A Levels 2015 Q5

During the recent world-wide recession many European countries chose low
interest rates as a monetary policy approach rather than adopting demand led
fiscal policy stimulation. At the same time, with most of these countries
governments introducing large cuts in government expenditure in order to
reduce their budget deficits, a fiscal contraction actually resulted.
Discuss which policy approach is appropriate for a country during a world-wide
recession. [25]
Command: Discuss
Content: Policy (monetary policy, fiscal stimulation policy, cuts in government
expenditure to reduce budget deficits)
Context: General
Question Requirement:
1) Appropriate policies
2) During recession
Key
Analysis
Introducti
on

Content
Analysis:
Monetary
policy

Explanation
The recent world-wide recession led to countries experiencing high
unemployment and low investors confidence. Some of the
countries which are highly dependent on trade might suffer from a
fall in demand for its exports and hence BOP worsens. Some of the
policies are more appropriate for some while not so appropriate for
the others.
It is appropriate for EU to adopt expansionary monetary policies
are they are unable to administer fiscal policies due to some of the
EU countries suffering from large budget deficits to spur economic
recovery and lowering of employment.
Thus when the central bank reduce commercial banks required
reserve ratio to simulate lending, money supply will increase from
MS to MS1 as banks can give out more loans. There will be an
excess quantity of money supplied at the prevailing interest rate, r.
People will use this excess holding of money to buy bonds, thereby
driving up bond prices and lowering interest rates from r to r1.
According to the marginal efficiency of investment (MEI) theory,
lower interest rates will encourage investment (I to I1), as
investors enjoy a lower cost of borrowing and increase expected
profit from their investments. Lower interest rate encourages
consumption as cost of credit decreases. Moreover, savings fall too
as reward for savings decreases. The increase in investment and
consumption will cause AD to increase from AD to AD1, leading to
a multiplied expansion in output, income and employment from Y
to Y1 as shown in Figure 1 while general price level will increase
from P to P1.

Fig1 : Money demand and supply Fig2: MEI

of an economy

Content
Analysis:
Fiscal
Policy
Stimulati
on

Fig3: AD-AS

However, due to the low investors confidence in the global

economy, low interest rates might not have effectively increase the
quantity of investment. Hence the actual economic growth may
not achieved and since firms may be unwilling to invest hence jobs
may not be created and hence unemployment will not fall.
For some countries like Singapore did not experience large budget
deficit, may still find it appropriate to employ the use of
expansionary fiscal policies to revive growth and reduce cyclical
unemployment.
These countries can adopt expansionary fiscal policies during
periods of recessions through the increase in G or decrease in tax
rates. Since one of the reasons from Spores recession and high
cyclical unemployment is due to the worldwide economic
recession, this lead to low investors confidence and nudges
investors to leave. At the same time, Spore was also facing tough
competition from developing countries like China which is
attracting investors like magnet. In order to retain existing
investors and to attract new ones amidst the recession, Singapore
could reduces its corporate tax rates from 18% to 17%.
The fall in corporate tax rates increases post-tax profits and hence
increases profitability. This will attract new /retain investors, and
allow firms to have more funds to continue to invest. Through,
multiplier effect RNY increase and with firms hiring more FOP such
as labour to cope with higher level of production, cyclical
unemployment falls. And AD increases and shift rightwards causing
increase in real national income as seen in Figure 3.
However, while this gives incentives to investors and producers
may not be useful if confidence level were not resolve. This
worldwide recession has happened for quite some time and it
seems to have signs of recovery, it is likely that confidence level
would rise again and fall in tax is timely to ride on the pickup of
confidence level to boost economy.

Nonetheless, even if the Singapore government has successfully

implemented the appropriate policies to achieve full employment,
there may be still some people who are unemployed in the
economy due to frictional unemployment. This is because there it
takes time for workers to be matched with the suitable jobs in the
economy. Or the students

Content
Analysis:
Exchange
rate
policy

Furthermore, other countries like Indonesia might also reduce their

corporate tax to be competitive as Singapore, hence might have
muted the effect of our lower corporate tax rates. Hence it is not
effective to consistently reducing tax rates.
For some countries like Singapore who is small and open economy
that has been negatively affected by the world-wide recession, it
would be appropriate for her to engage in the use of zeroappreciation stance of Singapore dollars in her attempt to maintain
economic growth and low unemployment and BOP.
As a small economy, Singapore is highly dependent on external
trade for growth will be negatively affected by world-wide
recession. As Singapore major trading partners like US and some
European countries are suffering from recession which meant
income level fall, leading to lower purchasing power hence
demanding for goods and services like electrical appliances, these
firms will also reduce production for such outputs, hence lowering
demand for Singapores exports such as electrical components
which caused a fall in net exports. Hence by adopting zero
appreciation stance which means that the upper limit of the target
band is fixed. This allows Singapore dollar to depreciate slightly
within the target bands, while ensuring that there is no excessive
depreciation which could result in imported cost-push inflation. The
slight depreciation would allow Singapore exports to more price
competitive and increase in the quantity demanded to partially
offset the fall in demand for exports due to the economic
downturn.
A depreciation of the currency makes the countrys exports
relatively cheaper in terms of foreign currency, hence resulting an
increase in quantity demanded for Singapores export by
foreigners. It will also cause the countrys imported final goods and
services to become relatively more expensive in domestic
currency. Consumers will now switch to consuming domestically
produced goods instead of imported goods from other countries.
Assuming Marshall-Lerner condition holds, where sum of price
elasticity of demand for exports and imports (in absolute value) is
more than 1, export revenue for Singapore will increase and import
expenditure will decrease.

General Price Level

AS 0

P1
AD1

P0

AD0
Real National Income

Y0 Y1
Figure 3: Effect of depreciation on AD and general price level

This will lead to an increase in net exports and through a series of

multiplied income-induced consumption, it will lead to an increase
in AD from AD0 to AD1. As seen in Figure 3, this will result in a
more than proportionate increase in real national income from Y0
to Y1 achieving actual economic growth, and unemployment rate
within the economy falls. Since net exports contributes
significantly to Singapores GDP, it is appropriate for Singapore to
employ such a policy during world-wide recession to also reduce
the impact on BOP by achieving balance of trade surplus in the
current account.
However, in view of world-wide recession other countries might
also engage in currency devaluation or depreciation, cancelling out
the favourable effects of depreciation. Furthermore in the very
short run, demand for goods tend to be very price inelastic as it
takes time to change consumption patterns. As a result the
Marshall-Lerner condition may not be initially satisfied.
Furthermore, in the longer run, price elasticities of demand and
supply of exports and imports are likely to be higher and thus
depreciation is more likely to be effective.
Content
Analysis:
Supply
side
policy

Supply Side Policies are appropriate to develop comparative

advantage and develop better quality products to boost exports to
ensure economic growth.
GPL

AS0

AS1

P0
P1
AD0
Y0 Y1

Real National Output

Figure 4: LRAS increases

For countries like Singapore, the global economic landscape is
changing, and challenges are pressing. Hence there is a need to
find every opportunity to transform, to emerge stronger in the
coming years despite having worldwide recession. The government
launched programme Industry Transformation Programme which
provided immediate relief and support amid the current cyclical
slowdown, so that domestic firms can continue press on with
economic transformation to achieve growth driven by innovation
and higher productivity. When firms engage in technology adoption
and innovation it will raise productivity hence productive capacity
also increases where LRAS increase from AS0 to AS2 as seen in
figure 4.
Furthermore, this policy is appropriate as it develops new areas of
comparative advantage which will lead to an increase in demand
for Singapores exports, which will also lead to an increase export
revenue, thereby maintain export competitiveness by non-price
competitiveness. For example, the food manufacturing sector
where Singapore food companies have put in place many
innovations. Some, such as Tan Seng Kee, have used technology to
develop a whole range of products which stay fresh for longer. This
enabled Tan Seng Kee to be the first company in Singapore to
export fresh noodles that can be easily prepared with its special
sauce mixes in flavours such as Laksa and Curry Mee. Others, such
as Foodgnostic, have transformed their business models to
enhance business growth through internationalisation and food
exports. Singapores food manufacturers built on their innovations
and Singapores trusted reputation for high quality and safe food to
jointly create the Tasty Singapore brand. Using this brand, firms
have been able to go international and exporting food items to
China, India, the Middle East, and even Africa. They are now
expanding through e-commerce, using websites such as
Tmall.com. Thus ensuring economic growth.
As a result of these supply side policies, what once appeared to be
a sunset industry because of low margins and high labour cost
is now a thriving sector. Hence it is appropriate for countries to
adopt supply side policies.
However, some obstacles faced are that some firms may not be
willing to change their methods of production and some domestic
firms would not want to change their mindset to adopt new
technologies. Furthermore, during worldwide recession, firms might
have suffered a fall in demand might have considered about
shutdown instead.

Conclusio
n

In view of the worldwide recession, the policies that are

appropriate for each economies might differ due to degree of the
impact of the worldwide recession on each economies and the
current situation such as existing large government deficits.