Download Term 2 Week 6 to 9 - Singapore A Level Notes

Contents Page
T2W6-9: Macroeconomic Aims, Issues and Policies Tutorial
T3W2 Lecture Essay Test
T3W3-7: Monetary Policy and Interconnectedness of Economic Problems and
Policies Tutorial
T3W8-9: Revision of Essay Writing Skills
Describe the appropriate measures the Singapore government can adopt to
deal with the recession.
Budget 2007
Explain the possible links between trade deficit and a budget deficit.
Explain what causes inflation.
Discuss why a high rate of inflation might have an adverse effect on output and
employment.
What are the advantages of a low rate of inflation?
Policies to control inflation
What is liquidity trap?
Using a diagram, explain what might cause a country’s exchange rate to
appreciate in a floating exchange rate system.
Explain how exchange rates are determined.
Discuss the extent to which problems are likely to result from an appreciation
of Singapore’s exchange rate.
Discuss how the Singapore government might use the concepts of price
elasticity of demand and income elasticity of demand to determine the impact
of a fall in exchange rates and a rise in worldwide incomes on the current
account of the Singapore balance of payments.
The government proposes to increase tax on petrol. Assess relevance of PED
and YED for success of proposal.
Policies to correct current account deficit
A government’s macroeconomic objectives are economic growth, low inflation,
full employment and healthy BOP. Consider some of the difficulties in its
attempts to meet them simultaneously.
A government’s macroeconomic objectives are economic growth, low inflation,
full employment and healthy BOP. Which of these aims do you consider most
significant for Singapore and why?
Discuss how a supplier of a product that is currently fashionable might use
concepts of PED, YED and CED in its price and output decisions.
Healthcare as a source of market failure
Large firms necessarily become monopolistic. Monopolies adopt practices that
are undesirable. Therefore, large firms should be regulated by governments.
Discuss whether there is any truth in this argument.
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6-7
8-11
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13-14
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22-23
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25-26
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27-28
29-30
31-32
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35-36
1
Term 2 Weeks 6 to 9
Macroeconomic Aims, Issues and Policies
Data Response Question 3
Ai)
Deficit. Must say deficit / surplus when asked to comment on government
budget, BOP, current account, BOT. [1m]
Possible decreasing. [1m]
ii)
Russia surplus vs. China deficit [1m]
Both budgets are moving towards a balanced budget [1m]
Bi)
Real GDP growth has been adjusted for inflation / at constant prices.
Nominal GDP growth is measured based on current prices.
ii)
Russia
C)
Brazil: falling surplus
1. Appreciation of currency (any 2)
Px more expensive in foreign currency + Pm cheaper in local currency 
Marshall Lerner condition  volume of exports decrease more than
proportionately + volume of imports increase by more than proportionately
 total revenue from exports decrease + total expenditure on imports
increase  BOT falls  current account surplus decreases
2. Increase in consumption and investment  firms need to import raw
materials and capital goods  total expenditure on imports increase 
current account surplus falls
3. Brazil inflation rate higher than China (if it is a major trading partner)  price
of exports increase + price of imports relatively cheaper  Marshall Lerner
condition  volume of exports decrease + Brazilians turn to Chinese goods
 total revenue from exports decrease + total expenditure on imports
increase  BOT falls  current account surplus decreases
4. Brazil: strong economic growth
- Extract 1: strong
- Table 2: GDP increasing at a falling rate = NY increase due to change in
income  increase demand for imports  if demand is income elastic eg.
luxury goods  increase in total expenditure on imports even more
significantly  BOT falls  current account surplus falls
5. Depreciation of Chinese yuan [extract 2: trading partner of China]
- Same elaboration as first point
2
D)
*Must state the indicators
Standard of living:
Material: real GDP per capita, income gap – Gini coefficient, type of spending –
budget balance (weak link)
Non-material: health – life expectancy and IMR, education – enrolment ratio,
negative externality eg. Pollution, average number of working hours
Data: real GDP increases for all 3 economies over period
However, population changes not taken into account. Cannot measure on
average per person – amount of goods / services consumed
Type of spending: extract 3: increase G to fuel household consumption 
increase NY
Income gap: Russia inflation rate projected to be high  affects COL  increase
Gini coefficient
E)
Unexpected decline in economic activity  fall in world income  fall in X (
fall in BOT) + fall in I (pessimism) and FDI  fall in AD ( fall in GPL *don’t focus
here because the benefits of this come later)  NY / N falls
China vs. Brazil
i)
Brazil: robust (C + I) – may offset fall in X
China: ‘slackening demand’ – due to China is tightening – contractionary
policy to deal with overheating – AD falls – C/I falls – coupled with fall in X
ii)
Brazil vs China: current account as % of GDP
China: 5% of GDP vs Brazil: 1% of GDP
iii)
China’s budget deficit decreasing – spending less
iv)
Chinese yuan depreciated (mitigate the effect fall in X) while Brazil
appreciated
Russia
- ‘shaken business confidence’ – C/I may decrease / increase more slowly
- Seems most dependent on trade – current account as % of GDP
- Rate of inflation highest, price of exports very expensive…
+ Selling important inputs / raw materials – demand is price inelastic
+ Russia adopts expansionary policy: increase G decrease T – increase AD –
increase NY – fuel growth
3
UCLES June 2007
4b) Discuss whether a budget deficit should be a cause for concern? [15m]
Budget deficit: revenue (includes tax revenue) < government spending
Issue 1: How it is financed
Yes: Depletes country’s reserves – persistent
If borrow from public – increase interest rate – C/I increases – AD falls – NY falls
If borrow from public – increase interest rate – ‘hot’ money inflow – currency
appreciates – price of X increases – crowds out X – fall in X
Issue 2: How it is spent
Yes: Finance war – no direct impact on SOL
Government bureaucracy + inefficiency – wastage – increased expenditure
No:
Merit goods – education and training, healthcare, r + d
Capital goods
Healthcare:
+ Macro: increase AS – increase NY
+ Micro: under-consumed if left to the free market
Issue 3: State of economy
Yes: Worry – economy near / at FE – demand-pull inflation – BOT fall
No:
If economy in a recession, need injection of G + decrease in T – multiplier –
increase NY
Keynes: increase G on public works = pump priming
Issue 4: Temporary vs persistent
Yes: Persistent
- Deplete reserves
- Loss of confidence – shows poor government – macroeconomic management –
I falls – NY falls
Issue 5: Deliberate policy to keep taxes low
No:
Low taxes – increase AD – increase in C/I
Low taxes – increase AS: keep / attract talent, FDI
4
Term 3 Week 2 Lecture Essay Test
1a) Intro:
Health (not equivalent to SOL)
- Attainment of 4 macro objectives
- Economic growth (actual + potential: whether it can sustain) – increase
SOL
1) Real GDP: 7.7% - value of all final goods / services
High for a DC, adjusted for inflation
Why it indicates health / why desirable:
- May be an increase in material SOL – able to buy more goods / services
Evaluation: economic performance – real GDP per head – GDP increase could be due to
increased labour productivity – data missing
2) Inflation: 2.1%
- 25 years, Singapore able to keep it below 3% but need to compare with other
countries
Why low inflation healthy: stimulates output – confidence – increase I, increase BOT
Concern: global prices increase – government’s efforts to keep inflation low may be
limited
3) Unemployment decrease to 1.6%
Why desirable
- Efficient use of resources - PPC
- Less potential loss of output
- Social unrest – loss of man hours – less output / I – loss of confidence
Evaluation: who the jobs went to / what jobs created
4) Budget surplus: government revenue > expenditure
Sign of a booming economy:
- Profits increase + incomes increase (progressive tax)  more tax revenue
- Buy more property – more property tax revenue
Conclusion: limitations
- BOP
*Gross fixed capital formation = I – future productive capacity
- Government expenditure on education
5
Term 3 Weeks 3 to 7
Monetary Policy and Interconnectedness of Economic Problems and Policies
November 01: Problems for the Japanese Economy
Ai)
1990s – slow down in economic growth – GDP increases at a slower rate
(positive)
1998 – recession – GDP decrease (negative growth) – 2.8%
ii)
Achieve BOP + low inflation
But growth slowed down, high unemployment
To attain low inflation – use contractionary policy – fall in Ad – fall in NY
(recession) – labour derived demand – workers retrenched – unemployment rate
increase
Phillips curve: contractionary policies to reduce inflation
Bi)
Yes:
Low interest rate – ‘hot’ money outflow – yen depreciates – price of exports fall
Low interest rate – cost of borrowing low – C/I increases – NY increases
No:
Demand: household, firms, government (interest rate dependent on demand
also)
Pessimism – less business activities – low C + low I by firms – decrease demand
for money – interest rate falls. Zero interest rate reflection of pessimism
Complex:
In a recession, GPL falls
Real interest rate = nominal interest rate – inflation rate = 0% - (-3%) = 3% savers gain
ii)
Incautious lending – bad debts (default) – less available to loan out – less supply
of loanable funds – increase interest rate – I falls – NY falls – pessimism
Bad debts – depositors may rush to get back money – massive withdrawal – run
on the bank – pessimism
iii)
MP ineffective in stimulating economy – proposed increase G
Money supply increase – interest rate falls – C/I increase – AD increase – N/ NY
increase
Japan in 1990s: liquidity trap (draw diagram seen in ‘What is liquidity trap’ notes)
– increase money supply – interest rate unchanged because opportunity cost of
holding cash balances (earn 0 interest) very low – pessimism – all that people
want to hold are cash balances – do not buy bonds – less funds available for I –
deters growth – no effect on AD – no effect on N / NY
*Use liquidity trap to evaluate effectiveness of MP / MEI
6
C)
Identify:
Explain:
Evaluate:
Identify:
Explain:
Evaluate:
Lower income taxes
Increased disposable income – increase C – increase AD – increase
NY / N
1) Effect of T unpredictable due to pessimism – zero interest –
save more
2) Size of k: likely small – huge MPS
Increase G on public works + gift vouchers
Increase AD – multiplier – increase NY / N
G may be a better option: direct injection
+ Vouchers: forced to spend – help people stay afloat
+ Increase G on public works – infrastructure – long term effect of
increased efficiency – increased AD
7
Term 3 Weeks 8 to 9: Revision of Essay Writing Skills
1a) Explain the likely effect of this change in GST on expenditure by consumers on
different types of goods. [10m]
GST (ad valorem) – goods and services tax – indirect tax – falls on firms – increase COP –
fall in SS
*Expenditure by consumers = revenue earned by firms = P x Q
Price
S1
S0
P1
P0
D
0
Quantity
Different types of goods
1) With price elastic demand
- Goods with many close substitutes eg. household products
- Luxury goods – can do without
Price
P0
P1
A
B
0
C
Q0
Q1
Quantity
Exports
- Expenditure by consumers falls: P increase – quantity demanded falls by more than
proportionately (can buy other substitutes / don’t buy) - % increase in P < % fall in
quantity demanded – total expenditure falls / total revenue of firms falls
TE0: A + B, TE1 = A + C: C<B: TE falls
2) With price inelastic demand
- Unique products – firm monopoly
- Necessities as a broad category eg. rice / food – cannot do without
8
Price
P0
P1
A
B
C
0 Q0
Q1
Quantity
Price increase – quantity demanded falls by less than proportionately - % increase in
P > % decrease in quantity demanded – total expenditure increase / total revenue by
firms increase
TE0 = A + B, TE1 = A + C: C > B – TE increase
b) Discuss whether the combined effect of the rise in incomes and the rise in GST is
likely to cause the quantities of different types of goods sold to rise or fall. [15m]
Income – YED: % change in quantity / % change in income
Normal goods: luxury / necessities; inferior goods
1) Inferior goods (normal supply-demand diagram)
GST – fall in supply – fall in quantity demanded
Income increase – demand falls – quantity falls
Combined effect – quantity falls
2) Luxury (normal supply-demand diagram)
Income increase – demand increase more than proportionately – huge shift
Likely that quantity can increase since income increased by 4.5% while GST increased by
2%
3) Necessities
GST – quantity demanded falls
Increase in income – demand increase less than proportionately – quantity demanded
increase
Effect on quantity indeterminate
Conclusion: 4.5% increase may not be for everyone, so predicted effects may not occur
9
3) With reference to examples, discuss whether there is a need to change the current
policies adopted by the Singapore government to deal with market failures caused by
externalities. [25m]
Market failure – failure of free market to allocate resources efficiently in order to
maximize society’s welfare: MSB = MSC: no one can be made better off without
someone else being worse off
Externalities: third party cost / benefit – not involved in production or consumption of
good – market failure
Market failure: [draw diagram and explain how externalities cause market failure]
Positive externalities: due to merit goods
Negative externalities:
- Production: factory
- Demerit goods
- Consumption: car usage – pollution and congestion
Policies to deal with negative externalities:
1) Tax per unit = MEC – increase COP for firm – reduce supply from MPC to MSC –
socially optimal level
Evaluate:
- Better than banning – production continues
- Incentive for firms to find ways to reduce pollution – pay less taxes
- Difficult to estimate MEC
- Demand may become price inelastic in the long run
- If demand for good price inelastic – higher tax incidence on consumers – firms
continue producing
2) Legislation – fine
3) Incentives to install anti-pollution equipment
4) Better urban planning – relocation to Jurong Island + greenery
5) Public education
6) Special case of car congestion: ERP, COE, affordable / efficient / integrated public
transport system, petrol tax, weekend cars, hybrid cars, car pooling, driving cars on
alternative days by legislation
*COE targets car ownership while ERP targets car usage
Suggested change in current policies: tradeable pollution permits
Policies to deal with positive externalities:
10
1) Subsidy per unit = MEB: subsidy on firm / consumer and at point of use: increase
demand from MPB to MSB – socially optimal level eg. subsidized school fees through
edusave
2) Public education / awareness
3) Free vaccinations
4) Compulsory education of primary level
5) Government provision up to pre-university level
(In-depth policy evaluation / suggestions found in ‘Healthcare as a source of market
failure’ notes)
11
Other questions / notes
Describe the appropriate measures the Singapore government can adopt to deal with
the recession. [25m]
Fall in X/I: externally induced
Solutions:
- Increase AD (immediate solutions) – FP, MP (limited role), exchange rate (short
term depreciation) eg. adopt neutral policy: 0% appreciation
- Increase AS (long term solutions – potential growth)
Budget 2007
Budgeted for a deficit but actually gained a budget surplus
Booming economy: company’s profits increase – corporate tax revenue increases +
property tax
GST revenue increase > decrease in tax revenue
Explain the possible links between trade deficit and a budget deficit. [10m]
BOT deficit – total expenditure on imports > total revenue from exports – government
uses contractionary demand mananagement to reduce imports – decrease G + increase
T – budget deficit reduced – fall in NY – fall in demand for import
Budget deficit – crowds out C/I – BOT deficit
Trade deficit (X-M) falls – NY falls – post-tax profits fall – corporate tax revenue falls –
budget deficit
Trade deficit (X-M) falls – NY falls – retrenched – income tax revenue falls – budget
deficit
12
Explain what causes inflation. [10m]
Inflation: persistent and sustained increase in GPL
Increase in AD: demand-pull inflation when near / at FE
*Shortage of inputs eg. raw materials, labour – cost of input increases – increase price
of goods / services
GPL
0
FE
Real national output
Factors
1)
Economy booming
Eg. China / Vietnam / 07 Singapore – real GDP growth 7.7%
High incomes – high consumption – increase demand for goods / services –
output cannot increase – price increase
2)
Optimism: increase C/I
3)
Increase X:
Depreciation of currency – dependent on PED: not for all countries eg. oilproducing countries
Comparative advantage
Trading partner’s boom
4)
Government actions:
Expansionary policies: increase G / decrease T – economy near / at FE – demandpull inflation
Printing money not backed by real growth – increase money supply – increase
interest rates – increase C/I – increase AD – near / at FE – demand-pull inflation
Some governments – excessive spending
Fall in AS – fall in COP: cost-push inflation
Factors
1)
Wage increase not matched by productivity increase due to strong / militant
trade unions eg. France – firms give in – increase COP – fall in AS – rise in GPL
(pass part of burden to consumers) – consumers = workers: demand for higher
wages to cope with rise in COL – firms give in… - spiral inflation
13
GPL
AS1
AS0
P1
P0
AD0
0
Real national output
2)
Imported cost-push inflation especially for Singapore: dependent on imported
raw materials
If foreign prices increase – increase COP – imported inflation
Current: increased price of crude oil
*Imported inflation – worldwide food shortages – increase COL
- Biofuel: alternative to crude oil
- Change in diet: affluence – eat less rice, more meat
- Industrialisation: less land for farming
- Natural disasters
3)
Increase in indirect taxes eg. GST in 07: from 5% to 7%
GST – falls on firm – COP increase – AS falls – GPL increase (part of price increase
passed to consumers)
14
Discuss why a high rate of inflation might have an adverse effect on output and
employment. [15m]
High inflation – price increase excessively – very unstable eg. double-digit
Internal:
1)
Price increase excessively – average households cannot afford basic necessities –
demand high wages – COP increase – AS falls: spirals out of hand – NY falls –
recession (extreme case)
2)
High inflation: uncertainty – affects firms – unable to forecast profits – deter I
plans – unwilling to take risks – fall in AD – NY falls - recession
3)
Discourages savings – value of savings falls – people switch to fixed assets eg.
property – lower savings (long run) – fall in I – affects long term growth
*Banks – due to uncertainty – less willing to extend long term loans to firms – fall
in I – affects long term growth
4)
Effect on FDI: high COP – deters FDI – reflects poor macroeconomic management
of government eg. Zimbabwe
External:
1)
Price increase excessively (inflation much higher than that of other countries) –
price of exports very expensive + price of imports relatively cheaper – volume of
exports fall + volume of imports increase – Marshall Lerner condition – total
revenue from exports fall + total expenditure on imports increase – BOT falls – XM component falls – NY/N falls
2)
Total revenue from exports fall + total expenditure on imports increase –
demand for country’s currency drops + demand for foreign currency increases
(increase in supply of country’s currency) – forex depreciates – speculators sell
currency – further depreciation – loss of confidence in economy – deters I
Evaluation:
However depreciation – price of exports decrease in foreign currency +
price of imports increase in local currency – volume of exports increase +
volume of imports decrease – Marshall Lerner condition – total revenue
from exports increase + total expenditure on imports decrease – BOT
recovers
Assume all trading partners have flexible exchange rates
15
What are the advantages of a low rate of inflation? [10m]
Price rises at a slow steady rate – certainty eg. Singapore past 25 years – 2 to 3%
Internal:
1)
Price increase due to high demand – stimulates output – increase I
(machines/plants) – increase AD – increase NY/N
*provided wage increase lags behind increase in productivity
*provided it is demand-pull inflation (ie. Increase in AD) – cost-push inflation
never desirable (fall in NY)
2)
Certainty – firms can forecast profits – increase I – increase long term growth
3)
FDI – lower COP + reflects good macroeconomic management by government
External:
1)
Price increase slow and steady (inflation lower than other countries)
Price of exports cheaper + price of imports more expensive – volume of exports
increase + volume of imports falls – Marshall Lerner condition – total revenue
from exports increase + total expenditure on imports falls – BOT improves –
increase NY/N
16
Policies to control inflation
Prescribe appropriate policy depending on the cause of inflation – policies usually
temporary
Causes:
Demand-pull inflation (overheating) – China, Vietnam (20%)
AD = C/I/X increase
Identify:
Explain:
Evaluate:
Contractionary FP
Decrease G + increase direct taxes to reduce C/I – decrease AD
1) G: size of k: if k is small, need huge decrease in G to effect a significant
fall in AD so as to achieve the desired objective of reducing inflation
2) Time lag: by the time contractionary policy takes effect, economy
could have gone into a recession on its own (due to some random factor)
– double whammy
3) G inflexible: education and training / healthcare – merit goods. Certain
projects cannot stop halfway.
4) Taxes: unpopular and unpredictable effect on C and I – C/I may not
decrease with increase T because people are optimistic – households:
better-paying jobs / increase in income + firms: anticipate higher C
5) Policy conflict: lower rate of economic growth (AD-AS diagram)
Phillips Curve: trade-off between inflation and employment
Inflation rate
0
Identify:
Explain:
Evaluate:
Level of unemployment
Contractionary MP
Decrease money supply – increase interest rates – fall in C/I – fall in AD –
fall in GPL
1) Size of k
2) Time lag: shorter because of shorter implementation lag
17
3) Unpredictable effect on C/I
Interest rate
P1
P0
Ie
Ii
0 I2
I1 I0
Quantity of investment
If demand for I is interest inelastic, I falls only from I0 to I1 – may not
achieve desired effect of controlling inflation due to optimism
MEI: expected rate of return > higher cost of borrowing
4) Increase in interest rates – ‘hot’ money inflow – if exchange rate
appreciates
Price of exports rise in foreign currency – volume of X falls – AD falls –
GPL falls
Price of imports falls in local currency (*only put in terms of which
currency if talking about exchange rate) – if dependent on imported raw
materials – COP falls – check imported cost-push inflation
Cause:
Cost-push inflation (draw AD-AS diagram)
1) Wage-push inflation: militant trade nuions – incessant increase in
wages not matched by productivity increase
2) Imported: increasing crude oil prices, worldwide food shortages
3) Sg: increase indirect tax – GST / VAT
4) Profiteering firms
Identify:
Explain:
Reduce power of trade unions
Sg: NTUC: harmonious tripartite relations in wage negotiations – no
labour interest
*National Wage Council: wage recommendation: wage increase <
productivity increase – output per man hour – GDP growth as a gauge
08 NWC recommended: 1-time inflation bonus - $300 vs. permanent
wage increase – spiral inflation
Identify:
Explain:
Evaluate:
Gradual and modest appreciation of S$
Price of imports falls in S$ - COP falls – check imported inflation
- Price of exports increase in foreign currency: may affect short term
export price competitiveness – BOT may worsen if demand is price elastic
18
- Appreciation can only mitigate / alleviate, but cannot solve – too large
and appreciation is detrimental to Singapore’s economy
Cause:
Identify:
Explain:
Increase in GST – fall in AS – cost-push inflation
Food coupons / exemptions
Food coupons: help lower income deal with rise in COL
Exempt some goods from GST – necessities – food / transport / medicine
– GPL may not rise as significantly
Identify:
Deregulation: break up monopolies / collusive oligopolies
Conclusion:
Identify:
Explain:
Best long term measure: supply-side policy
Education and training, r+d, tax incentives, reduce welfare benefits
Increase productivity – increase AS
- Potential growth – NY increases
- Maintains price stability: GPL falls – price of exports fall – demand for
exports price elastic – BOT rises – NY increases
- Takes time
- May not yield results
Evaluate:
Comparing use of contractionary policies with supply-side policies
Contractionary policies:
- Policy conflict
- Lower rate of economic growth, employment rate falls
+ Reduce inflation
Supply-side policies:
+ No policy conflict: price stability, potential growth, BOT increases
Generic question: demand-pull inflation  FP and MP, exchange rate, the rest
Singapore question: exchange rate, NWC, demand-pull inflation, the rest
19
What is liquidity trap? (Keynesian explanation)
*Draw this
Interest rate
MS: perfectly inelastic: can be determined by Central Bank
MS1
MS2
MS3
LP: liquidity preference
0
Liquidity
Quantity of money
trap
*Don’t need to write this because liquidity trap is not in the syllabus
Liquidity trap eg. Japan in 1990s for 10 years: demand for money perfectly interest
elastic – all that people want to hold is money (cash balances) – do not buy bonds – less
loanable funds available – totally averse to risk due to pessimism
Keynes: money (no interest), bonds (pay interest)
Government increase money supply from MS0 to MS1: interest rate falls – C/I falls – NY
increases (achieve growth)
*Write this for evaluation only
Implication for economy when at liquidity trap
Expansionary MP to lower interest rates ineffective
Reason: Increase in money supply from MS2 to MS3 – interest rate does not change
Why? People totally risk averse – all they want to hold is money (cash balances) ie. They
do not buy bonds (do not lend out the money)
20
Using a diagram, explain what might cause a country’s exchange rate to appreciate in a
floating exchange rate system. [10m]
Basket of currencies: currency of major trading partners
Intro: Price of country’s currency vis-à-vis to other countries
Floating – determined by market forces of demand and supply of currency
Appreciation of currency (eg. Singapore)
Before: 1S$ = US$0.60
After: 1S$ = US0.70
Development: In turn determined by trade and investment between the countries
1)
Trade
- Boom in trading partners’ economy: increase NY – increase demand for
Singapore’s goods – if YED > 1: quality services: luxury goods: medicine,
education, tourism – very significant rise in total revenue for Singapore –
increased demand for S$ - S$ appreciates
- Lower inflation rate in Singapore relative to trading partners – price of exports
drops + price of import relatively more expensive – Marshall Lerner condition –
volume of exports increase + volume of imports decrease – total revenue from
exports increase + total expenditure on imports decrease – demand for
S$ increase + supply of S$ decrease – S$ appreciates
US$/S$: US$ per S$
S1
0.90
S0
0.70
0.60
D1
D0
0
Quantity of S$
- Country has comparative advantage in goods
Eg. China – labour-intensive products – cheap + unskilled labour – increase
demand for Chinese goods – increase total revenue for China – yuan appreciates
2)
Investment – portfolio + physical / direct by firms
- Increase interest rate – ‘hot’ money inflow – increased demand for country’s
currency – exchange rate appreciates
- Speculators expect further appreciation – buy currency – further appreciation
- Huge domestic market, cheap labour – increase MNCs in China – increased
demand for yuan – yuan appreciates
21
Explain how exchange rates are determined. [10m]
Intro: Exchange rate
Flexible / free floating – market forces – trade and investment
But government can also intervene
Fixed: pegged to another country’s currency (eg. to US$: China before 06)
Managed float: allow fluctuations but within a target band (eg. China after 06,
Singapore)
Development:
1)
Flexible – any 3 from previous question
2)
Fixed – increase demand for Chinese yuan – value of yuan likely to increase – to
keep it fixed: Chinese government increases supply of yuan – sell yuan = buy
foreign dollars
US$/yuan
S1
S0
0.30
D1
D0
0
3)
Quantity of yuan
Managed float - Singapore
Foreign currency / S$
S
target
band
D1
0
D
Quantity of S$
US recession – fall in X
22
Eg. reduce demand for S$ - S$ depreciating beneath the band – to bring back
within band – increase demand for S$ - buy S$ = sell foreign $ - foreign exchange
reserves
23
Discuss the extent to which problems are likely to result from an appreciation of
Singapore’s exchange rate. [15m]
Intro: Singapore small: no natural resources: very dependent on import of raw material
+ open: small domestic market: very dependent on export revenue: 3 times of
GDP
Appreciation: Before: 1S$ = US$0.60, After: 1S$ = US0.70
Basic development:
Appreciation of S$ - price of export increase in foreign currency + price of import
decrease in local currency – Marshall Lerner condition – volume of exports drop more
than proportionately + volume of imports increase more than proportionately – total
revenue from exports drop + total revenue from imports increase – (X-M) (services:
tourism / education / medicine) drops – BOT drops – AD falls – fall in NY / employment –
fall in GPL (reduce demand-pull inflation)
Price of import decreases in local currency – fall in COP / fall in price of raw materials
(reduce cost-push inflation) – increase AS – fall in price of exports in long run – if
demand for exports price elastic – BOT improves – NY / N increases
*Effect depends on extent of appreciation – Singapore government recognizes conflict
in policy objectives – while imported inflation lowered but short term export price
competitiveness affected – MAS stand: gradual and modest appreciation of S$
Complex development:
Capital account: portfolio + direct
Direct – FDI
- MNCs planning to invest in Singapore postpone plans – home currency converted to
less S$ - but MNCs decisions dependent on host of factors – huge domestic market,
efficient infrastructure, human capital
- MNCs already in Singapore – goods they produce (price of exports increase) less
competitive but in the long run may be able to buy imports more cheaply to decrease
COP
+ However appreciation can be a sign of a booming economy and increasing prospects.
MNCs may decide to come after all.
Conclusion: Speculators expect further appreciation – buy more S$ - cause S$ to
appreciate further. Bu too huge an appreciation is not what the government wants.
24
Discuss how the Singapore government might use the concepts of price elasticity of
demand and income elasticity of demand to determine the impact of a fall in exchange
rates and a rise in worldwide incomes on the current account of the Singapore balance
of payments. [25m]
Intro: Definition
Current account: visible: export and import of goods and services + invisible:
income from I
A) Fall in exchange rates
Scenario 1: In a case where demand for export and import both price elastic / a case
which fulfills Marshall Lerner condition
Price of exports falls in foreign currency + price of imports rises in S$ - Marshall Lerner
condition – volume of exports increase more than proportionately + volume of imports
decrease more than proportionately – total revenue from exports increase + total
expenditure on imports decrease – (X-M) increase – BOT increase – current account
improves
Reason: demand for Singapore’s exports elastic – many close substitutes
Price
P0
P1
A
B
0
C
Q0
Q1
Exports
Quantity
Scenario 2: Import price inelastic
Reason: no natural resources / no raw materials – price of imports increase in S$ volume of imports fall less than proportionately – total expenditure on imports increase
– total effect on current account C > B
Price
P0
A
P1
B
0
C
Q0
Q1
Quantity
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Scenario 3: In theory, J-curve in short run, demand for X and M both price inelastic –
take time to adjust (contractual obligations, take time to find alternative suppliers) –
current account worsens in the short run because inelastic demand
Current account
inelastic
elastic
Time
Scenario 4: In long run, Singapore very dependent on imported raw materials
Price of imports increase in S$ - COP increase – later: price of exports increase – demand
price elastic – total revenue from exports falls – current account deteriorates
So J-curve effect may not apply to Singapore
B) Increase in worldwide incomes
Normal: Luxury goods + necessities eg. integrated circuits /disk drives: inputs for luxury
goods (MP3, laptops): world affluence – demand for luxury goods income elastic –
increase more than proportionately – total revenue increase very significantly
Inferior goods
Eg. oil rigs: world affluence – demand more products – need to produce more goods –
increase demand for oil rigs to refine oil
Increase in worldwide incomes – increase demand for luxury goods and quality services
– Singapore: services: tourism, education, medical hub – Singapore government
recognizes this and augments comparative advantage in high value-added knowledgeintensive, technologically-intensive, service-oriented – total revenue for Singapore
increases
Evaluation:
- Face competition from other countries – they also develop comparative
advantage in these areas
- May lose out to Korea eg. cosmetic surgery
- Worldwide income increase, Singapore increase – may spend more on
imports – current account may suffer
Conclusion:
- Values only estimates
- Ceteris paribus – real world – many things change at the same time
26
The government proposes to increase tax on petrol. Assess relevance of PED and YED
for success of proposal. [15m]
Objectives: correct market failure: road congestion + increase tax revenue
PED: directly relevant
Tax on petrol – COP increase – supply decrease vertically upwards by amount of specific
tax – price of petrol increase (draw diagram to show shift in supply)
Demand for petrol price inelastic – no close substitutes
YED: not directly relevant because tax on petrol affects price
YED: changes on income
Government likely to be less successful if they increase tax on petrol in period of
economic boom
Boom: incomes rise – demand for cars (luxury good) – increase by more than
proportionately – derived demand – increase demand for petrol
Policies to correct current account deficit
Causes: total revenue from exports < total expenditure on imports
1) Rise in national income of the country
2) Lack of comparative advantage eg. USA
3) No domestic substitutes – low productive capacity – USA
4) Exchange rate strengthened
5) Higher relative inflation rate
Identify:
Explain:
Evaluate:
Identify:
Explain:
Evaluate:
Contractionary policies
FP: increase T decrease G – decrease AD – NY falls – demand for imports
fall – total expenditure on imports fall significantly especially if demand
income elastic
MP: increase interest rate – increase AD – GPL fall – price of exports fall –
demand for exports price elastic – total revenue from exports increase
- Repercussion: lower rate of economic growth thus useful when inflation
is cause of deficit because economy possibly overheating
Expenditure-switching policies
1) Devaluation – fixed exchange rate or devaluation – managed float
2) Tariff / quota
3) Subsidies to export firms
2) Price of imports increase – volume of imports decrease – total
expenditure on imports fall
3) Lower COP – lower price of exports – PED > 1 – total revenue from
exports increase
1) PED > 1
J-curve effect (short run)
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Countries small and open and dependent on raw materials – COP
increase – BOT falls in long run
2) Retaliation
Society: deadweight loss
Consumer: price increase
Encourages inefficiency
Other firms may face increase COP if import is raw materials
3) Burden on government finances and taxpayers
Encourages inefficiency unless subsidy on r+d, education and training
Retaliation
Allow firms to develop new technology / reap EOS
Identify:
Explain:
Supply-side policies (long term policy)
Education and training, r+d, incomes policy, increase export through FTAs
and trade mission
R+d – lower AC + better quality products to make demand price inelastic
Incomes policy – increase productivity – increase AS – lower GPL (citizens
buy cheaper home products – total expenditure on imports falls) – price
of export falls – PED > 1 – total revenue from exports fall
28
A government’s macroeconomic objectives are economic growth, low inflation, full
employment and healthy BOP. Consider some of the difficulties in its attempts to meet
them simultaneously. [25m]
Objective 1: Pursuit of economic growth (draw in AD/AS diagram)
i) Expansionary FP / MP (increase G, decrease T, decrease interest rate) – increase AD –
near / at FE – demand pull inflation – if excessive – price of exports increase, price of
imports fall – Marshall Lerner condition – BOT falls
Increase AD – increase NY – achieve growth – demand for imports increase – especially
if do not produce much at home – BOT deficit
ii) Increase in G financed by borrowing from public – increased increase rate – external
crowding out – exchange rate appreciation (secondary effect) – price of exports increase
in foreign currency + price of imports decrease in local currency – Marshall Lerner
condition – BOT falls
iii) If country pursues long term growth through restructuring and developing of
comparative advantage in new industries – structural unemployment – displaced
workers in sunset industries do not have skills for new industries
Objective 2: Low inflation rate
i) To reduce demand-pull inflation, use contractionary policies (decrease G, increase T,
increase interest rate) – decrease AD (NY/N falls) – decrease GPL – inflation controlled
Phillips curve (not necessary). Can just refer to previously drawn AD-AS diagram
Singapore’s case
ii) If Singapore – low inflation – gradual and modest appreciation – price of imports in
S$ falls – check imported inflation
But price of exports in foreign currency increases – PED>1 – BOT falls in short run
Objective 3: Healthy BOP
- If country faces a BOT deficit
i) Contractionary policy – decrease AD (fall in NY [decrease demand for imports to
correct deficit] and N)
ii) Devaluation (fixed exchange rate) – price of exports fall in foreign currency + price of
imports increase in local currency – BOT deficit corrected
Difficulties:
- If dependent on imported raw materials – imported cost-push inflation
- Possible demand-pull inflation
- Persistent devaluation – loss of confidence – deters I – fall in NY/N
iii) Tariff: inflation + jobs lost
Objective 4: Achieving full employment (can integrate with objective 1)
29
Rather similar to objective 1. Economic growth creates jobs.
i) Recession: reduce cyclical unemployment – expansionary policies – underestimate the
size of k – possible demand-pull inflation – BOT falls
ii) Tariffs to protect jobs in industries that have lost comparative advantage to other
countries eg. USA tariff on Chinese textiles
If tariff is on input (eg. steel / textile) – increase COP for domestic firms – imported costpush inflation
If tariff on US firms in China – less profits repatriated – fall capital account – BOP deficit
Conclusion:
Supply-side policies: no difficulty
Increase AS – price stability – PED > 1 – BOT improves
Increase AS – potential growth – increase N and decrease structural unemployment
30
A government’s macroeconomic objectives are economic growth, low inflation, full
employment and healthy BOP. Which of these aims do you consider most significant for
Singapore and why? [25m]
Intro: ultimate objective: increase SOL  sustainable economic growth  low inflation:
one of the keys to achieve sustainable growth
Opinion: low inflation most significant aim generally, especially for Singapore
Development:
A) Why low inflation (choose 2)
Approach A: low inflation desirable
External: BOP surplus
Internal:
i) Price increase – firms increase output – higher profits (if wage lags behind productivity)
– increase I – NY/ N increase (provided it is demand-pull inflation)
ii) Ability to forecast profits – increase I – NY / N increase
ii) Value of savings less – more willing to save – more loanable funds – lower interest
rate – increase I – NY / N increase
iv) Confidence in government management of economy – increase I – NY/N increase
v) Low inflation – lower COP – attracts I / FDI
Summation: I – increase AD / increase AS – actual + potential growth
Approach B: excessive inflation undesirable
External: BOP deficit if inflation higher than other countries – BOT falls – NY/N falls
Internal: the reverse of all discussed in approach A
i) I falls
If inflation due to cost-push inflation – COP increase – AS falls – GPL increase – workers
ask for wage increase to meet rising COL – firms give in – spiral inflation – NY falls (draw
AD-AS diagram)
Apply to Singapore:
- Singapore’s dependence on imported raw materials makes it all the more important
for the control of inflation as primary prerogative – fear of increase foreign prices:
today’s context: crude oil, worldwide food shortages
- Efforts to keep wages competitive (incomes policy) – NWC/ NTUC: wage increase <
productivity increase – control wage-push inflation because very vulnerable to it due to
tight labour market
Summation: low inflation – increase output, confidence, exports
B) Why not the others?
31
If economic growth most significant aim – keep increasing AD – demand-pull inflation, if
excessive…
Evaluation: for potential growth use of supply-side measures – increase AS – price
stability – low inflation important
If BOP most significant aim – demand-pull inflation – strain on domestic production
Apply to Singapore:
Willing to compromise short term export competitiveness (affect BOT) to control
imported cost-push inflation – long term growth
Why not full employment as most significant aim – cyclical unemployment often beyond
our control – usually due to trading partners
Safest bet: reduce cyclical unemployment – able to maintain low and competitive prices
Conclusion:
However, certain circumstances: 01 recession. Most significant aim is economic growth
– even allow for depreciation of S$ - main objective to increase X in short term –
improve BOT – increase NY to mitigate recession
32
Discuss how a supplier of a product that is currently fashionable might use concepts of
PED, YED and CED in its price and output decisions. [15m]
Currently fashionable eg. MP3 player (many close substitutes)
PED: demand price elastic
Pricing strategy: lower price – quantity demanded increase more than proportionately –
total revenue increase (include diagram)
Output strategy: mass production – reap EOS to reduce AC + increase supply – lower
price
YED: % change in quantity / % change in income
Luxury goods eg. sports car
Boom: income increase – demand increase more than proportionately – huge shift in
demand curve (include diagram)
Output strategy: increase stock
Launch high-end models / limited edition (niche market)
Cater different ranges of products to all income groups
*Complex: price strategy: increase demand – increase price; many rivals – decrease
price
CED: % change in quantity of good A / % change in price of good B
Good B can be a substitute: if Samsung decreases price of MP3 player – close substitutes
– CED > 1 – your firm: demand falls more than proportionately – market share falls
Good B can be a complement: if price of downloading songs falls – demand for MP3
increases
Your firm:
Pricing strategy: lower price – price war – does not benefit anyone – non-pricing:
advertising and promotion, others – differentiate product – make demand price inelastic
OR if market is oligopoly – may collude
*Complex: Apple IPOD is a market leader – demand price inelastic so may increase price,
CED: less fear of rivals, YED same strategies
Conclusion:
Values – limitations
- Estimates
- Ceteris paribus: if firm reduces price – expects quantity demanded to increase more
than proportionately but there are other factors involved:
- Switch in taste and preference – another firm launches a better quality product
- Consumers associate fall in price with drop in quality
- Recession
- Product cycle
- Need to look at PED / YED / CED trends and taste and preferences together
33
Healthcare as a source of market failure
1) Positive externality: under-consume leads to under-production
Subsidies – UK vs Singapore
UK: Heavy burden on taxpayers, abuse / overcrowdedness / long waiting list / poor
quality
Singapore: 3M framework: Medisave (individual CPF), Medishield (insurance), Medifund
(government help for the needy) – individual responsibility and government help when
necessary
Evaluation:
Singapore – more help for needy / lower-income group
Individual responsibility ensures users do not abuse the system and more willing to take
care of their health
Increase in medical cost very significant
2) Related to point 1: inequity: lower-income group cannot afford
Means testing: subsidise more for the lower-income group. Singapore can really
implement it
3) Possible monopoly / oligopoly: large MES – huge sunk cost (equipment) [draw
diagram]
High price – possible collusion – allow more competition – coexistence of private and
public sector
China: public monopoly – complacent + bureaucratic – needs regulation
4) Imperfect information because doctor has monopoly power over his specialized
knowledge
Greater transparency: detailed list of cost – consultation fees / surgery / medicine,
hospitals publish surgery charges
Reduce imperfect information and monopoly power
34
Large firms necessarily become monopolistic. Monopolies adopt practices that are
undesirable. Therefore, large firms should be regulated by governments. Discuss
whether there is any truth in this argument. [25m]
*Three parts to the question. Must respond to all three but in varying degrees of
importance.
A) Large firms  monopolistic [one paragraph]
Firms become large due to high demand – increase in total revenue / mergers and
acquisitions – internal EOS (any 2 types) – reduce AC (able to block new entrants:
natural BTE) – able to reduce price – demand price elastic – increase total revenue –
increase profits – ploughed into r+d and advertising and promotions – better technology
(further reduce average cost) + better quality products to make demand more price
inelastic – increase market share – monopolistic since have the ability to set price –
price setters
B) Practice: price setters – monopolies restrict output to increase price
Undesirable:
1) Allocative inefficiency: price > marginal cost vs perfect competition industry
Draw in diagram: underconsumption – need for regulation
2) X-inefficiency
Complacency – lax in cost practice – able to pass any cost increase to consumers –
demand price inelastic – need regulation
However, government, instead of regulating
i) Make market more contestable – significantly reducing BTE eg. airlines – more
licensees
ii) Allow more competition such as foreign competition – big foreign conglomerates –
domestic monopoly forced to be cost-efficient
3) Price discrimination
- 1st degree: zero consumer surplus. But very few industries in the world – need
regulation
Desirable:
1) Price discrimination in some cases can be beneficial
3rd degree: price elastic vs price inelastic due to smaller proportion of income – can
charge higher price
Eg. movie tickets, bus fares
Loss-making monopoly due to low demand – bus service in a remote town – practise
price discrimination in order to continue: shut down and all lose service vs. keep service
intact with price discrimination
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2) Where the monopoly enjoys substantial EOS, able to pass cost savings to consumers
But there is no guarantee of monopoly charging at lower price Pm – need to regulate to
MC or make market more contestable
P/R/C
MCpc
MCm
Pc
Pm
MR
0
Qc
Qm
AR
Quantity
OR can say that Qm > Qc (socially optimal level) so it can be detrimental
3) Dynamic efficiency: ability to plough supernormal profits to r+d
But monopoly less likely than competitive oligopoly in investing in r+d – regulate
through antitrust / competition
Conclusion: certain undesirable practices
Regulate:
- Antitrust, lump sum tax, MC pricing: mention
- But better to allow more competitive – deregulation of industry
36