Q3

A key feature of the Singapore economy is its openness to trade and capital flows.
(a) Explain with the aid of examples, the features of small and open economies.
[10]

(b) Evaluate the assertion that economic policies in Singapore are limited mainly by the
price elasticities of demand for exports and imports.
[15]

(a) Introduction:
Small and open economies refer to a spectrum of economies of various sizes and degrees of
openness. These range from the island economies e.g. Caribbean to relatively larger
economies such as Canada.
Body:
1. Small (Any one of the points below)
Domestic market size (C+I+G)
Linked to population size.

2. Open (Any one of the points below)
Open to trade, labour and capital flows.
High trade to GDP ratio, e.g. in the case of Spore, total trade (X+M) is 3.5x its GDP.
Level of domestic demand is low relative to external demand.

3. Price-takers (Any one of the examples below)
Not able to influence the world interest rate
Changes in domestic interest rate will have no effect on the world interest rate.
Any deviation from the world interest rate will trigger destabilizing flows of hot-money
that will affect money supply and undermine the initial policy e.g. a cut in the domestic
interest outflow of hot-money fall in the supply of loanable funds increase in
domestic interest rate.
Therefore, SOEs such as Spore choose to use exchange rates as an instrument of
monetary policy.

Not able to influence prices of goods and services which they trade in domestic
demand and supply are not large enough to influence the world price of traded
merchandize and services. By implication, the world supply curve for imports is perfectly
elastic at the world price.
4. Import Dependence
Small economies usually do not produce everything they need. The small domestic
market does not enable them to enjoy internal EOS in production. Singapore tends to
import goods that are labour/land intensive in production e.g. agricultural and farm
produce.
High import content in exports. 50% of Singapores total exports consist of re-exports.
5. Export Dependence
Economic survival is dependent on the ability of these economies to generate export
revenue to sustain growth consumption and employment. This explains why Singapore
actively pursues bi-lateral and multilateral FTAs, e.g. ASEAN-China FTA.
6. Dependence on foreign labour and foreign direct investment
In labour intensive industries e.g. construction, these economies may be reliant on foreign
workers to augment the small labour force and tight labour market.
Growth strategies of SOEs may be anchored on technology, and the availability of
manufactured and human capital. FDI and foreign talent are required to boost production
in high tech sectors e.g. biomedical research.

7. Exposure to external shocks
Also over-reliance on trade and capital flows leads to susceptibility to external shocks,
e.g. global financial crisis of 2008, high oil prices (2008) and food prices (2011).






Conclusion:
Highlight the relative importance of the external sector in determining economic
performance.

(b) Students are expected to analyze how changes in relative price levels arising from economic
policies affect economic performance and weigh the importance of price elasticity of demand
for traded goods against the other constraints faced by the Singapore economy.
Introduction:
Singapore is import-dependent due to its lack of resources PEDm < 1
Singapore does not export primary products but high end manufactured goods and
services which are substitutable. Generally PEDx > 1, although for some goods, e.g.
refined oil; it is likely to be price inelastic.
Direction and Interpretation of the question:
o Economic policies are limited to the extent that they are less effective in achieving
a particular macro-economic objective or are likely to result in conflicts among the
macro-economic goals.
Body:
Thesis: Demand management policies are mainly limited by PEDx and PEDm in
Singapore
Conflict between internal and external goals
1. Use of monetary policy to address import-induced inflation i.e. gradual appreciation of the
Singapore dollar.
Relative to large economies, Small and Open Economies are susceptible to import
induced inflation. To the extent that PEDm < 1, Small and Open Economies are less
able to switch from more expensive imported inputs to local substitutes, adding to the
cost-push inflationary impact.
Appreciation of the Singapore dollar, reduces the price of imports and the cost of
production AS increases (AS
1
to AS
2
), and cost-push inflation is dampened (P
1
to
P
2
). Ceteris paribus, internal balance is achieved (Growth Y
1
to Y
2
and a fall in
cyclical unemployment).
However, assuming the Marshall-Lerner condition (PEDx+PEDm >1) holds, an
appreciation of the currency would adversely affect the trade balance fall in net
exports fall in AD through the multiplier process (AD
1
to AD
2
). Consequently,
negative growth (Y
1
to Y
2
) and an increase in cyclical unemployment.
Note: Small multiplier size.
To be discussed as a limitation of policies in part (b).
Given that the Marshall-Lerner condition is likely to hold in the long-run owing to the
high price elasticity of demand for exports, the conflict in macroeconomic goals limits
the use of exchange rate policy.

















Evaluation:
i) Gradual appreciation slows down the decline in export competitiveness, allowing
domestic producers to rationalize cost in other ways.
ii) Assuming the threat of imported inflation is neutralized, and in the long-run domestic
inflation < foreign inflation, there will be an improvement in the current account and
the AD curve will shift to AD
3
, leading to actual growth and a fall in unemployment.
Alternatively, it is possible to consider how a devaluation in the currency leads to import-
induced inflation.
2. Inflationary impact from expansionary fiscal policy (or monetary policy)
To address slow growth the government may use a fiscal stimulus (increase spending
and cut personal income and corporate taxes)
The resulting increase in aggregate expenditure (G, I, C) will increase national
income by a multiplied amount and reduce demand deficient unemployment.
However, rising GPL may contribute to demand-pull inflationary pressure if economy
is close to full employment.
If domestic inflation > foreign inflation Trade balance worsens conflicts with the
goal of healthy BOP (avoidance of a CA deficit).
Hence, expansionary demand management policies are limited to the extent that they
lead to overheating and the demand for exports is price elastic.

Effectiveness of economic policies: Application of the Marshall-Lerner condition
3. Limited effectiveness of exchange rate monetary policy when PEDx+PEDm < 1
Assuming that expansionary monetary policy (a devaluation) is used to stimulate
exports price of X falls in foreign currency while price of M increases in local
currency assuming the Marshall-Lerner condition holds, there will be an
improvement in the current account, and consequently an increase in income and
employment.
GPL
Real NY
AS
1

AS
2

AD
1

AD
2

AD
3

P
1

P
2

Y
1
Y
3
Y
2

P
3

However in the very short-run, the Marshall-Lerner condition is not likely to hold due
to pre-arranged contracts or consumption habits which take time to change. This
gives rise to the J-curve effect where the current account temporarily worsens upon
depreciation due to the inelasticity of demand for exports and imports before it
improves.
To the extent that the Marshall-Lerner condition is not satisfied in the short-term,
expansionary monetary policy is limited.

4. Limited effectiveness of expansionary fiscal policy: Opening economy to crowding out
If government spending is financed by borrowing increase in interest rates.
Due to openness inflow of hot-money appreciation of exchange rate.
Assuming Marshall-Lerner condition holds (X-M) decreases reduces expansionary
impact on AD (increase in G may be offset by the fall in net exports).
Evaluation: However, owing to fiscal prudence the Singapore government is not
dependent on borrowed capital for financing its deficit, preferring instead to draw upon
accumulated reserves from previous budget surpluses. Therefore, this is a less likely
constraint.

Anti-thesis: Economic policies are still effective and there are more pressing
constraints facing small and open economies
5. Demand management policies are not limited when used together with supply-side
policies
Supply-side policies moderate inflationary pressure in the economy by shifting AS to
the right and lowering the GPL mitigates negative impact of expansionary demand
management policies on the trade balance.
6. Other factors are relatively more important in limiting the effectiveness of economic
policies
Small size of multiplier due to high marginal propensity to import Ineffectiveness of
demand management policies in general.
For fiscal policy, a larger fiscal stimulus may be required to achieve a desired
increase in national income strain on government budget.
However, the small multiplier may mean that there is less likelihood of demand pull
inflation arising from expansionary policies and hence lower the conflict between
internal and external goals mentioned earlier.
Uncertainty
Supply side policy Supply side policies (provision of infrastructure, R&D
incentives) are used to achieve dynamic comparative advantage in certain sectors.
However, due to changes in the pattern of trade, it is difficult for the government to
predict high growth sectors. The success of other policies such as training also
depends on the receptiveness of the workers.
Evaluation:
The extent in which PEDx and PEDm constrains policymaking depends on:
1. The prevailing economic conditions In the context of a global recession, the threat
of demand-pull and cost-push inflation is low suggesting that expansionary demand
management policies are less likely to result in conflicts.
2. Whether economic policies can alter the values of PEDx and PEDm.
E.g. Supply side policies that aim to diversify the economy could reduce the
dependence on imports, making PEDm more elastic in the long-run. New
breakthroughs for e.g. in alternative sources of energy, medical technology would
reduce PEDx. As Singapore moves up the technological ladder to achieve dynamic
comparative advantage, it is likely to venture into new frontiers where few compete
resulting in a lower value of PEDx.
Conclusion:
Compared to larger economies, Singapore is disadvantaged due to its dependence on imports
and exports. This makes the trade-off between domestic and external goals more pronounced.
Notwithstanding, the price elasticities of demand for X and M is not the most pressing
constraint owing to the reasons stated above. The low multiplier value due to high leakages
may be a more binding constraint for demand management policies.




Q4
In the light of America's growing twin deficits (budget deficit and current account
deficit), the US government is putting pressure on China to revalue her domestic
currency.
a. Explain the problems faced by a country if it incurs a twin deficit [10]
b. Discuss whether conflicts in achieving macroeconomic objectives will arise for
the Chinese authorities when she revalues her domestic currency. [15]

Suggested outline

Part (a)

Introduction:
Clarify key terms: Twin deficits i) Budget deficit (G>T),
ii) Balance of trade deficit (M>X)
Body:
Explain the problems faced by a country if it incurs a growing budget deficit (G>T)
i. Expansionary FP inflationary pressures problems associated with
high inflation
ii. Financing problems/How to finance
1 Borrow from other countries
a. Indebtedness to other countries
2 Borrow from public
a. Crowding out effects
b. Inter-generational equity problems
3 Print money inflationary pressures
4 Any others
Explain the problems faced by a country if it incurs a growing balance of trade deficit
(M>X)
iii. If the growing balance of trade deficit results in growing balance of
payments deficit, => total currency outflow > total currency inflow => net
increase in dd for foreign currency / net increase in ss of domestic
currency domestic currency will be under pressure to depreciate /
Central Bank under pressure to devalue her currency.
1 For countries operating on a fixed exchange rate regime
Central Bank must buy domestic currency and sell foreign
reserves to support the domestic currency.
i. However, if unable to do so because of insufficient foreign
reserves domestic currency will depreciate.
ii. Consequence:
1. Prices of imports in terms of domestic currency
increase hurt ability to buy imports and greater risk
of imported inflation especially if heavily reliant on
imports => compromise on cost competitiveness of X
and cost of living.
2. If depreciation is excessive speculative attacks on
the domestic currency => higher degree of uncertainty
=> difficult for investment plans and trade.
2 Countries operating under flexible exchange rate regimes will see
their currency depreciating
i. This will reduce their ability to buy imports
ii. Imported inflation rising
iii. The impact on the United States of America is different (the
US$ is still strong relative to other foreign currencies)
because the US$ is being demanded by other countries as
a reserve currency
iv. Contractionary effect on the economy slowdown in economic growth
v. Indebtedness to other countries
vi. Inter-generational equity problems
May consider broad characteristics of America in the answer (optional)

Conclusion:
Make a stand on what the main problems are that these countries will be facing
i. Combined effects on a country if it incurs a twin deficit
1 Inflationary pressures intensifies due to demand-pull inflation and
cost-push inflation rising (problems arising from high inflation)
2 Financing problems
a. Indebtedness to other countries domestic currency
weaken
b. Inter-generational equity problems
-Higher taxes in the future will contract the economy even
further


Part (b)
Introduction:
Clarify that a revaluation of the Chinese Yuan suggests that China gives in to the pressure
from US government (preamble)
i. Allow the Chinese domestic currency to appreciate against US$
ii. State and explain briefly the 4 macroeconomic goals: Low inflation rate, economic
growth, full employment and external balance.

Body
Thesis: Revaluation of the Chinese domestic currency can lead to conflicts in
achieving macroeconomic objectives for the Chinese authorities
Slowdown in actual growth and rise in unemployment
Revaluation of the Chinese domestic currency P
x
in terms of foreign currency
increases while P
m
in terms of domestic currency falls according to the Marshall-
Lerners condition, so long as the sum of PEDx and PEDm is greater than one, a
revaluation of the Chinese Yuan will worsen Chinas balance of trade and in turn,
balance of payments, ceteris paribus.
Fall in BOT will lead to a fall in AD and hence a more than proportionate fall in
National Income ceteris paribus.
The slowdown in economic growth results in increased unemployment social
instability and other costs of unemployment.
(Use AD/AS framework for analysis)
Burden of debt
Anti-thesis: Revaluation of the Chinese domestic currency need not lead to conflicts
in achieving macroeconomic objectives for the Chinese authorities
Ease of inflationary pressure
Imported inflation will fall as price of imported raw materials fall in terms of domestic
currency assuming China imports a significant amount of raw materials for her
industries reduce cost of production (increase in AS) fall in cost-push inflation.
Positive effects on economic growth and employment
The benefits of achieving low domestic inflation relative to foreign inflation can also
bring about improvement in export competitiveness economic growth (actual) and
reduction in unemployment
Cheaper imports including import of cheaper capital goods larger volume of import
of capital goods and equipment lead to capital deepening in the long run,
increase in potential growth for China.


Conclusion: (Possible evaluation)
1. Make a stand and explain your stand taking into consideration the context of China, that
is, they should take into account some of the characteristics that are unique to China.
For eg, consider the extent of revaluing the Chinese domestic currency and whether it
will have a significant impact on the 4 macroeconomic goals starting point in pricing of
their products. Even if Chinas exports are more expensive to the foreigners after
revaluation of the Yuan, given that the prices of Chinas exports were relatively much
lower than what the rest of the world could offer, the impact of this revaluation could be
might just be minimal.
2. Other evaluative points:
More of a political decision to revalue the Chinese domestic currency rather than an
economic one
The decision to revalue the Chinese domestic currency is in line with economic
principles based on the Theory of Comparative Advantage that in the absence of
protectionism, gains from specialization and trade can be maximized
China should implement complementary policies (e.g supply-side) to mitigate ill-
effects /minimize the potential conflicts between macroeconomic objectives arising
from revaluing her domestic currency