JC Economics Economic Growth for Small & Open Economy Essay Model Answers
What is meant by a small and open economy (SOE)? On the other hand, what do you understand by a large and less open economy (LLE)?
Here are some generalisations about the characteristics of an SOE:
1. High dependence on external demand: There are a few conventional measures of external reliance of an economy. One is the ratio of exports to total aggregate demand (AD). For S’pore in 2010 this was about 75% (inclusive of import content). The import-adjusted proportion was about 55%. Another measure is the size of next exports to AD. Singapore’s GDP proportion of net exports in 2011 was about 20%. Furthermore, the size of trade sector (X+M) ass a ratio to GDP is also another measure. In SG, it’s about 400% in 2012.
Foreign direct investment is another source of demand for SOE, but most likely smaller than the source of exports.
As opposed to SOE, large and less-open economies (LLEs) also look to exports and FDI for source of demand but the degree of dependence is much lesser.
2. High import content of domestic production :Singapore’s import content of domestic demand was 43% and of exports was 60%, whereas for Ireland (another example of small and open economy) it was 17% and 50%.
(More updated source of data at Singapore Economic Survey)
3. Reliance on foreign labour and talents supply: With small population, inflow of foreign workers is needed to boost domestic labour market. With more acute scarcity of resources compared to large economies, the growth strategies. of small and open economies necessarily have to be anchored on talents and technology. This requires such countries to allow the inflow of foreign professionals and experts.
4. Reliance on investment and technology: With limited labour supply and reliance on external demand, investment is highly essential to boost productivity and innovation is the key to acquire and sustain comparative advantage in trade.
Question
The Ministry of Trade and Industry (MTI) of Singapore announced in July 2011 that it expected the economy to expand by 6-7% for the year.
Discuss whether small and open economies such as Singapore should adopt different economic policies from those of large and less open economies in order to sustain healthy economic growth. [25]
JC Economics Essay – Exchange Rates: Application & Analysis to S’pore Economy
Suggested Answer Part (a)
Requirements for ‘sustain healthy rates of economic growth’
Sustaining growth requires countries’ capacity for production to cope with growth in aggregate demand hence avoiding overheating/inflationary pressures that can slow down or even reverse the expansion.
Growth in aggregate demand/expenditure
Growth in potential output
(Use a diagram to make the requirements clearer)
Students can form different perspectives in their approach to this question.
Approach 1: Because of their unique economic characteristics, small and open economies should adopt policies which are distinct from those prevalent in large economies. They use exchange rate policy and much more of supply side policies in order to grow external demand and potential output. They also cannot afford to have continuous budget deficit, unlike the observed problem in large economies.
But, when come to economic downturns, these small economies should still adopt deficit budget as pump-priming method. The effectiveness is limited in reversing contraction but it buffers the economy against larger contraction.
Approach 1: Policies used by both groups of economies are essentially the same but because of the difference in the economic characteristics, there ought to be a difference in the emphasis placed on policy instruments.
When economies slow down, expansionary demand policies apply to both types of economies but in small and open economies these policies on their own are not sufficient to activate a recovery. Fiscal policy being less effective does not mean that they should not adopt deficit budget during recession. However, the monetary policy instrument to adopt to stimulate demand should be exchange rate depreciation instead of interest rate policy. To sustain continuous growth in aggregate demand during normal economic conditions, both types of economies should not rely on expansionary demand measures because sustainability of economic growth requires attention on the effectiveness of supply side policies (SSP)
Role of expansionary demand side policies (DSP) during economic downturns (eg: recession) For large economies, the large proportion of domestic demand over the overall aggregate demand makes these policies appropriate and effective to power up growth in aggregate demand. Governments may adopt these policies: 1. expansionary monetary policy (MP) and 2. expansionary fiscal policy (FP)
Students to explain and illustrate:
how during slack economic condition, by keeping interest rates low the central banks in large economies can sustain or raise domestic consumption and investment how sticking to deficit budget allows government spending to support domestic demand.
In the 2008-2009 economic slowdown, big economies have gone the full throttle in fiscal stimulus via government spending and interest rates have been kept very low. Just in August this year, when US government identified that the economy was slowing down it had announced ‘quantitative easing’ (expansion in money supply and letting domestic interest. rate stays at low level).
Should small and open economies adopt expansionary fiscal policy? Expansionary demand management will not enable these economies to recover from a slowdown but expansionary fiscal policy is still necessary to avoid excessive negative economic growth, to cushion SG from negative effects arising from recession. .Example; Singapore adopted counter cyclical deficit policy in 2009 and 2010 budgets to fight the recession.
However, the extent of the impact of expansionary fiscal policy is limited by small proportion of domestic demand over total demand small multiplier effect due to high marginal propensity to import (MPM).
Should small and open economies adopt expansionary monetary policy? Yes they should but because of the large importance of external demand, exchange rate is a more appropriate policy instrument compared to interest rate and money supply intervention. Singapore adopts ‘zero appreciation policy, hence allowing Singapore Dollar to depreciate during economic downturns in order to lower export prices overseas and stimulate demand.
How do the economies create aggregate demand during normal economic conditions Large economies can continue relying on domestic demand to power up economic growth but for small and open economies they need to look at ways of generating external demand. The key for the latter is through sharpening international competitiveness – by keeping prices stable and improving quality of production.
Keeping domestic inflation low is fundamental and in this respect again exchange rate policy is important because the high import content of production makes the strength of exchange rate a more potent factor to stabilize import prices and domestic cost levels.
Students can also argue that the openness of the domestic funds market to the entry and exit of foreign funds make it difficult for the central bank to influence domestic interest rate, for the purpose of influencing domestic demand.
Role of SSP
The significance of supply-side policies to boost productive capacity and to improve international competitiveness applies to both economies. They both need to grow productive capacity to be able to continue producing more goods and services with price stability. Emphasis on R & D for example is a critical factor for economic growth in both economies.
But, supply-side improvements to improve the country’s potential output are more crucial to small and open economies because of the labour constraints they face and the need to continue creating external demand through competitiveness.
Eg of SSP: (improving the efficiency, productivity and cost conditions – LRAS and SRAS) some examples of these which are implemented in Singapore, with a focus on how these measures improve potential output and the ability to attract external demand. Examples: training and wage policies, pro-competition policy.
JC Economics Exchange Rates Essay – Evaluation
Evaluation: Not apt to say SOE should adopt different policies because creating potential economic growth lies fundamentally in supply side conditions and this applies to both types of economies. But small and open economies need to use SSP more actively to deal with their resource constraints and to sharpen international competitiveness. The clear-cut distinctiveness is in the use of exchange rate policy as their MP approach, unlike the case in large economies which tend to adopt interest rate intervention.
Both economies adopt fiscal policy but the intensity as a fiscal stimulus differs. SOE uses EFP too but the orientation is more towards improving supply side. The budget is typically counter-cyclical but it functions to reduce the magnitude of fluctuations in AD rather than reversing it.
Marking Scheme of 25-mark, no–part essay:
L1: Narrates economic polices for economic growth without justifying how these are relevant small and open economies
L2: Appropriate economic policies for small and open economies are justified, basing them on the economic characteristics of these countries. Relevant answer but lacking in depth of explanation; Non-comparative, not elaborating on why relative importance between types of policies differs between the two groups of economies differs.
L3 lower: Use the economic characteristics of small and open economies to justify why the relative importance attached on policies they use differs from large economies. Few examples of policy measures given.
L3 higher: Well justified and well applied (examples used at many parts of answer as support of claims)
E1: Argues that small and open economies uses different policies/ adopt different orientation in policies but these claims are mostly unsubstantiated with economic characteristics of countries and examples of policies
E2: Uses the economic characteristics of countries as basis of arguments about how policies differ vary in orientation on how demand created
Remarks from our H2 Econs Essay tutor:
1. Are you able to sketch the diagram of AD-As? This diagram is most likely required by the exam this year.
2. What other evaluative comments can you offer? Are you able to reproduce for yourself, and then use it for subsequent essays for JC Econs exams and tests?
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