to a decrease in net exports possibly resulting in a deterioration in the current account and hence the balance of payments, assuming the sum of the price elasticities of demand for exports and imports is greater than one. Furthermore, an appreciation of the Singapore dollar will increase the costs of investments in foreign currency in Singapore which will lead to a decrease in foreign direct investments resulting in a deterioration in the capital and financial account and hence the balance of payments.

When austerity measures are implemented in the European Union, aggregate demand in Singapore may fall which may lead to decrease in national output and hence national income. 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. The decrease in net exports and investment expenditure will lead to a decrease in aggregate demand which will induce firms to decrease production resulting in a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income.

Diagram

In the above diagram, a decrease in aggregate demand (AD) from AD0 to AD1 leads to a decrease in national output and hence national income (Y) from Y0 to Y1. When firms decrease production in response to a decrease in aggregate demand due to a decrease in net exports and investment expenditure, they will employ less factor inputs from households and hence will pay them less factor income resulting in a decrease in national income. When national income falls which will lead to a decrease in disposable income, households will decrease consumption expenditure which will lead to a further decrease in aggregate demand and this will induce firms to further decrease production. When this happens, firms will employ even less factor inputs from households and hence will pay them even less factor income. The further decrease in national income and hence disposable income will induce households to further decrease consumption expenditure resulting in a further decrease in aggregate demand. Therefore, the initial decrease in aggregate demand due to the decrease in net exports and investment expenditure will lead to decreases in consumption expenditure and hence further decreases in aggregate demand resulting in a larger decrease in national output and hence national income. This is commonly known as the reverse multiplier effect.

The decrease in national output due to the decrease in aggregate demand in Singapore will lead to a fall in the demand for labour in the economy resulting in a rise in unemployment.

The decrease in aggregate demand in Singapore will lead to a fall in the general price level resulting in deflation. A decrease in aggregate demand in Singapore will lead to a surplus of goods and services resulting in a fall in the general price level. Furthermore, when aggregate demand in Singapore falls which will induce firms to decrease production, the decrease in the demand for factor inputs in the economy will lead to a fall in the prices. When this happens, the cost of production in the economy will fall which will induce firms to decrease prices to maintain competitiveness resulting in a fall in the general price level. When the general price level falls, households may expect it to fall further. If this happens, consumption expenditure will fall which will lead to a further decrease in aggregate demand.

When austerity measures are implemented in the European Union, aggregate supply in Singapore may rise at a slower rate in the long run. 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. The decrease in investment expenditure in Singapore will lead to a less rapid increase in the production capacity in the economy in the long run, assuming net investment remains positive. Therefore, aggregate supply will rise at a slower rate in the long run. When this happens, assuming aggregate demand is rising which is the normal state of the economy, national output and hence national income will rise at a slower rate which may increase unemployment, and the general price level will rise at a faster rate resulting in higher inflation which may worsen the balance of payments.

Austerity measures in the European Union may not adversely affect the Singapore economy. Austerity measures in the European Union may lead to a decrease in the budget deficit which will reduce the rate of increase in the public debt. This may lead to a decrease in the public debt-to-GDP ratio which will reduce the likelihood of a sovereign default. If this happens, consumer sentiment may rise which may lead to an increase in consumption expenditure. When this happens, exports in Singapore will rise which will lead to an improvement in the current account and hence the balance of payments. Due to the same reason, global business sentiment may rise which may lead to an increase in global investment. If this happens, foreign direct investments in Singapore will rise which will lead to an improvement in the capital and financial account and hence the balance of payments. In addition, if austerity measures in the European Union include an increase in corporate income tax, expected after-tax returns on planned investments will fall. When this happens, expected after-tax returns on planned investments in Singapore will become relatively higher which will lead to an increase in foreign direct investments resulting in an improvement in the capital and financial account and hence the balance of payments. The capital and financial account and hence the balance of payments of Singapore will also improve due to the increase in hot money inflows. The increase in hot money inflows in Singapore will lead to an increase in the supply of loanable funds resulting in a fall in interest rates. When interest rates in Singapore fall, the incentive to save and the costs of borrowing will decrease which will lead to an increase in consumption expenditure. Furthermore, a decrease in the costs of borrowing will lead to more profitable planned investments resulting in an increase in domestic investment. Coupled with the increase in exports and foreign direct investment, this will lead to an increase in aggregate demand which will lead to an increase in national output and hence national income resulting in a fall in unemployment. When the Singapore dollar appreciates, the prices of imported intermediate goods in domestic currency will fall. Therefore, the cost of production in the economy will fall which will lead to an increase in aggregate supply. An increase in aggregate supply will lead to an increase in national output and hence national income resulting in a fall in unemployment. Assuming aggregate demand is rising which is the normal state of the economy, an increase in aggregate supply will also lead to a smaller rise in the general price level resulting in lower inflation and if this makes Singaporeโ€™s goods and services relatively cheaper than foreign goods and services, net exports will rise which will lead to an improvement in the current account and hence the balance of payments. In addition to lower indirect imported inflation or imported cost-push inflation, an appreciation of the Singapore dollar will lead to a decrease in the prices of imported consumer goods in domestic currency which will lead to lower direct imported inflation. Due to the increase in investment expenditure in Singapore, the production capacity in the economy and hence aggregate supply will rise at a faster rate in the long run, assuming net investment is initially positive. When this happens, assuming aggregate demand is rising which is the normal state of the economy, national output and hence national income will rise at a faster rate which may decrease unemployment, and the general price level will rise at a slower rate resulting in lower inflation which may improve the balance of payments.

Evaluation

In the final analysis, austerity measures in the European Union are likely to adversely affect the Singapore economy in the short run. As austerity measures in the European Union will have a contractionary effect on the trading bloc and hence the world economy, they are unlikely to lead to an increase in consumer sentiment and hence consumption expenditure in the short run. Therefore, they are unlikely to lead to an increase in exports in Singapore. This is particularly true in view of the fact that the contractionary effect of austerity measures in the European Union is likely to lead to an increase in the public debt-to-GDP ratio in the short run as it will reduce economic growth. For example, the austerity measures implemented in Greece in 2010 led to a rise in the public debt-to-GDP ratio. In the long run, however, austerity measures in the European Union are likely to benefit the Singapore economy. Many economies in the European Union have been experiencing rising public debt-to-GDP ratio due to their large budget deficits. In the absence of austerity measures, this will eventually and inevitably lead to a sovereign default. A sovereign default in the European Union will lead to a fall in exports in Singapore. As domestic exports account for a large proportion of aggregate demand in Singapore, a decrease in exports is likely to lead to a substantial decrease aggregate demand. This will lead to a large decrease in national output and hence national resulting in a large rise in unemployment. Therefore, austerity measures in the European Union are likely to help the Singapore economy avert a recession in the long run.

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