Economics Model Essay 7

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

Discuss the view that Singapore has few policies to deal with an external shock. [25]

Answer

Introduction

An external shock is an unexpected external economic event that has undesirable effects on the economy. There are two types of external shocks: external demand shock and external supply shock. The view that Singapore has few policies to deal with an external shock can be discussed with reference to the effectiveness of monetary policy, fiscal policy, exchange rate policy and short-term supply-side policies in Singapore.

Decrease in National Output/National Income

An external demand shock will lead to a decrease in national output and hence national income. An external demand shock occurs when an unexpected external economic event leads to a substantial fall in exports and hence aggregate demand. For example, the 2008-2009 Global Financial Crisis caused by the Subprime Mortgage Crisis in the United States led to a substantial fall in exports 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. A decrease in exports 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 exports, they will employ less factor inputs from households and hence will pay them less factor income. When households’ income falls, they 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 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 exports 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.

Rise in Inflation

An external supply shock will lead to a rise in the general price level resulting in higher inflation. An external supply shock occurs when an unexpected external economic event leads to a substantial rise in the cost of production in the economy resulting in a large decrease in aggregate supply. For example, the Organisation of Arab Petroleum Exporting Countries (OAPEC) imposed an oil embargo against the United States, the United Kingdom, the Netherlands, Japan and Canada in October 1973 which led to a large decrease in the supply of oil resulting in a sharp rise in the prices and hence a substantial rise in the cost of production 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. When the cost of production in the economy rises independently of demand, firms will increase prices at the same output levels to maintain profitability. In other words, they will decrease output at the same prices which will lead to a decrease in aggregate supply resulting in a rise in the general price level.

In the above diagram, a decrease in aggregate supply (AS) from AS0 to AS1 leads to a rise in the general price level (P) from P0 to P1. Although national output and hence national income (Y) falls from Y0 to Y1 which leads to a rise in unemployment, the general consensus is that the adverse effects of high inflation are more severe than those of high unemployment.

Fiscal Policy is Ineffective in Singapore

Although fiscal policy can be used to deal with an external shock in large economies, it is ineffective in Singapore. Fiscal policy is a demand-side policy that is used to control government expenditure or taxation to influence aggregate demand. To deal with an external demand shock, the government can increase expenditure on goods and services. For example, the Singapore government implemented the Resilience Package which included an increase in expenditure on infrastructure to increase economic growth in the 2008-2009 Global Financial Crisis. It can also increase disposable income to increase consumption expenditure by decreasing direct taxes such as personal income tax and corporate income tax or increasing transfer payments. In addition to an increase in consumption expenditure, a decrease in corporate income tax will lead to higher expected after-tax returns on planned investments resulting in an increase in investment expenditure. An increase in consumption expenditure, investment expenditure and government expenditure on goods and services will lead to an increase in aggregate demand resulting in an increase in national output and hence national income, other things being equal. To deal with an external supply shock, the government can decrease expenditure on goods and services, increase direct taxes or decrease transfer payments. Given any decrease in aggregate supply, a decrease in aggregate demand will lead to a smaller rise in the general price level resulting in lower inflation. Fiscal policy is not used to deal with an external supply shock in Singapore. It is difficult to decrease government expenditure on goods and services in Singapore significantly as a large part of it is made on important areas such as education, healthcare, infrastructure and national defence. This problem is compounded by the prudent fiscal policy and hence the small government expenditure on goods and services. Although fiscal policy is used to deal with an external demand shock in Singapore, the effectiveness is likely to be limited. An increase in disposable income in Singapore is likely to lead to only a small increase in consumption expenditure due to the low marginal propensity to consume which is a result of the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. Furthermore, the consumption expenditure, investment expenditure and government expenditure on domestic goods and services in Singapore are small relative to the domestic exports. Therefore, the increase in consumption expenditure, investment expenditure and government expenditure on domestic goods and services is likely to only partially offset the decrease in domestic exports resulting in a smaller decrease in aggregate demand and hence lower negative economic growth.

Monetary Policy is Ineffective in Singapore

Although monetary policy can be used to deal with an external shock in large economies, it is ineffective in Singapore. Monetary policy is a demand-side policy that is used to control the money supply and hence interest rates to influence aggregate demand. To deal with an external demand shock, the central bank can increase the money supply by conducting an open market purchase. When the money supply increases, the amount of reserves in the banking system will rise. When this happens, interbank rates will fall which will lead to a fall in the level of interest rates in the economy. For example, the Federal Reserve increased the money supply to lower the federal funds rate from 5.25 per cent in October 2007 to 0-0.25 per cent in December 2008 to boost the faltering U.S. economy. 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 and investment expenditure will lead to an increase in aggregate demand resulting in an increase in national output and hence national income, other things being equal. To deal with an external supply shock, the central bank can decrease the money supply by conducting an open market sale. Monetary policy is not used to deal with an external shock in Singapore due to four reasons: the choice of a managed float exchange rate, the role of an interest rate-taker, the small consumption expenditure and investment expenditure on domestic goods and services relative to the domestic exports and the low interest elasticity of consumption and investment. For example, if the Monetary Authority of Singapore (MAS) increases the money supply to lower interest rates, hot money inflows will decrease and hot money outflows will increase which will lead to a decrease in the money supply. Due to the small and open nature of the Singapore economy, the effect of the changes in hot money flows on the money supply will be substantial. Therefore, the decrease in the money supply will lead to a rise in interest rates back to the initial level.

Although demand-side policies are ineffective for dealing with an external shock in Singapore, there are policies which may be effective.

Exchange Rate Policy in Singapore

Exchange rate policy may be effective for dealing with an external shock 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. To deal with an external demand shock, the MAS can devalue the Singapore dollar by lowering the exchange rate policy band to allow the currency more room to depreciate as the demand falls due to the decrease in exports. For example, in April 2009 in the midst of the 2008-2009 Global Financial Crisis, the MAS lowered the exchange rate policy band when it re-centred it to the prevailing nominal effective exchange rate of the Singapore dollar which was in the lower half of the policy band to allow it more room to fall. A weaker Singapore dollar will make Singapore’s goods and services relatively cheaper than foreign goods and services which will lead to an increase in net exports and hence aggregate demand resulting in an increase in national output and hence national income, other things being equal. However, a fall in the exchange rate will increase the prices of imports in domestic currency resulting in higher imported inflation. As the imports in Singapore are high due to lack of factor endowments and the embracement of free trade, the MAS cannot devalue the Singapore dollar dramatically to prevent high imported inflation. Therefore, the modestly weaker Singapore dollar will only cushion the decrease in exports resulting in a smaller decrease in aggregate demand and hence lower negative economic growth. Furthermore, the fall in the exchange rate which will increase the prices of imported intermediate goods in domestic currency will increase the cost of production in the economy which will lead to a decrease in aggregate supply resulting in a decrease in national output and hence national income. To deal with an external supply shock, the 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 rise in the prices of imported intermediate goods in domestic currency which will lead to a smaller the rise in the cost of production in the economy and hence a smaller rise in the general price level resulting in lower inflation. However, the stronger Singapore dollar will reduce export competitiveness which will lead to lower economic growth.

Short-term Supply-side Policies in Singapore

Short-term supply-side policies may be effective for dealing with an external shock in Singapore. Short-term supply-side policies are policies that are used to decrease the cost of production in the economy in the short term and hence increase aggregate supply. To deal with an external demand shock, the Singapore government can reduce the employers’ CPF contribution rate in the short term to decrease the labour cost in the economy. For example, it reduced the employers’ CPF contribution rate from 20 per cent to 10 per cent in the 1997-1998 Asian Financial Crisis. The Singapore government can also help firms pay a certain proportion of wages in the short term to decrease the labour cost in the economy. For example, it implemented the Jobs Credit Scheme which helped firms pay 12 per cent of the wages of a worker up to the first $2500 in the 2008-2009 Global Financial Crisis. When the cost of production in the economy falls, aggregate supply will rise which will lead to an increase in national output and hence national income. The same policies can be used to deal with an external supply shock in Singapore. However, as Singapore is a small economy that is highly dependent on external demand with the domestic exports accounting for a large proportion of the aggregate demand, a fall in exports is likely to lead to a substantial decrease in aggregate demand. Therefore, unless the fall in the cost of production in the economy is large, the increase in aggregate supply is likely to only partially offset the decrease in aggregate demand resulting in a smaller decrease in national output and hence national income. Furthermore, these policies will lead to an increase in the profits of firms which are generally owned by high income individuals and this may result in a less equitable distribution of income.

Evaluation

In the final analysis, it is arguably not true that Singapore has few policies to deal with an external shock. Although demand-side policies are ineffective for dealing with an external shock in Singapore, exchange rate policy is effective due to the high imports of intermediate goods and the high dependence on external demand with the domestic exports accounting for a large proportion of the aggregate demand. Furthermore, when an external demand shock occurs in Singapore, expansionary fiscal policy and short-term supply-side policies can be used in conjunction with exchange rate policy to produce a greater expansionary effect on the economy and hence cushion the negative effect on economic growth by a larger extent. Indeed, in the 2008-2009 Global Financial Crisis, the Singapore government implemented a policy mix consisting of exchange rate policy, expansionary fiscal policy and short-term supply-side policies to cushion the negative effect on economic growth. However, Singapore is a small economy that is highly dependent on external demand with the domestic exports accounting for a large proportion of the aggregate demand. Therefore, unless exports pick up with an economic recovery in large economies, such as the United States and China, economic growth in Singapore is likely to remain sluggish. In a recession, due to the limitations of the policies, exchange rate policy, expansionary fiscal policy and short-term supply-side policies can only go some way towards increasing economic growth in Singapore. Nevertheless, these policies should be used as they can cushion the negative effect of an external shock on economic growth in Singapore by a significant extent.

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

Author’s comments

Students simply need to explain the effectiveness of monetary policy, fiscal policy, exchange rate policy and short-term supply-side policies to deal with an external shock in Singapore.

Students should understand that unlike ‘a few’, ‘few’ carries a negative connotation.

Students should distinguish between external demand shock and external supply shock as these two different types of external shocks require different policy responses.

Students should discuss the limitations of the exchange rate policies and short-term supply-side policies in Singapore. However, they need not discuss the limitations of demand-side policies.

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

As the essay is on the long side, students who cannot produce it within the examination time constraint may want to curtail the explanation of fiscal policy.

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