Economics Model Essay 6

This question will be discussed in the fourth week of term 2 (JC2) in economics tuition.

Discuss whether an increase in savings in Singapore would lead to problems in the economy. [25]

Answer

Introduction

Savings are the excess of disposable income over consumption expenditure. The question on whether an increase in savings in Singapore would lead to problems in the economy can be discussed in terms of the effects on the balance of payments, national output and hence national income, unemployment and inflation.

Deterioration in the Balance of Payments

An increase in savings in Singapore may lead to a deterioration in the balance of payments. 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. Given any amount of disposable income in Singapore, an increase in savings will lead to a decrease in consumption expenditure. For example, the increase in savings in Singapore due to the decrease in consumer sentiment and the wealth of households in the 2008-2009 Global Financial Crisis led to a decrease in consumption expenditure. When this happens, business sentiment may fall which may lead to a decrease in investment expenditure. As a proportion of the decrease in investment expenditure will be foreign direct investment, the capital and financial account and hence the balance of payments will deteriorate.

Fall in National Output/National Income

When savings in Singapore rise, aggregate demand may fall which may lead to a 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 consumption expenditure and investment expenditure in Singapore 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.

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 consumption expenditure and investment expenditure, they will employ less factor inputs from households and hence will pay them less factor income. When households’ income falls, they will further 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 households’ income will induce them 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 consumption expenditure and investment expenditure will lead to further 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.

Rise in Unemployment

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.

Deflation

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.

Decrease in Aggregate Supply

An increase in savings in Singapore may lead to a decrease in aggregate supply. 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. When savings in Singapore rise, the supply of loanable funds will rise. Therefore, interest rates will fall which will lead to a decrease in hot money inflows and an increase in hot money outflows resulting in a decrease in the demand for Singapore dollars and an increase in the supply. When this happens, the Singapore dollar will depreciate. A depreciation of the Singapore dollar will lead to a rise in the prices of imported intermediate goods in domestic currency in Singapore. Therefore, the cost of production in the economy will rise which will lead to a decrease in aggregate supply. A decrease in aggregate supply will lead to a decrease in national output and hence national income resulting in a rise in unemployment. A decrease in aggregate supply will also lead to a shortage of goods and services resulting in a rise in the general price level and hence higher inflation, and if this makes Singapore’s goods and services relatively more expensive than foreign goods and services, net exports will fall which will lead to a deterioration in the current account and hence the balance of payments, assuming the demand for exports is price elastic. In addition to higher indirect imported inflation or imported cost-push inflation, a depreciation of the Singapore dollar will lead to an increase in the prices of imported consumer goods in domestic currency which will lead to a rise in the general price level resulting in higher direct imported inflation.

Slower Rise in Aggregate Supply in the Long Run

When savings in Singapore rise, aggregate supply may rise at a slower rate in the long run. 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.

Smaller Multiplier

An increase in savings in Singapore will lead to a smaller multiplier which may be undesirable for the economy. The multiplier is the number of times by which national output and hence national income increases due to an increase in autonomous expenditure. It is inversely related to the marginal propensity to save. Therefore, when savings in Singapore rise, the multiplier will fall. A smaller multiplier will reduce the effectiveness of demand-side policies which may make it difficult for the government to achieve the four macroeconomic goals of high economic growth, low unemployment, low inflation and a balance of payments equilibrium.

Antithesis

An increase in savings in Singapore may not lead to problems in the economy. When households in Singapore decrease consumption expenditure, not only will they purchase less domestic goods and services, they will also buy less imports. Imports will also fall due to the decrease in national income. Furthermore, the fall in the general price level due to the decrease in aggregate demand may make Singapore’s goods and services relatively cheaper than foreign goods and services which will lead to an increase in net exports. If these happen, the current account and hence the balance of payments will improve, assuming the demand for exports is price elastic. When the Singapore dollar depreciates, Singapore’s goods and services will become relatively cheaper than foreign goods and services which will lead to an increase in net exports resulting in an improvement 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, a depreciation of the Singapore dollar will decrease the costs of investments in foreign currency in Singapore 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. Lower interest rates will decrease the incentive to save and the costs of borrowing and this 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 investment expenditure. An increase in consumption expenditure, investment expenditure and net exports will lead to an increase in aggregate demand resulting in an increase in national output and hence national income resulting in a fall in unemployment. Furthermore, the increase in investment expenditure will lead to a more rapid increase in the production capacity in the economy in the long run, assuming net investment is initially postive. Therefore, aggregate supply will rise at a faster rate in the long run. Singapore operates under the managed float exchange rate system whereby the Singapore dollar is pegged to a basket of other currencies within a policy band set by the central bank. Therefore, if the exchange rate of the Singapore dollar is initially at the lower bound of the policy band, the Monetary Authority of Singapore (MAS) will intervene in the foreign exchange market to prevent it from falling. If this happens, a fall in interest rates will not lead to a depreciation of the Singapore dollar. Therefore, the cost of production in the economy will not rise and hence aggregate supply will not fall. A smaller multiplier may be desirable for the Singapore economy. The Singapore economy may be at or near the full-employment equilibrium. If this happens, a smaller multiplier may prevent a decrease in autonomous expenditure from causing a substantial decrease in aggregate demand and hence national output and therefore national income from falling substantially from the full-employment level. Similarly, it may prevent an increase in autonomous expenditure from causing a substantial increase in aggregate demand and hence the general price level from rising substantially.

Evaluation

In the final analysis, a rise in savings in Singapore is unlikely to lead to problems in the economy. Singapore has a high savings rate of close to 50 per cent due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. Therefore, any increase in savings and hence decrease in consumption expenditure is likely to be small. Furthermore, a large proportion of investment expenditure in Singapore is foreign direct investment which depends on the domestic market to only a small extent as it is mainly export-oriented. Therefore, a decrease in consumption expenditure in Singapore is unlikely to lead to a significant decrease in investment expenditure. In addition, consumption expenditure and investment expenditure on domestic goods and services are small components of aggregate demand in Singapore. Therefore, the effect of a decrease in consumption expenditure and investment expenditure on aggregate demand is likely to be small and hence is unlikely to have any substantial effects on the economy in the short run. Singapore has been pursuing an export-driven economic growth strategy for the last few decades and this strategy has helped Singapore achieve a high rate of economic growth, propelling it to near the top of the world ranking of GDP per capita. However, the pursuit of export-driven economic growth strategy in Singapore has led to a disproportionately high level of exports. Singapore’s exports are now over 200 per cent of its national income and this has resulted in a high volatility of economic growth, as evidenced by the large swings in national output and hence national income. Therefore, a rise in savings which will reduce the multiplier and hence the volatility of economic growth is likely to be desirable for the economy.

Author’s comments

Students simply need to explain whether an increase in savings in Singapore would lead to problems in the economy in terms of the effects on the balance of payments, national income, unemployment and inflation. At the end of Chapter 11 Macroeconomic Performance in economics tuition, Mr. Edmund Quek will engage in a more detailed discussion of the question with the students.

Students should understand that the question is asking about an increase in autonomous savings and not an increase in induced savings as the latter has limited scope for discussion.

Students should understand that this is not a cost-and-benefit question. Therefore, in the antithesis, instead of discussing other benefits, they should explain why the same problems that they discussed in the thesis may not occur.

In addition to the effects of an increase in savings in Singapore on the economy via the effect on aggregate demand, students should discuss the effects on the economy via the effect on aggregate supply, both in the short run and in the long run.

Students should understand that an increase in savings and hence the supply of loanable funds in Singapore is unlikely to lead to a substantial fall in interest rates. As Singapore is a small and open economy, a decrease in hot money inflows and an increase in hot money outflows will lead to a large decrease in the supply of loanable funds resulting in a substantial rise in interest rates, substantially offsetting the initial fall in interest rates.

Students should explain both direct imported inflation and indirect imported inflation to demonstrate a deeper understanding of imported inflation.

Students should explain the reverse multiplier effect as it is an important concept in the Singapore-Cambridge GCE ‘A’ Level Economics.

Students should discuss the size of the multiplier when the question involves savings.

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