JC Economics Essay Worldwide Recession & Limitations of
Discretionary Expansionary Fiscal Policy Model Answers
In Macroeconomics, a discretionary fiscal policy constitute changes in government spending (G) and taxation (T) that need specific approval from Parliament. Examples include increases in spending on roads, bridges, indoor and outdoor stadiums, new airports, seaports and other public works.
It must be contrasted with automatic stabilizers are features of the structure of modern government budgets, particularly (progressive) income taxes and unemployment benefits (aka welfare spending), that act to dampen fluctuations in real Gross Domestic Product (GDP).
Question
(a) Explain the limited effectiveness of expansionary fiscal policy as a stimulus to the Singapore economy.[10]
The recent COVID-19 worldwide recession caused many governments around the world to re-think their use of fiscal policy in order to stimulate their countries to economic recovery.
(b) Assess alternative policies that might be adopted in managing the S’pore economy when faced with a worldwide recession. [15]
Limitations of Discretionary Expansionary Fiscal Policy for Singapore
Part (a)
Introduction:
FP is a policy to affect aggregate demand (AD) by altering the balance between government expenditure (G) and taxation (T). Government uses expansionary fiscal policy to stimulate the economy: increased government spending & / or cutting direct taxes to boost AD
Components of aggregate demand (AD) would be affected. There will be an increase in AD.
Example:
Explain how expansionary fiscal policy works: More government spending (G) →directly raises AD
Cutting corporate and personal income taxes → more investments and consumption → raises AD indirectly
Fiscal policy provides the initial injection, after which subsequent rounds of induced consumption results in further increases income through the multipler effect
*If the economy is below full employment: higher AD leads to higher output and employment thus raising economic growth → lowering demand deficient unemployment
The increase in AD will trigger off the multiplier effect which increase the national income (NY) by a multiple of the increase → the component of AD
N= k multiplied by (change in AD)
What would reduce the effectiveness of fiscal policy?
Limitations:
1. Crowding out effect (is this likely in SG?)
With a large FP needed to close the output gap, a budget deficit is required which results in → increased government borrowing
→ which raises interest rates.
Higher r:
i) Reduces consumption and investments and attracts hot money inflows
ii) Causes appreciation of the exchange rate →Px in foreign currency more expensive → DDx falls
→Pm relatively cheaper in domestic currency DDm rises
→Assuming M-L condition holds→leads to a reduction in net exports
The fall in → consumption, investment and net exports offsets the initially expansionary effects.
(Qn: is it necessary to look at external impacts?)
2. time lags (is this a strong answer?)
Due to extensive government bureaucracy and also social and political considerations, much time is required for a government to allocate and implement the spending and tax cuts.
By the time the policies take effect, the economy could have worsened further or even recovered on its own.
3. small multiplier value.
SG has high leakages, in particular high marginal propensities to save (MPS), due to high compulsory CPF savings. Also high marginal propensities to import (MPM), since no natural resources, high tendency to import.
So (MPW) = MPS +MPT +MPM
Then each subsequent round of induced consumption in the multiplier process is small leading to a smaller multiplier effect. As government spending typically forms a small part of AD, a small multiplier means that a very large budget deficit is required to close the deflationary/output gap. Hence fiscal policy will be very costly and not very effective.
4. high government debt. (is this valid for SG GOV?)
A government that needs to borrow to finance a budget deficit →this will raise the level of government debt. High debt levels mean that large amounts of future tax revenue is used to pay off such debts → thus resulting in less spending on social services and infrastructure development. Hence future welfare has to be sacrificed.
5. Small domestic market. (Explain why so for SG)
With a population of only about 5.8M, the household expenditure component of AD is small. Also more than 85% of local firms are SMEs, so
Singapore has a small multiplier due to the high leakages/withdrawals from the circular flow caused by the high marginal propensity to save (CPF) and import. Singapore has a large marginal propensity to save because she has a compulsory national saving scheme where individuals are mandated to save about 40% of the wage income for future social security purposes, like to finance housing, education, health care and retirement.
Singapore has a large marginal propensity to import because it is a small country with no natural resources and thus needs to import all its food, oil and all other raw materials.
Conclusion:
Therefore, the MPW for Singapore is high. This will result in a small k value for the multiplier which then limits the effectiveness of the use of EFP. The key limitations in the Singapore context is the small multiplier and the small domestic market size.
Alternative Macroeconomic Policies for Singapore for Worldwide Recession
Recognise the impact of a global recession on a country and identify the alternative policies that can be used to manage such a situation
A worldwide economic downturn results in
-falling income in a country’s exports markets
– thus reducing the demand for its exports -less / Unfavourable Balance of payments (BOP) In the long run.
– Fall in NX also cause significant fall in AD due to Spore large external sector -fall in NY; slower EG & ünN (Cyclical unN→ recession) SoL
Singapore economy has both long and short term goals. In order to achieve these goals, it is important to implement the right policies. As already explained in part 9a), EFP has limited effectiveness in achieving the goals due to Singapore’s small multiplier.
What other alternative policies?
1. Expansionary monetary policy.
(Qn: is this a good idea for SG?)
Expansionary monetary policy involves lower Interest rate – to boost domestic consumption and investment, hence raising AD. EMP is to manage the economy by lowering prevailing interest rates by increasing the supply of money. An increase in money supply from Ms1 to Ms2 results in a fall in interest rates from i₁ to i₂. This will decrease the cost of borrowing, Due to the lower interest rates, consumers are encouraged to save iess and therefore have more disposable income for spending. This will increase consumption:
Businesses will also start to invest as the cost of borrowing is lower now than before..
Through the multiplier effect, there should be a multiple increase in AD. An expansionary monetary policy will result in an increase in aggregate demand (AD). Effect of an expansionary MP, like the expansionary FP, is limited due to the small K.
Limitations of MP
Singapore manages its exchange rate and also does not employ capital controls since it is a financial hub.-Hence it is unable to control domestic interest rate and therefore cannot use of domestic monetary policy. (a price taker in the global economy)
Why? money supply increases for r to fall, causes outflow of foreign capital from SG – which nullify the effects of increasing MS
Increase in C & I: may not be sufficient to compensate for the fall in X. Business confidence/consumers spending are not solely dependent on interest & it may be interest inelastic (pessimism/poor ec outlook etc)
(Note, if choses this policy, likely ends up with L1+ only)
2. Exchange rate depreciation (lower S$)
A depreciation of the exchange rate – export prices relatively cheaper in terms of foreign currency (X more competitive) , which raises export Volume Increase DDX). It also raises import prices in domestic currency – causing domestic firms and households to switch from Imports to domestically produced goods. Assuming M-L holds : PEDx+PEDm> 1, TRX increase & TEM fall. This causes net exports and hence AD to rise (AD shifts right)
Limitations of ER policy (depreciation):
• As Singapore’s exports are made largely from Imported components a depreciation of the exchange rate has limited Impact on boosting exports and AD as the higher cost of imported inputs will drive up COP and decreasing SRAS which eventually offsets much of the initial gains in export competitiveness
World wide recession means that other countries are also facing recession, the fall in NY will mean that trading partners have less ability to buy our X even if the Px is relatively cheaper and so this may not lead to large increase In DDx and AD. If the increase in AD is smaller than the fall in SRAS➜ overall NY may not rise.
Other negative effects to using exchange rate policy:
1. When Singapore dollar is devalued, there will be a direct impact on the business confidence in Singapore as the dollar is a gauge for investors about the business outlook of the country. Therefore, business in and out of Singapore will slow down.
2. Along with the depreciation, Singapore may experience imported inflation and a rise in cost of living since Singapore is relatively small and most of the consumer goods or capital goods are imported.
3. The assumption that demand for both Imports and exports are elastic may not hold true in the real world. This will limit the effect of the exchange rate policy too.
3. Protectionism can be used to boost the country’s AD
(Qn: is this a good policy for SG?)
Protectionism reduces the price of imports, – thus causing domestic firms and households to switch from buying imports to domestically produced goods -thereby increasing AD
Limitations of Protectionism:
Protection is pointless given Singapore’s small domestic market. Also, as much of the goods that Singapore imports are not produce locally, so there will be limited expenditure switching.
(Note, if choses this policy, likely ends up with L1+ only)
Which policy is most appropriate?
Make a stand: Given that all forms of demand agement are unable to significantly raise AD, S’pore is left only with supply-side policies when faced with an economic downturn.
4. Supply side policies can be used to raise the country’s AS
How SS side policies work: productivity / & wages → lower COP. Supply side policies can be used to reduce production costs for all firms. This shifts the A& curve downwards in the short run thereby raising real output.
Singapore has typically responded by reducing wages either through CPF cuts or →through direct wage subsidies, as in the recent 2020 (or 2009) global financial crisis. Hage cuts provide the incentive for firms keep their workers. →This has enabled them to preserve their productive capacity so that they are better able to respond to rising demand when the global economy recovers Singapore has always rebounded quickly after a major recession, which is evidence of the effectiveness and usefulness of such supply side measures.
However the CPF cuts have disrupted many households’ housing and retirement plans, while the waqc subsidies were so costly that it required the Singapore government to dip into its past reserves, which was unprecedented.
Nevertheless, supply side measures are the only viable policy options available for Singapore to counter an economic downturn so they are inevitably the most appropriate; explain the use wage policy learnt earlier Jobs credit scheme below:
Explain how wage policy (Jobs credit scheme), might be a more appropriate policy in resolving the harmful effects of the recent global financial crisis in Singapore
i) How wage policy improve cyclical unemployment
To sustain jobs for Singaporeans, the Government Introduced a Job Credit Scheme that will encourage the businesses to preserve jobs in the downturn.
This is a temporary scheme to help companies through an exceptional downturn. Details of the scheme: Employers will receive 12% cash grant on the first $2,500 of each month’s wages for each employee on their CPF payroll. The Jobs Credit Is for one year, and employers will receive the Jobs Credit in four payments: March, June, September and December 2009.
For each payment, employers will receive Jobs Credits on the employees that are on their CPF payrolls at the start of the quarter in which the payment is made Tha wages paid to these employees in the previous quarter will be the qualifying wagas used to calculate the 12% cash credit that employers will receive. For example, for the first payment to be received at the end of March 2009, businesses will receive Jobs Credit on the employees that are on the payrolls.
In January 2009. The wages paid to these employees In October to December 2008 will be the qualifying wages used to calculate the 12% cash credit that employers will receive.
Anchoring on the AD / AS framework, this will result in a rightward shift of the SRAS due to the fall In unit COP given the wage subsidy. Jobs can be preserved as during the downturn and resolve cyclical unemployment.
Comments on appropriateness of the policy to tackle these harmful effects.
This is an appropriate policy targeted at resolving cyclical unemployment. As compared to one which provides a cash subsidy to the firm to tide over the difficult period, this specifically encourages preservation of jobs as the subsidy is on the CPF payrolls of the workers. In addition, as explained earlier, this approach is applicable to sectors beyond construction such as the finance and tourism sectors which are also severely hit by the crisis.
Conclusion:
Nevertheless, supply side measures are the only viable policy options available for Singapore to counter an economic downturn so they are Inevitably the most appropriate To have a more targeted approach and for effects to be more Immediate, one policy may not work well and It may need to be complemented with other policies such as the wage policy/MP…etc In the reality, there is no fast and easy solution to stimulate the economy. A country would have to weigh the pros and cons of the various policies and Judge its effectiveness according to the nature of the problem and the characteristic of the country’s economy.
Given SG’s reliance on X as main driver of growth and that X account for a large proportion of GDP, ER policy may be considered appropriate as it directly influences NX and boost EG.
JC Econs Essay Markers’ Comments:
1. Students are expected to first explain and justify the most harmful effects of the 2009 global financial crisis in Singapore.
2. Question requires at least 3 policies to manage these most harmful effects and evaluate the appropriateness of the policies, with exchangrate poitty as a compulsory one for discussion.
3. Students are required to conclude with a judgement on the most appropriate policies in managing the harmful effects of the recent global financial crisis in Singapore with the following consideration:
Effectiveness of the policies in resolving the most harmful effects in the SR and LR?
Is the policy consistent In achieving other macroeconomic goals?
Is the policy the most Important given alignment to how harmful the effects are?
Factual Check
2007-09 Financial Crisis (aka US Sub-Prime Mortgage crisis)
Between 2007 and 2009 the U.S. witnessed a series of banking failures that led to a prolonged recession. The financial crisis was the worst since the Great Depression and caused a significant increase in the federal budget deficit.
The collapse of the American housing market in 2006 and 2007 had a profound effect on the U.S. and global banking systems. Because many large financial institutions were heavily invested in mortgages, the bursting of the housing bubble led to a steep deterioration In bank balance sheets. Questions about bank solvency shook Investor confidence, particularly after the failures of Wall Street firms Bear Stearns and Lehman Brothers In 2008, and precipitated a government bailout of affected Institutions that fall.
However, while government intervention prevented the collapse of the banking system, it did little to restore economic growth, and the U.S. entered a deep recession in December 2007. Although the National Bureau of Economic Research has concluded that the recession ended in June 2009, recovery has been modest, with the American economy experiencing both low growth and high unemployment ever since.
The slow recovery has, in turn, placed significant pressure on the federal budget: low growth has reduced tax revenues while increasing claims on the government’s resources for measures such as unemployment insurance. Although its origins were American, the financial crisis has had worldwide effects, Economic globalization meant that many non-American Investors were heavily exposed to U.S. financial markets and, as such, the deterioration of those markets negatively impacted institutions and individuals abroad.