Macro 10: Macroeconomic Problems and Policies

Macro 10: Macroeconomic Problems and Policies

At the end of this set of notes, you should be able to explain:

1. Macroeconomic Objectives ........................................................................................2

2. Relationships between macroeconomic problems ..............................................4
3. Fiscal policy ....................................................................................................................7
4. Monetary policy ............................................................................................................10
5. Exchange rate policy ..................................................................................................12
6. Supply side policies ....................................................................................................13
7. Possible policy conflicts ...........................................................................................14
8. Singapore’s macroeconomic policies ...................................................................15

Note: This set of notes is meant to concise with just enough information for “A” level
students. It is best used as a cheat sheet, complementary with official school notes.

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Macro 10: Macroeconomic Problems and Policies

1. Macroeconomic Objectives

1.1 A government's primary macroeconomic objectives are to stabilize the

economy and attain growth.

1.2 Its macroeconomic objectives can be internal and external goals :

Internal goals:
a. High and sustainable economic growth;
b. Low and stable inflation;
c. Full employment.
External goals:
a. Balance of payments (BOP) equilibrium;
b. Stable exchange rate

a. High and sustainable economic growth

1.3 A country's economic growth is measured by the annual percentage

increase in its real Gross Domestic Product (GDP).

1.4 Higher economic growth leads to the following benefits:

a. Higher material standard of living for an average citizen as real
GDP per head rises;
b. Reduction in the level of unemployment as production level
increases;
c. Improved fiscal position as government tax revenue increases
with income, and government expenditure falls with lower
unemployment benefits due to lower unemployment;
d. Encourage further consumption and investment as firms’ and
consumers’ confidence in the economy increases.

1.5 Sustainable economic growth is economic growth achieved in such

way as to not damage future generations' ability to produce more.

1.6 In assessing an economy's performance, it is important to judge not only

the rate of economic growth but also whether it is sustainable.

1.7 While economic growth measures only the improvement in the mat erial
aspect of the society, economic development measures the material
and non—material improvement in society.

1.8 Economic development takes into account changes in economic growth

and changes in the qualitative aspect of the economy, like the economic,
social and political structure of the economy.

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1.9 A measure of economic development is usually the Human Development

Index (HDI).

b. Low and stable inflation

1.10 Inflation is defined as a period of sustained and inordinate increase

in the general price level.

1.11 It is measured by the annual percentage change in the consumer price

index.

1.12 Governments wish to keep inflation rate as low as possible because:

a. Investment, production, employment and economic growth
tend to be adversely affected by high and uncertain inflation rate ;
b. Resources will be inefficiently allocated as the pricing system
is distorted due to high and uncertain inflation;
c. The country's BOP will be negatively impacted if the domestic
inflation rate is relatively higher than other competing countries,
eroding the international competitiveness of a country's exports.

c. Full employment

1.13 Full employment occurs when the number of workers who are able and
willing to work at prevailing wage rates equals the number of job
vacancies available.

1.14 Full employment is usually defined at between 2% to 3% unemployment,

as there will always be some disequilibrium unemployment occurring.

1.15 This does not mean zero unemployment since there will always be some
level of disequilibrium unemployment occurring.

1.16 It is necessary to ensure that unemployment rate is kept as low as

possible because:
a. Resources are under-utilised as the economy is producing
below its potential output;
b. Material standard of living worsens due to lower output and
income;
c. The fiscal position worsens as government tax revenue
decreases with income, and government expenditure increases
with higher unemployment benefits;
d. Non-material standard of living worsens due to social problems
such as increased crime and delinquency rates;

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e. The longer people are out of work, the greater the costs
involved as they will miss out on training and upgrading and will
find it more difficult to gain employment.

d. BOP equilibrium and stable exchange rate

1.17 A long term, persistent and unplanned disequilibrium is a serious

problem and indicates a fundamental economic problem in the
economy.

1.18 A persistent balance of payments deficit means that the country is

continually living beyond its means, and the government may have to
draw on its reserves or borrow money from abroad to finance the debt.

1.19 Long-term debt will lower the standard of living of future generations
in the country.

1.20 A balance of payments deficit will also cause the foreign exchange rate
to fall, which will push up the price of imports and fuel imported inflation.

1.21 Also, if the exchange rate fluctuates, this can cause great uncertainty
for traders and can damage international trade and economic growth.

2. Relationships between macroeconomic problems

a. Internal vs external value of money

2.1 A country's inflation rate reflects the internal value of money of a country
and is represented by the purchasing power of a unit of domestic
currency within the country.

2.2 On the other hand, a country's exchange rate reflects the external value
of money of a country and is represented by the purchasing power of a
unit of domestic currency outside the country.

2.3 The internal and external value of a country's money is directly related.

2.4 A relative rise in inflation (a fall in the country's internal value of money)
would cause the country's exports to become relatively more expensive
compared to other country's' exports, while imports become relatively
cheaper compared to domestically produced goods.

2.5 Assuming that the Marshall Lerner condition, export revenue will fall and
import expenditure will rise.

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2.6 This leads to a fall in demand of the domestic currency and a rise in
supply of the domestic currency in the foreign exchange market.

2.7 This will result in a depreciation of the domestic currency, reducing

the country's external value of money.

2.8 Conversely, a fall in the exchange rate (a fall in the country's external
value of money) will lead to a fall in the price of the country's exports in
foreign currency while the price of imports in domestic currency rises.

2.9 Assuming that the Marshall Lerner condition holds, export revenue will
rise and import expenditure will fall, increasing net exports and
aggregate demand.

2.10 Assuming that the economy is operating near or at full employment,

demand-pull inflation may arise, lowering the country's internal value
of money.

b. inflation and BOP disequilibrium

2.11 A relative rise in inflation will cause the country's exports to become
relatively more expensive compared to other countries’ exports, while
imports become relatively cheaper compared to domestically produced
goods.

2.12 Assuming that the Marshall Lerner condition holds, export revenue will
fall and import expenditure will rise, causing a fall in net exports, and
worsen the current account.

2.13 In addition, if inflation is driven by rising costs of production in the

domestic economy, foreign investors may find it unattractive to invest in
the country since they would expect lower profits to be earned.

2.14 Existing investors may also pull out and relocate their activities to lower
cost countries, leading to capital outflow – cost push inflation is likely
to worsen the capital account of the country.

2.15 Conversely, a BOP surplus causes an increase in money supply (net

inflow of money into the country), which will lower the interest rate and
generate demand pull inflation, assuming that the economy is
operating near or at full employment.

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c. Inflation and unemployment

2.16 Referring to the Short-run Phillips curve in Figure 1 below, there is an

inverse relationship between unemployment rate and inflation rate in the
short-run.

2.17 A fall in unemployment may cause higher inflation due to the increase
in aggregate demand generated when national income rises, exerting
possible upward pressure on prices.

2.18 This is especially true if the government tries to adopt demand

management policies to either control inflation or achieve full
employment.

Figure 1: Short-run Phillips Curve

2.19 However, such a relationship does not appear to exist in the long run,
with countries experiencing both high rate of inflation coupled with high
unemployment and low economic growth.

2.20 The vertical Long-run Phillips curve gives a satisfactory response to

stagflation by many schools of thoughts.

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Macro 10: Macroeconomic Problems and Policies

Figure 2: Short-run Phillips Curve

3. Fiscal policy

3.1 Fiscal policy is a form of demand-management policy, that makes use

of government expenditure and taxes as instruments of
macroeconomic policy to adjust AD.

3.2 A demand-management policy can be expansionary (increase AD), or

contractionary (decrease AD).

3.3 In general, demand-management policies are relatively effective in

stabilising the economy in the short-run, while supply-management
policies are better suited to achieving long-term growth.

a. Government expenditure

3.4 Government expenditure can be trouped into two main categories:

a. Operating expenditure
Day to day running costs incurred by the government to ensure its
smooth operation and includes expenditure on transfer payments .
b. Development expenditure
Expenditure for social or economic purposes, such as building
schools, hospitals, transport system etc.

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b. Taxation

3.5 A direct tax is imposed on the individual, household or firm that is meant
to bear the burden (i.e. the incidence of tax cannot be shifted) –
examples include personal income tax, corporate tax.

3.6 An indirect tax is imposed when goods and services are bought, and
the tax incidence can be shifted from the producer to the seller through
higher prices.

3.7 Indirect tax can be grouped as ad-valorem tax (levied at a percentage of

the value of the good – e.g. GST, VAT) or specific tax (levied at a fixed
amount per unit of output – e.g. excise duty on alcohol and tobacco).

3.8 Taxes can also be categorised as:

a. Progressive
Where taxpayers pay a greater proportion of their income as tax
as their income rises;
b. Regressive
Where taxpayers pay a smaller proportion of their income as tax
as their income rises;
c. Proportional
Where taxpayers pay a constant proportion of their income as tax
as their income rises;

c. Government budget

3.9 The annual budget sets out the planned expenditure and revenue of the
government for the year:
a. A balanced budget arises when the government revenue
collected is equal to the amount of government expenditure ;
b. A budget surplus arises when the government revenue collected
is higher than the government expenditure;
c. A budget deficit arises when the government revenue collected
is lower than the government expenditure.

3.10 The amount that that the public sector borrows to finance a budget deficit
is known as the Public Sector Borrowing Requirement (PSBR).

3.11 Internal borrowing includes selling bonds and treasury bills to the
private sector or borrowing directly from the Central Bank.

3.12 External borrowing encompasses borrowing from other countries or

from international organizations, e.g. International Monetary Fund (IMF).

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3.13 If the annual deficits accumulate and persist over many years, the
accumulated debt is then known as the national debt.

d. Automatic Stabiliser

3.14 Automatic stabilisers are fiscal features built into the system to
counteract cyclical changes in the level of aggregate expenditure
without the government having to take any deliberate action .

3.15 When national income rises, a higher rate of income tax is collected,
and less unemployment benefits will be given out automatically.

3.16 This lowers the level of disposable income and hence consumption
leading to lower aggregate demand, dampening the effect of the boom.

3.17 The opposite is true when national income decreases – thus the
automatic stabilisers act to reduce fluctuations in economic
performance.

e. Discretionary fiscal policy

3.18 Discretionary fiscal policy refers to the government's deliberate action to

alter its expenditure and/or the level of taxes in the economy in order
to influence AD.

3.19 An expansionary fiscal policy to increase AD through raising

government expenditure and/or reducing taxes has the effect of
worsening the government's budgetary position.

3.20 A contractionary fiscal policy to decrease AD through lowering

government expenditure and/or raising taxes has the effect of improving
the government's budgetary position.

f. Evaluation of fiscal policy

3.21 Government expenditure tends to be inflexible because a large part

of it is geared towards political and social programs such as healthcare.

3.22 Any attempt to reduce the such spending will be strongly resisted.

3.23 Moreover, much of the government spending is directed towards long

term projects such as building of infrastructure which cannot be altered
easily to meet the short-term needs of the economy.

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3.24 Increases in tax rate to finance government expenditure tend to be

unpopular and may have adverse effects on the incentives to work.

3.25 Financing government expenditure by borrowing from the banking sector

(or printing money) may lead to a crowding out effect as well as a
growth in money supply which brings about inflationary pressures.

3.26 Borrowing from external sources to finance government expenditure may

pose a burden to future generations of the country who need to
finance the interest and principal repayments.

3.27 If the multiplier is small, there will be less impact on national

income as a result of changes in government spending or taxation , and
may require large changes in spending and taxation, to bring the desired
changes in national income.

3.28 Government intervention often overshoots or undershoots because of

inaccurate projection or time lags, which can destabilize the economy
and worsen the situation.

3.29 Some reasons for that may include:

a. Unpredictable business and consumer sentiments which may
cause changes in the agents’ reactions to the fiscal policy ;
b. Difficulty in estimating size of multipler;
c. Any changes in policy will take time to work through the economy,
by which time the policy change may not be needed, or worse,
counterproductive.

3.30 Conflicts in achieving the different macroeconomic objectives may

arise when the government implements discretionary fiscal policy.

3.31 An expansionary fiscal policy to raise output and employment may result
in inflationary pressures if the economy is operating near full
employment and worsen the country's BOP.

3.32 On the other hand, a contractionary fiscal policy to control inflation may
lower employment and economic growth of the country.

4. Monetary policy

4.1 Monetary policy refers to the central bank's deliberate action to alter the
country's money supply or interest rates in order to influence AD.

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4.2 An expansionary monetary policy to increase AD is done by

increasing money supply or lowering interest rates.

4.3 A contractionary monetary policy to decrease AD is done by

decreasing money supply or increasing interest rates.

a. Effectiveness of monetary policy

4.4 Referring to Figure 3 below, If the country is in a liquidity trap, any

increase in money supply will have no effect on interest rate (at r*), and
hence on AD.

Figure 3: Liquidity Trap

4.5 Consumption and investment may not be sensitive to interest

changes, for example if consumer and business optimism are buoyant,
as a rise in interest rate may not deter firms and households from
borrowing to finance consumption and investment.

4.6 Also, an increase in interest rate may not have any impact as firms and
consumers may depend on their past savings to finance spending.

4.7 In such cases, large changes in money supply or interest rates are
necessary to effect desired changes in national income.

4.8 If the multiplier is small, there will be less impact on national income
as a result of changes in consumption or investment.

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4.9 This will also mean that in order to bring the desired changes in national
income, large changes in money supply is necessary.

4.10 Time-lag will also mean that any changes in policy will take time to work
through the economy, by which time the policy change may not be
needed, potentially causing overshoot.

4.11 High interest rates can add on to the cost of production due to higher
borrowing costs, causing cost-push inflation.

4.12 High interest rates also tend to be politically unpopular since the
general public does not like paying high interest rates on overdraft, credit
cards and mortgages.

4.13 Conflicts in achieving the different macroeconomic objectives may

arise when the government implements monetary policy.

4.14 An expansionary monetary policy to raise output and employment may

result in inflationary pressures if the economy is operating near full
employment and worsen the country's BOP.

4.15 On the other hand, a contractionary monetary policy to control inflation

may lower employment and economic growth of the country.

5. Exchange rate policy

5.1 Exchange rate policy works by altering the external value of the
country's currency to influence the price of imports and exports to
achieve its desired macroeconomic objectives.

5.2 Devaluation refers to a deliberate attempt by the government to revise

the value at which a country's currency is pegged at in terms of foreign
currency downwards.

5.3 Revaluation refers to a deliberate attempt by the government to revise

upwards the value at which a country's currency is pegged at in terms of
foreign currency.

a. Effectiveness of exchange rate policy

5.4 The effectiveness of the exchange rate policy in impacting the current
account of a country is dependent on whether the Marshall-Lerner
condition holds (i.e. PEDx + PED M > 1).

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5.5 In the short run especially, the PED for a country's imports and exports
tends to be highly price inelastic, due to domestic and foreign consumers
requiring some time to respond to the price changes.

5.6 Hence, devaluation may initially cause the current account to worsen in
the short run but will eventually lead to an improvement in the current
account in the long run when the demand for exports and imports
become more price elastic.

5.7 Devaluation could be ineffective in improving the current account of a

country if trading partners retaliate by competitive devaluation.

5.8 Devaluation will cause a fall in the price of the country's exports in
foreign currency while the price of imports in domestic currency rises.

5.9 Conflicts in achieving the different macroeconomic objectives may

arise when the government implements exchange rate policy.

5.10 Assuming that the Marshall Lerner condition holds, export revenue will
rise and import expenditure will fall, increasing net exports which may
lead to demand-pull inflation.

5.11 For countries which import a large proportion of raw materials, a

devaluation could also result in imported inflation as it raises the price
of the imported raw materials and hence the cost of production.

5.12 A revaluation of the country's exchange rate to control inflation on the

other hand reduces net exports and thus AD, leading to lower output and
employment and worsening of the country's BOP.

6. Supply side policies

6.1 Supply side policies focus on managing AS to improve the performance

of the market, workers and firms.

a. Supply side policies

6.2 Crowding out effects can be minimised by reducing government

spending so that less money is borrowed by the government to allow
more funds for the private sector to invest.

6.3 Cutting income and corporate tax rates and unemployment benefits
increases the returns from working and production.

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6.4 Increasing labour flexibility and mobility can be achieved by reducing

trade union power, upgrading of workers' skills and education .

b. Effectiveness of supply side policies

6.5 The government's budget position may worsen as a reduction in tax

rates necessarily means a fall in government revenue , and the
government's involvement towards promoting labour flexibility and
mobility will inevitably result in higher spending.

6.6 Workers may not welcome the reduction in power of trade unions
as it will reduce their bargaining power.

6.7 Also, workers may be reluctant to upgrade their skills and education
as it may mean a sacrifice in their social and family life.

6.8 Moreover, firms may not be willing to send their workers for
upgrading courses as they may be costly and the workers may leave
the company for another firm once they acquire the new skills.

6.9 Supply side policies tend to take time to bear fruit, making them
unsuitable for short-term adjustments to economic performance.

7. Possible policy conflicts

a. Inflation vs unemployment

7.1 The inverse relationship between inflation and unemployment between

inflation and unemployment is evident in the short run Phillips curve,
represented by Figure 2.

7.2 A government may seek to lower demand-pull inflation by adopting

contractionary demand management policies, however, these policies
have the effect of reducing output and increasing unemployment.

7.3 Interestingly, in the long run, empirical evidence shows that such a trade-
off does not exist, and thus the long-run Phillips curve is vertical.

b. Economic growth vs inflation / BOP disequilibrium

7.4 To promote actual economic growth when the economy is operating

below full employment, expansionary monetary and fiscal policy can be
implemented to increase AD.

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7.5 However, the possible adverse effects are that inflation and BOP
problems may surface, with the trade-off becoming more severe as the
economy approaches full employment.

7.6 The best solution may be to adopt both demand management policies
and supply side policy to raise economic growth while avoiding the
adverse effects.

c. BOP equilibrium vs inflation

7.7 Devaluation of a country's domestic currency can help to correct its BOP
deficit, by making exports relatively cheaper in foreign currency and
imports relatively more expensive in domestic currency.

7.8 Assuming the Marshall-Lerner condition holds, then this improves the
BOP position, though the advantages of devaluation may be eroded by
higher inflation (as AD increases).

8. Singapore’s macroeconomic policies

8.1 Singapore mainly pursues price stability and sustainable economic

growth, using exchange rate and fiscal policies.

a. Monetary policy

8.2 The govt. does not try to manage money supply or domestic interest
rates because any attempt to do so would lead to large capital
movements into or out of the country, causing serious BOP and
exchange rate instability.

8.3 Even if money supply and interest rates could be easily controlled, their
influence on the AD is limited as:
a. There is no impact on export demand;
b. The impact on domestic consumption is weakened by high import
leakages;
c. The impact on investments is limited because Multi-National
Corporations (MNCs) depend on their own financing.

b. Exchange rate policy

8.4 Unlike monetary policy, managing the exchange rate is effective in

maintaining price stability in Singapore, as it has a small and open
economy.

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8.5 Being a very small economy, Singapore cannot influence world prices ,
and is heavily dependent on imported raw materials.

8.6 Thus, to curb imported inflation, Singapore can revalue its exchange
rate to offset the impact of any increase in the prices of imported inputs,
dampening the rise in unit cost of production and hence the domestic
price level in the country.

8.7 In addition, export expenditure comprises a very large proportion of the

total demand, and revaluing its exchange rate would make exports less
competitive, causing the demand for exports to fall and hence
dampening the rate of inflation as well.

c. Fiscal policy

8.8 Singapore's fiscal policy is geared towards supply side policies as

shown by the emphasis on spending for human resource development
through education and worker training, tax reforms to encourage greater
savings, work incentives and greater compatibility with international
trends in taxes.

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