Course: Bachelor of Business Studies (BBS)
Module: FIN2001S Economic Policy and the Global Environment
Assignment Title: Discuss the Policies Which A Government Can Implement to Achieve Long-Term Economic Growth and Macroeconomic Stability in The Short-Run
Submitted by: Merritt Chua Jaan-E
Student Number: 17210480
Lecturer: Rodney Sim
Submisson Date: 20 May 2018
Word Count: 1575 words
Introduction (136 words)
Macroeconomic stability safeguards against currency and interest rate instabilities in the international market. Various factors for consideration are, rate of economic growth, inflation and employment rates and the health of its balance of payments (BOP). The economy’s real Gross Domestic Product (GDP) is used to measure economic growth.
Real GDP is calculated by:
Real GDP = (Nominal GDP/ GDP Deflator) x100
In macroeconomic studies, the AD/AS model represents the economy, where
Aggregate Demand (AD) is:
AD= Consumer (C) + Investments (I) + Government consumption and Gross investment (G) + Net exports (X-M)
As AD reflects the total expenditure in goods and services (G&S) it is equal to the output of final G&S otherwise known as Nominal GDP. Whereas, Aggregate Supply (AS) reflects the overall output of G&S produced within an economy at a given price level.
Long-Term Economic Growth (54 words)
Sustainable, long-term economic growth consists of both real and potential economic growth. To ensure growth while managing inflation, Demand (dd) and Supply (ss) side policies must be executed to complement each other. Policies that shift AD are known as dd-side policies, namely fiscal, monetary and exchange rate policies, while ss-side policies shift the AS.
Monetary Policy to shift AD- What is Monetary Policy? (62 words)
Implementing Monetary Policy (MP) is one way to increase AD. MP refers to the way a government controls the supply of money to consumers and businesses, to ensure the prices of G&S continue to remain stable while achieving economic development (Williams, 2015). Examples include controlling interest rates or influencing the exchange rate of an economy’s currency, in order to control money supply.
Monetary Policy to shift AD- When is it applied? (86 words)
This policy is implemented when AD is below optimal level at AD 2, resulting in under-utilization of an economy’s full potential as seen in Figure 1. This usually happens during a worldwide recession which reduces consumer confidence, causing the components of AD to fall resulting in slow or negative growth in real GDP. Effective MP will be able to shift the AD to AD1 from AD 2, resulting in a more than proportional increase in real GDP as compared to increase in Prices (PL) or inflation.
Monetary Policy to shift AD- Case Studies (173 words)
Examples of expansionary MP would be lowering of interest rates or increasing the rate of money supply in an economy. An example where both policies were implemented to complement each other was in 2009 when the Bank of England lowered its interest rates by 90%, in order to boost bank lending (BBC News, 2009). The Bank of England also concurrently increased money supply within the economy by £150Bn, through Quantitative Easing (QE), by purchasing assets such as corporate bonds and government securities.
By lowering interest rates, the government aims to make borrowing more affordable to encourage consumers to borrow in order spend more on big ticket items to increase (C). Simultaneously, it also lowers the incentive to save as savings will yield less returns. Subsequently, firms will find it more attractive to borrow from banks to make more investments in the economy, increasing (I).
Hence, the increase in these factors will contribute to an increase in AD, allowing the economy to better utilize its potential and benefit from an increase in real GDP.
Limitations of Monetary Policy on AD (67 words)
However, existing consumer confidence and other components of AD could limit the effectiveness of the above-mentioned MP.
If consumer confidence remains low, consumers and investors may still be deterred from borrowing limiting the benefits of lower interest rates.
Next, if other components of AD such as (X-M) are severely affected during a recession, the increase in (C) and (I) might be insufficient in boosting the economy’s AD.
Supply Policies to shift AS- What are ss-side policies? (126 words)
Ss-side policies aim to develop the quality and quantity of resources in an economy. Thereby, increasing the productive capacity of an economy. This is illustrated as a rightward shift in Long Run Aggregate Supply (LRAS) from LRAS1 to LRAS2 as seen in Figure 2.
2 main types of supply side policies are:
1. Interventionist SS-side policies – Comprises of government intervention to deal with market failure. (E.g. government funding of educational institutions to improve labour productivity or funding to improve public infrastructure to attract Foreign Direct Investments (FDI).)
2. Free-market SS-side policies – Involves the use of policies that increase competition and competitiveness to encourage efficiency and prevent complacency. (E.g. reduction of welfare benefits to increase incentive to work and deregulation to introduce monopolies to competition.)
Supply Policies to shift AS- When is it applied? (82 words)
SS policies are planned for and put in place whenever the government foresees the economy’s potential will be maxed out. Without a rightward shift in LRAS and assuming AD rises from AD4, we can observe from Figure 2 that stagflation ensues, causing macroeconomic instability. Therefore SS-side policies are implemented to sustain non-inflationary economic growth.
If LRAS shifts right assuming AD is at AD4, we observe that real national income rises from YFE1 to YFE2 with prices/ inflation falling, from P3 to P2.
Figure 2- Rightward shift in AS curve
Supply Policies to shift AS- Case Study on Interventionist ss-side policy (91 words)
After the 2007 Financial Crisis, Singapore Government’s 2010 National Budget emphasized strongly on improving the quality and adaptability of her labour force.
Fiscal policies aimed at boosting productivity were implemented in the form of training subsidies, tax benefits and grants, costing the government $1.1Bn a year (Singapore Budget, 2010).
It seeks to fund the upgrade of Singapore’s workforce in order to keep up with current skill demands. This increases production output, given existing resources. This is a form of interventionist ss-side policy that will help LRAS to experience a rightwards shift.
Supply Policies to shift AS- Case Study on Free Market ss-side policy (136 words)
Singapore also practices Free-Market oriented ss-side policies.
Firstly, Singapore boasts one of the lowest corporate tax rate of 17% (Inland Revenue Authority of Singapore, 2018) and even offers partial or full tax exemption schemes for new start-up companies. This increases the net profit of a company and encourages global companies to set up operations within Singapore.
Secondly, Singapore has signed over 21 Free Trade Agreements (FTA) with 32 trading partners worldwide (Enterprise Singapore, 2018). By lowering trade barriers, companies operating from Singapore save in import duties and benefit from increased export quotas (enterprise Singapore, 2018).
With more businesses set up, unemployment rates will fall and Singapore could benefit from technology transfer from Muti-National Corporations (MNCs). Therefore, the AS of an economy will shift rightwards due to better utilization of the workforce and improved methods of production.
Supply Policies to achieve long run economic growth- Limitations (107 words)
However, interventionist ss-policies are expensive to implement and unlikely to produce quick results. Therefore, governments must consider the health of its reserves and the severity of the current situation to decide the policies’ effectiveness on the economy.
As for free-market ss-side policies, productivity growth largely depends on the decisions of private enterprises to invest in a given economy. Other factors such as political stability and fairness of business regulations also play a big role in shaping investors’ decision to invest. Therefore, these factors must be considered before implementing free-market ss-side policies.
Lastly, ss-policies are unable to improve the economic situation if AD is too low (eg. AD1).
Macroeconomic stability in the short-run- What causes instability and how? (97 words)
To understand how to achieve macroeconomic stability, we first identify causes of macroeconomic instability in the short run. Events that can lead to immediate instabilities are:
Natural disasters/ War- If supplies from major exporters are abruptly disrupted from destruction, prices of affected commodities will increase sharply, causing imported inflation. Since companies must now produce less with the same amount of capital, AS fall from LRAS2 to LRAS1.
Recessions- (C) and (I) are usually shaken during recessions. Leading to sharp fall in AD from AD2 to AD1, as seen in Figure 2, causing real GDP to fall significantly.
Duplicate of Figure 2
Policies for Macroeconomic Stability in the short run- Case Study (136 words)
To mitigate imported inflation, the Monetary Authority of Singapore (MAS) utilized exchange rate-centered monetary policy and strengthened the Singapore dollar (SGD) in response to increased cost of imported raw materials in October 2007. Subsequently, in the second half of 2008, MAS depreciated the SGD in line with slowed growth and diminishing inflation rates (Monetary Authority of Singapore, 2009). This allowed Singapore’s exports to regain competitiveness, allowing for the (X-M) component to increase. This policy is especially effective for a trade-oriented country like Singapore, where up to 40% of domestic consumption is made up by imports with exports being the country’s main driver of economic growth. By constantly monitoring inflation and exchange rates to determine the strength of the SGD, Singapore’s government is able to determine the ideal strength of its exchange rate to ensure macroeconomic stability.
Policies for Macroeconomic Stability in the short run- Case Study (73 words)
In the beginning of 2009, the government utilized fiscal policy via the Resilience Package worth S$20.5bn to tide Singapore over the crisis (Ministry of Finance, 2009). This policy contained 5 major components (Ministry of Finance, 2009) aimed at preventing massive unemployment, strengthening the economy’s potential, improving cashflow and competitiveness of firms and supporting needy families.
This policy aims to increase (G) and put Singapore in a position to capitalize on future growth opportunities.
Macroecnomic Stability in the short run- Limitations of policies (76 words)
Exchange rate monetary policy is mainly effective in containing inflation caused by imported inflation. It does not resolve inflation arising from domestic sources.
The effectiveness of fiscal policy depends largely on the multiplier effect (ME), which varies between countries. This means governments must study the ME carefully in order to decide the appropriate amount of funds required to boost the economy to desired levels. Too little or too much can cause ineffectiveness and unwanted inflation respectively.
Conclusion (73 words)
To adapt to the ever-changing world economy, governments need to accurately forecast their economy’s performance and decide on appropriate policies. To achieve long-term growth, governments need to strategically manage its spending to ensure the economy’s ability to combat unavoidable external shocks, such as the 2007 Financial Crisis. Finally, policies implemented, regardless of its short-term goals, should always have long-term goals in consideration to ensure the economy’s ability to stay ahead of its time.
Bibliography
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BBC News. 2009. UK interest rates lowered to 0.5%. [ONLINE] Available at: http://news.bbc.co.uk/2/hi/business/7925620.stm. [Accessed 7 May 2018].
Enterprise Singapore. 2018. Singapore Free Trade Agreements. [ONLINE] Available at: https://www.iras.gov.sg/irashome/Businesses/Companies/Learning-the-basics-of-Corporate-Income-Tax/Corporate-Tax-Rates–Corporate-Income-Tax-Rebates–Tax-Exemption-Schemes-and-SME-Cash-Grant/. [Accessed 8 May 2018].
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Monetary Authority of Singapore (2009). Annual Report 2008/2009. Singapore: Monetary Authority of Singapore, p.18.