Which of the following is likely to result from a rapid rise in aggregate demand?

Students can refer to Economics – A Singapore Perspective for the diagrams. The book is available in the major bookstores in Singapore.

1          INTRODUCTION

The performance of an economy is often measured in terms of economic growth, unemployment, inflation and the balance of payments. An economy with high economic growth, low unemployment, low inflation and a balance of payments equilibrium is generally considered well performing. In contrast, an economy with low or negative economic growth, high unemployment, high inflation and a persistent balance of payments disequilibrium is generally considered poor performing. As the performance of a government is often measured in terms of the performance of the economy, all governments aim to achieve high economic growth, low unemployment, low inflation and a balance of payments equilibrium. This chapter provides an exposition of economic growth, unemployment, inflation and the balance of payments.

2          ECONOMIC GROWTH

2.1       Sources of Economic Growth

Economic growth refers to an increase in real national output.

The economic growth rate is calculated as the percentage increase in real national output.

                                     Real National Output (t) – Real National Output (t–1)

Economic Growth Rate (t) = ——————————————————————– × 100%

                                     Real National Output (t–1)

It is important to note that the economic growth rate is calculated as the percentage increase in real national output rather than nominal national output. As the size of the economy is measured by the amount of goods and services produced, the economy grows when the amount of goods and services produced increases. As nominal national output is national output measured at current prices, an increase in nominal national output may be due to a rise in the prices of goods and services rather than an increase in the amount of goods and services produced. However, as real national output is national output measured at base-year prices, an increase in real national output can only be due to an increase in the amount of goods and services produced as base-year prices do not change. Therefore, real national output is a better measure of economic growth than nominal national output. Developing economies such as China generally have higher economic growth than developed economies such as the United States. Singapore has a record of high economic growth. Economists distinguish between two types of economic growth: actual economic growth and potential economic growth.

Actual Economic Growth

Actual economic growth is an increase in actual output. This basically means that the economy actually produces more goods and services. An increase in aggregate demand will lead to actual economic growth.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to an increase in actual output (Y) from Y0 to Y1. Aggregate demand may increase due to an increase in any of its components. Consumption expenditure is determined by several factors such as consumer sentiment, the wealth of households, interest rates, expectations of price changes, the availability of credit and the distribution of income. For example, when households are more optimistic about the economic outlook, they will expect their income to rise and hence increase consumption expenditure. Investment expenditure is determined by several factors such as interest rates, business sentiment, business costs, capital costs, corporate income tax, technological advancements and the availability of credit. For example, a fall in interest rates will decrease the costs of borrowing and this will lead to more profitable planned investments resulting in an increase in investment expenditure. Government expenditure on goods and services is largely determined by the objective of the government. For example, the government may increase expenditure on infrastructure to attract foreign direct investments. Net exports are determined by several factors such as the exchange rate, domestic inflation relative to foreign inflation, domestic income and foreign income. For example, an increase in foreign income will lead to an increase in net exports. Refer to Chapter 9 for more factors that will lead to an increase in aggregate demand.

Apart from an increase in aggregate demand, an increase in aggregate supply due to a fall in the cost of production in the economy independently of demand will also lead to actual economic growth.

In the above diagram, an increase in aggregate supply (AS) from AS0 to AS1 due to a fall in the cost of production in the economy independently of demand leads to an increase in actual output (Y) from Y0 to Y1. The cost of production in the economy may fall independently of demand due to several reasons. For example, firms may bargain for lower wages when they have greater bargaining power due to a looser labour market. The prices of imported intermediate goods will fall when there is deflation in other economies. A rise in the exchange rate will also lead to a fall in the prices of imported intermediate goods in domestic currency. The cost of production in the economy will also fall independently of demand due to a decrease in oil prices or the goods and services tax. An example is the substantial fall in the cost of production in the economy due to the sharp fall in oil prices from June 2014 to February 2016 as a result of the boom in the shale oil industry in the United States.

Actual economic growth in Singapore is export-driven. Exports in Singapore are generally increasing as the world economy is generally expanding and hence the world income is generally rising. As Singapore is a small economy that is highly dependent on external demand with the domestic exports accounting for a large proportion of the aggregate demand, an increase in aggregate demand is mainly due to an increase in exports. For example, the increase in exports in Singapore in the global economic recovery in 2010 led to a substantial increase in aggregate demand. Actual economic growth in Singapore also occurs due to an increase in domestic demand but to a smaller extent. Domestic demand in Singapore constitutes a smaller proportion of aggregate demand and hence an increase in domestic demand has a smaller effect on aggregate demand. Consumption expenditure generally does not increase substantially due to the high savings rate which is a result of the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. Government expenditure on goods and services generally does not increase substantially due to the prudent fiscal policy.

Potential Economic Growth

Potential economic growth is an increase in the full-employment national output which is also known as potential output. This basically means that the economy can potentially produce more goods and services. An increase in aggregate supply due to an increase in the production capacity in the economy will lead to potential economic growth and to a lesser extent, actual economic growth.

In the above diagram, an increase in short-run aggregate supply (SRAS) from SRAS0 to SRAS1 and an increase in long-run aggregate supply (LRAS) from LRAS0 to LRAS1 due to an increase in the production capacity in the economy leads to an increase in potential output (Yf) from Yf0 to Yf1 and a smaller increase in actual output (Y) from Y0 to Y1 [description for Neoclassical economics]. In the above diagram, an increase in aggregate supply (AS) from AS0 to AS1 due to an increase in the production capacity in the economy leads to an increase in potential output (Yf) from Yf0 to Yf1 and a smaller increase in actual output (Y) from Y0 to Y1 [description for Keynesian economics]. The production capacity in the economy may increase due to an increase in the quantity or the quality of the factors of production in the economy. The quantity of labour in the economy is determined by several factors such as the retirement age, government support to working mothers to care for their children, personal income tax, foreign worker policy and immigration policy. For example, loosening restrictions on foreign workers will lead to an increase in the size of the labour force in the economy. The quality of labour in the economy is determined by several factors such as education and training, foreign worker policy and immigration policy. For example, education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy. The quantity of capital in the economy is determined by several factors such as interest rates, business sentiment, business costs, capital costs, corporate income tax and the availability of credit. For example, an increase in business sentiment will lead to an increase in investment expenditure resulting in a more rapid increase in the size of the capital stock in the economy, assuming net investment is initially positive. The quality of capital in the economy is determined by several factors such as research and development and government support to firms to adopt better production technologies. For example, research and development will lead to technological advancement which will increase the efficiency of capital in the economy. Factors that will lead to an increase in the production capacity in the economy and hence aggregate supply will be explained in greater detail in Chapter 12.

Potential economic growth in Singapore is mainly due to an increase in the quantity and the quality of capital and labour in the economy, largely due to the use of government measures.

The Singapore government has lowered the corporate income tax from 40 per cent in 1986 to 17 per cent currently to increase expected after-tax returns on planned investments in order to increase foreign direct investments. It has improved the infrastructure of the economy to attract more foreign direct investments. For example, it has built Jurong Island for high-end chemical manufacturing and Biopolis for pharmaceutical manufacturing. The Singapore government has signed over 20 free trade agreements to attract more foreign direct investments. Free trade agreements will be explained in greater detail in Chapter 13. The increase in foreign direct investments has led to a more rapid increase in the quantity of capital in the economy.

The Singapore government has allowed more foreign workers and immigrants in the economy. It has attracted more foreigners to migrate to Singapore by increasing after-tax personal income through lowering the marginal tax rate in the top personal income tax bracket from 40 per cent in 1986 to 22 per cent currently, with corresponding reductions in the marginal tax rates in other personal income tax brackets. The Singapore government has increased the retirement age to allow Singaporeans to work longer. The increase in foreign workers, immigrants and retirement age has led to an increase in the quantity of labour in the economy.

The Singapore government engages in research and development directly, by setting up research institutes, and indirectly, by giving subsidies and tax incentives to firms to encourage them to engage in research and development. For example, it has set up the Biomedical Research Council (BMRC) and the Science and Engineering Research Council (SERC) under the Agency for Science, Technology and Research (A*STAR) to engage in research and development. The Singapore government incentivises firms to adopt better production technologies through subsidies and tax incentives. It has improved the intellectual property rights regime to attract more foreign research firms to invest in the economy. These efforts have led to an increase in the efficiency of capital in the economy.

The Singapore government provides education and training directly, by setting up educational institutes, and indirectly, by giving subsidies and tax incentives to firms to encourage them to send their workers for education and training. For example, it has set up the Institute of Technical Education, polytechnics and Continuing Education and Training campuses to provide education and training. The Singapore government has allowed more foreign high-skilled workers and talented immigrants in the economy. It has attracted more foreign talents to migrate to Singapore by increasing after-tax personal income through lowering the marginal tax rate in the top personal income tax bracket from 40 per cent in 1986 to 22 per cent currently, with corresponding reductions in the marginal tax rates in other personal income tax brackets. These education and training efforts and the increase in foreign talents have led to an increase in the skills and knowledge of labour in the economy.

Note:   Apart from the aggregate demand-aggregate supply analysis, economic growth can also be illustrated with the production possibility curve. Actual economic growth can be shown by a movement from a point inside the production possibility curve to a point nearer to it. Potential economic growth can be shown by an outward shift in the production possibility curve. 

Potential economic growth per se will not lead to a rise in the standard of living. However, as actual economic growth is constrained by potential economic growth, potential economic growth is essential for achieving sustained economic growth. Therefore, governments around the world use supply-side policies to achieve potential economic growth. Supply-side policies will be explained in greater detail in Chapter 12. 

Although the Neoclassical model is more realistic than the Keynesian model, students are allowed to use either model to illustrate economic growth in the examination.

The Principal Economics Tutor will discuss the sources of economic growth in greater detail in the economics tuition class.

2.2       Inclusive Economic Growth

Although it is important for the government to achieve high economic growth, it is equally important for the government to ensure that the benefits of economic growth are equitably distributed. Therefore, many governments in the world, including the Singapore government, seek to achieve inclusive economic growth. According to the Organisation for Economic Co-operation and Development (OECD), inclusive economic growth is economic growth that is distributed fairly across society and creates opportunities for all. In Singapore, the government seeks to achieve inclusive economic growth through focusing on the inclusion of low-skilled workers in the pursuit of economic growth via engaging them in productive employment.

Singapore has achieved a high rate of economic growth over the last few decades which has propelled it to near the top of the world ranking of GDP per capita. According to the International Monetary Fund, Singapore now has the third highest GDP per capita in the world, behind Qatar and Luxembourg. However, the Gini coefficient in Singapore, which is a measure of inequality of income distribution, is above the internationally recognised alarming level of 0.4 and is one of the highest among developed countries. Even after taking into consideration taxes and transfer payments, the Gini coefficient in Singapore still remains above 0.4 while those of other developed countries all fall below 0.35. This means that the benefits of sustained high economic growth in Singapore have not been equitably distributed. Therefore, in an effort to reduce income inequity while pursuing economic growth to achieve a more equitable distribution of the benefits of economic growth, the Singapore government seeks to achieve inclusive economic growth through focusing on the inclusion of low-skilled workers in the pursuit of economic growth via engaging them in productive employment.

To achieve inclusive economic growth through the inclusion of low-skilled workers in the pursuit of economic growth via engaging them in productive employment, the Singapore government engages in education and training to increase the skills and knowledge of low-skilled workers. An increase in the skills and knowledge of low-skilled workers will lead to an increase in the production capacity in the economy. An increase in the skills and knowledge of low-skilled workers will also lead to an increase in their productivity resulting in a fall in the cost of production in the economy. When the production capacity in the economy increases and the cost of production in the economy falls, aggregate supply will rise which will lead to an increase in national output. In addition, when the cost of production in the economy falls, expected returns on planned investments will rise which will lead to an increase in foreign direct investments. When this happens, aggregate demand will rise which will lead to an increase in national output. Education and training will also equip the low-skilled workers who have been displaced by globalisation, technological advancement and economic restructuring with the relevant skills and knowledge to find jobs in the expanding industries which are typically high value-added industries and hence require high skills resulting in an increase in national output. When the productivity of low-skilled workers rises as a result of education and training, firms that employ these workers will experience a fall in their costs of production. When this happens, they will be able to increase the wages of the workers which will lead to a decrease in income inequity. In addition, the low-skilled workers who were displaced but who have found a job as a result of the new skills and knowledge that they have acquired will start earning income again resulting in a decrease in income inequity. A decrease in income inequity in the pursuit of economic growth will lead to a more equitable distribution of the benefits of economic growth.

In addition to reducing income inequity while pursuing economic growth through including low-skilled workers in the pursuit of economic growth via engaging them in productive employment, the Singapore government seeks to achieve inclusive economic growth in order to achieve a more equitable distribution of the benefits of economic growth through other measures which include transfer payments, progressive taxes and foreign worker policy. Although these measures, which have been discussed in Chapter 7, do not help achieve economic growth in Singapore, at least not significantly, they help make economic growth more inclusive through reducing income inequity when the Singapore economy is expanding which is the normal state of the economy. The Singapore government also provides subsidies for essential goods and services which low income individuals consume such as healthcare, education and housing. Although these subsidies will also benefit high income individuals, the benefit will be greater for low income individuals as these subsidies expressed as a percentage of income are higher for low income individuals than for high income individuals.

Note:   The Principal Economics Tutor will discuss inclusive economic growth in greater detail in the economics tuition class.

2.3       Sustainable Economic Growth

Sustainable economic growth refers to economic growth which occurs in a manner that will not impede economic growth in the future. There are several necessary conditions for sustainable economic growth which include potential economic growth, conservation and development of resources and protection of the environment.

Potential Economic Growth

Actual economic growth can occur only when there is excess production capacity in the economy. However, as the economy continually produces more goods and services, it will eventually reach the full-employment equilibrium. In the absence of excess production capacity in the economy, unless potential economic growth occurs, actual economic growth will not be possible. Therefore, actual economic growth is constrained by potential economic growth. As actual economic growth is constrained by potential economic growth, potential economic growth is essential for achieving sustained economic growth. Therefore, potential economic growth is necessary for achieving sustainable economic growth. Supply-side policies to achieve potential economic growth will be explained in greater detail in Chapter 12.

Conservation and Development of Resources

The production of goods and services requires resources. As many resources are non-renewable such as fossil fuels, over-exploitation of resources will result in limited resources being available for future use which will hinder future economic growth. Therefore, the government needs to conserve resources to achieve sustainable economic growth. There are several measures that the government can take to conserve resources. For example, it can impose a tax on resources which are overly exploited to discourage their use. In addition to conserving resources, the government needs to develop new sources of energy such as solar power and wind power. As these sources of energy are renewable, they are necessary for achieving sustainable economic growth. The government can develop new sources of energy directly, by setting up research institutes, or indirectly, by giving subsidies or tax incentives to firms to encourage them to develop new sources of energy.

Protection of the Environment

Economic growth may lead to an increase in the amount of negative externalities such as carbon emissions which will result in a more polluted environment. An increasingly polluted environment will lead to a less healthy and hence less productive labour force. A fall in labour productivity in the economy will lead to a rise in the cost of production in the economy resulting in a decrease in aggregate supply and hence lower economic growth. In addition, an increasingly polluted environment will lead to a shorter life expectancy which will lead a decrease in the size of the labour force. A decrease in the quantity of labour in the economy will lead to a decrease in the production capacity in the economy resulting in a decrease in aggregate supply and hence lower economic growth. Therefore, the government needs to protect the environment to achieve sustainable economic growth. There are several measures that the government can take to protect the environment. For example, it can impose a carbon tax or a tradable emissions permit scheme to reduce carbon emissions.

Note:   Students should not confuse sustainable economic growth with sustained economic growth. Although potential economic growth is essential for achieving sustained economic growth, sustainable economic growth requires more than potential economic growth. Therefore, sustainable economic growth is a broader concept than sustained economic growth.

The Principal Economics Tutor will discuss sustainable economic growth in greater detail in the economics tuition class.

2.4       Benefits and Costs of Economic Growth

Benefits of Economic Growth

Rapid Rise in the Standard of Living

High economic growth may lead to a rapid rise in the standard of living. Recall that the standard of living refers to the material and non-material welfare of the people. A rapid increase in national output may lead to a rapid increase in the amount of goods and services available for consumption. If this happens, the material standard of living may rise at a fast rate.

Full Employment

High economic growth will help the economy achieve full employment. The labour force in the economy is generally expanding. An increase in national output will lead to an increase in the demand for labour in the economy. Therefore, high economic growth will ensure that sufficient new jobs are created in the economy for the new entrants in the labour force which will help the economy achieve full employment.

Redistributive Benefit

Economic growth will increase the ability of the government to redistribute income from high income individuals to low income individuals. When national output and hence national income rises, the government will automatically collect more tax revenue which can be used to finance transfer payments to low income individuals. Therefore, the government can redistribute income from high income individuals to low income individuals to reduce income inequity without increasing direct taxes and hence lowering anyone’s disposable income.

Environmental Benefit

Economic growth may lead to a cleaner environment. When people’s income rises, they will become more concerned with a clean environment. This is because pollution will become a matter of social concern when economic growth has ensured the provision of basic necessities such as food and housing to the majority of the population. A cleaner environment will lead to a rise in the non-material standard of living.

Costs of Economic Growth

Lower Amount of Goods and Services Available for Consumption

Achieving economic growth may lead to a fall in the amount of goods and services available for consumption. Economic growth may be achieved through a diversion of resources from the production of consumer goods, such as ice creams and cookies, to the production of capital goods, such as factories and machinery. If this happens, the amount of goods and services available for consumption will fall which will lead to a fall in the material standard of living.

Generation of Demands

Economic growth may generate demands which may make people feel less contented. An increase in national output will lead to an increase in the amount of goods and services available for consumption. However, when people have more to consume, they may want to attain an even higher level of consumption. Therefore, if economic growth generates demands and makes people more materialistic, it may make them feel less contented which will lead to a fall in the non-material standard of living.

Environmental Costs

Economic growth may lead to environmental costs. An increase in national output may lead to an increase in the amount of negative externalities such as carbon emissions which will result in a more polluted environment. If this happens, the non-material standard of living will fall.

Depletion of Non-renewable Resources

Current economic growth may preclude future economic growth. Economic growth will deplete non-renewable resources such as fossil fuels which include crude oil, coal and natural gas. When this happens, there may be lack of resources to achieve economic growth in the future.

Worsening Income Inequity

Achieving economic growth may worsen income inequity. To achieve economic growth, the government may cut corporate income tax to attract foreign direct investments, and it may cut personal income tax to attract foreign talents. However, as income taxes are progressive, a decrease in these taxes will worsen income inequity. Furthermore, to avoid a budget deficit, the government may raise goods and services tax to offset the fall in income tax revenue. However, as goods and services tax is regressive, an increase in this tax will also cause income inequity to worsen.

High Structural Unemployment

High economic growth may lead to high structural unemployment. High economic growth may occur due to rapid technological advancement. However, although rapid technological advancement may lead to high economic growth, it may lead to substantial losses of low-skilled jobs resulting in high structural unemployment.

Balance of Payments Deficit

High economic growth may lead to a persistent balance of payments deficit. High economic growth will lead to high import growth. However, if export growth is low, high import growth may lead to a persistent balance of payments deficit resulting in adverse consequences such as high imported inflation, lower national output and hence national income, higher unemployment and rising public debt.

High Demand-pull Inflation

High economic growth may lead to high demand-pull inflation. High economic growth usually occurs due to a rapid increase in aggregate demand. However, when aggregate demand rises rapidly, demand-pull inflation will be high if aggregate supply does not also rise rapidly. This is particularly true when the economy is near the full-employment equilibrium.

Note:   Although economic growth brings about both costs and benefits to the economy, the benefits generally outweigh the costs which explains why governments around the world aim to achieve high economic growth.

The Principal Economics Tutor will discuss the benefits and costs of economic growth in greater detail in the economics tuition class.

3          UNEMPLOYMENT

3.1       Measurement of Unemployment

Unemployment is the state of the economy where some people who are able and willing to work are not employed in the production of goods and services.

For the purpose of measuring unemployment, the population can be divided into the working-age population and the non-working-age population. In Singapore, the working-age population refers to those who are 15 years of age and over. The working-age population can be further divided into the economically active population, which is also called the labour force, and the economically inactive population. The labour force refers to those who are 15 years of age and over (i.e. working-age population), who are able and willing to work, and are either employed or actively seeking employment.

The unemployment rate is the unemployed expressed as a percentage of the labour force.

                            Unemployed

Unemployment Rate = ————————– × 100%

                             Labour Force

The labour force participation rate is the labour force expressed as a percentage of the working-age population.

                                                  Labour Force

Labour Force Participation Rate = ———————————– × 100%

                                                 Working-age Population

Note:   According to the International Labour Organisation (ILO), the unemployed are persons of working age who are without work, are available to start work within two weeks and either have actively looked for work in the last four weeks or are waiting to take up an appointment. However, students need not discuss this in the examination. 

3.2       Causes of Unemployment

There are four causes of unemployment: demand-deficient/cyclical unemployment, structural unemployment, frictional unemployment and seasonal unemployment.

Demand-deficient/Cyclical Unemployment

Demand-deficient unemployment, or cyclical unemployment, refers to unemployment which occurs due to a deficiency in demand. A deficiency in demand usually occurs when aggregate demand falls or when aggregate demand rises at a slow rate relative to the size of the labour force. When aggregate demand falls, firms will decrease production which will lead to a decrease in the demand for labour in the economy. As real wages are inflexible downwards due to factors such as the existence of employment contracts, trade unions protecting the standards of living of their members and firms unwilling to lower real wages to avoid decreasing the productivity of their workers, a decrease in the demand for labour in the economy will lead to demand-deficient unemployment.

In the above diagram, given the demand for labour in the economy (ADL0) and the supply of labour in the economy (ASL0), the real wage rate (w) is w0. A decrease in aggregate demand leads to a fall in the demand for labour in the economy from ADL0 to ADL1. At the same real wage rate (w0), the supply of labour in the economy exceeds the demand which results in demand-deficient unemployment. In the case where aggregate demand rises at a slow rate relative to the size of the labour force, the economy will not create sufficient new jobs for the new entrants in the labour force which will also lead to demand-deficient unemployment.

Demand-deficient unemployment in Singapore is mainly due to external factors. As Singapore is a small economy that is highly dependent on external demand with the domestic exports accounting for a large proportion of the aggregate demand, a decrease in aggregate demand is mainly due to a decrease in exports. For example, the decrease in exports in Singapore in the 2008-2009 Global Financial Crisis caused by the Subprime Mortgage Crisis in the United States led to a substantial decrease in aggregate demand. Demand-deficient unemployment in Singapore also occurs due to a decrease in domestic demand but to a smaller extent. Domestic demand in Singapore constitutes a smaller proportion of aggregate demand and hence a decrease in domestic demand has a smaller effect on aggregate demand. Consumption expenditure generally does not decrease substantially due to the high savings rate and hence the low consumption expenditure which is a result of the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. Government expenditure on goods and services generally does not decrease substantially due to the low government expenditure which is a result of the prudent fiscal policy.

To reduce demand-deficient unemployment, the government can use policies to increase aggregate demand. These policies will be explained in greater detail in Chapter 12.

Structural Unemployment

Structural unemployment refers to unemployment which occurs due to a change in the structure of the economy. The structure of the economy changes when some industries expand and some industries contract and this may be due to technological advancements, changes in comparative advantage or changes in the pattern of demand. When this happens, the expanding industries which are typically high value-added industries will create jobs and the contracting industries which are typically low value-added industries will lose jobs. However, as workers who will lose their jobs in the contracting industries possess low skills, they will not have the relevant skills and knowledge to find jobs in the expanding industries which require high skills and this will lead to structural unemployment. Structural unemployment always exists.

There are three main causes of structural unemployment in Singapore: globalisation, technological advancement and economic restructuring. Globalisation refers to the increased integration of economies through an increase in flows of goods and services, capital and labour across international borders. The production of low value-added goods such as disk drives requires low-skilled labour. Singapore has a comparative disadvantage in producing low value-added goods due to the small amount of low-skilled labour. Therefore, globalisation has led to a more rapid decline in the low value-added industries. For example, the relocation of manufacturing plants by firms that produced low value-added goods in Singapore, such as Hitachi, Sanyo and Seagate, to China where the cost of production was lower caused the low value-added industries in Singapore to decline at a faster rate. As a result, the rate at which low-skilled workers are laid off has increased which has led to a rise in structural unemployment. Globalisation will be explained in greater detail in Chapter 13. Singapore had been pursuing the labour-driven economic growth strategy for decades which had greatly contributed to economic growth. However, the labour-driven economic growth strategy requires the support of a loose foreign worker policy which will lead to rising population. As Singapore is a small country with a small land area of slightly over seven hundred square kilometres, rising population will exert a strain on the country’s infrastructure which may lead to problems such as severe traffic congestion, crowded public buses and trains and rapid rises in housing prices. Therefore, the labour-driven economic growth strategy is unsustainable in Singapore. In contrast, as the productivity-driven economic growth strategy will not lead to rising population, the small land area of Singapore is not a constraint for this strategy. Therefore, the Singapore government has been restructuring the economy from one which is labour-driven to one which is productivity-driven over the last few years. To increase labour productivity in the economy, the Singapore government has been increasing the skills and knowledge of labour in the economy through education and training. In addition, it has been increasing the efficiency of capital in the economy through research and development and encouraging firms to adopt better production technologies. Research and development will lead to technological advancement. Technological advancement and adoption of better production technologies will increase the efficiency of capital in the economy which will lead to a rise in labour productivity in the economy. However, technological advancement and adoption of better production technologies will lead to losses of low-skilled jobs which will result in a rise in structural unemployment. Therefore, economic restructuring from labour-driven economic growth to productivity-driven economic growth in Singapore over the last few years has led to losses of low-skilled jobs resulting in a rise in structural unemployment.

To reduce structural unemployment, the government can provide education and training directly, by setting up educational institutes, or indirectly, by giving subsidies or tax incentives to firms to encourage them to send their workers for education and training. Education and training will equip low-skilled workers who are unemployed with the relevant skills and knowledge to find jobs in the expanding industries which require high skills. However, due to the effort that has to be expended on the part of the structurally unemployed workers who are mostly low-skilled, such measures may not decrease structural unemployment significantly. The government can also engage in protectionism to support declining industries to help them to phase out at a slower rate. When this happens, low-skilled workers who are employed in the declining industries will have more time to undergo education and training in order to acquire the relevant skills and knowledge to find jobs in the expanding industries. However, providing protection to declining industries may reduce the incentive for low-skilled workers who are employed in the industries to acquire new skills and knowledge. Furthermore, providing protection to declining industries will prolong the inefficient use of resources in the economy which may hinder the development of comparative advantage in new industries.

Frictional Unemployment

Frictional unemployment refers to unemployment which occurs due to lack of perfect information about the job market. Firms are not fully informed about the types of labour available and workers are not fully informed about the types of jobs available. In other words, although firms and workers have information about the job market, the information is imperfect. Therefore, firms need time to find the most suitable workers and workers need time to find the most suitable jobs. In other words, firms and workers need time to explore the job market and this leads to frictional unemployment. Frictional unemployment always exists.

The cause of frictional unemployment in Singapore is lack of perfect information about the job market, which is the theoretical cause of frictional unemployment. This is also true for other economies.

To reduce frictional unemployment, the government can set up job market intermediaries to match firms searching for workers and workers searching for jobs. Such job market intermediaries may be set up in the form of employment agencies or job matching websites. The government may also organise job fairs which bring together firms searching for workers to conduct a mass recruitment exercise. Job market intermediaries and job fairs provide information about the job market to firms searching for workers and workers searching for jobs which will reduce the searching time. However, firms and workers may not be responsive as they may think that they are better able to assess prospective employers and employees by themselves. If this happens, setting up job market intermediaries and organising job fairs may not lead to a significant fall in frictional unemployment.

Seasonal Unemployment

Seasonal unemployment refers to unemployment which occurs due to the low demand for certain types of labour during certain seasons of the year. For example, some agricultural workers are unemployed during the off-harvest-season and some construction workers and lifeguards are unemployed during winter. Seasonal unemployment always exists. The solution to seasonal unemployment is the same as the solution to structural unemployment. In reality, it is difficult to decrease seasonal unemployment significantly because a large part of it is voluntary. However, seasonal unemployment is usually insignificant and is hence rarely a matter of social concern.

Full Employment and Natural Unemployment

Full employment is the state of the economy where there is no demand-deficient unemployment. When the economy is at full employment, there still exists unemployment which comprises structural unemployment, frictional unemployment and seasonal unemployment. Natural unemployment refers to the sum of structural unemployment, frictional unemployment and seasonal unemployment. The natural rate of unemployment in Singapore is estimated to be around 2 per cent. In the United States, it is estimated to be around 5 per cent. In practice, to determine whether the economy is at full employment, the government compares the actual rate of unemployment and the natural rate. If the actual rate of unemployment is equal to the natural rate, the economy is said to be at full employment. If the actual rate of unemployment is above the natural rate, the economy is said to be at below full employment. If the actual rate of unemployment is below the natural rate, the economy is said to be at above full employment. As there still exists unemployment when the economy is at full employment, full employment is also called low unemployment. Singapore has a record of low unemployment.

Note:   If the examination question asks about the causes of unemployment in Singapore, students need not explain seasonal unemployment as it is low due to the fact that Singapore has only one season all year round.

The Principal Economics Tutor will discuss the causes of unemployment in greater detail in the economics tuition class.

3.3       Costs and Benefits of Unemployment

Costs of Unemployment

High unemployment will cause the economy to lose a large amount of output resulting in substantial productive inefficiency as a large amount of labour is not employed in the production of goods and services. A substantial loss in national output may lead to a large fall in the standard of living. High unemployment will cause a large number of workers to lose income and often suffer a fall in morale and self-confidence. Furthermore, if the unemployed workers remain jobless for a prolonged period of time, they may lose their skills and knowledge which could make it harder for them to gain employment. When unemployment is high, workers who are employed will also suffer a fall in income in the form of a pay cut. High unemployment will lead to a substantial fall in the purchasing power of households. The resultant substantial fall in the demand for goods and services will cause firms to lose a large amount of profit. When unemployment is high, the government will lose a large amount of tax revenue. It may also need to increase expenditure on unemployment benefits substantially. If this leads to a persistent budget deficit, the public debt will rise persistently which may lead to adverse consequences such as a higher tax burden on future generations. High unemployment may lead to high social costs such as a high crime rate, a high divorce rate and a high suicide rate. In the event of very high unemployment, social unrest could break out.

Benefits of Unemployment

Some workers leave their jobs in order to search for a better job. Although they will suffer from temporary unemployment, they may experience a rise in income if they manage to find better employment. If workers leave their jobs in order to search for a better job, this may lead to a better match between workers and jobs which will result in an increase labour productivity in the economy. Recall that labour productivity refers to output per hour of labour. An increase in labour productivity in the economy will lead to a fall in the cost of production in the economy resulting in an increase in aggregate supply. When this happens, economic growth will rise which may reduce unemployment, and inflation will fall which may improve the balance of payments. If people are willing to bear with some unemployment, inflation may be kept at a low rate. In contrast, the cost of eliminating unemployment may be an intolerably high inflation rate. Recall that the inverse relationship between inflation and unemployment can be shown with the short-run Phillips curve.

In the above diagram, the short-run Phillips curve (SRPC) is downward sloping due to the short-run inverse relationship between inflation and unemployment. When the unemployment rate is m0, the inflation rate is p0, which may be low. At zero per cent unemployment rate, the inflation rate is p1, which may be intolerably high.

Note:   The Principal Economics Tutor will discuss the costs and benefits of unemployment in greater detail in the economics tuition class.

4          INFLATION

4.1       Measurement of Inflation

Inflation is a sustained rise in the general price level.

The inflation rate is calculated as the percentage increase in the consumer price index.

Inflation Rate (t) = (CPIt – CPIt–1)/CPIt–1 × 100%

where CPIt = ∑[(Pit/Pi base year × 100) × Wi]

The consumer price index is a price index which measures the cost of a basket of goods and services purchased by the average household. It is calculated by choosing a basket of goods and services purchased by the average household, dividing them into categories, assigning a weight to each category based on the proportion of total expenditure spent on it, choosing a base year, measuring the prices of the goods and services in the current year as well as in the base year.

Suppose that there are only two goods produced in the economy, Good A and Good B. Further suppose that the base year is 2009 (i.e. CPI2009 = 100).

CPI2012 = [(12/8 × 100) × 1/4] + [(14/16 × 100) × 3/4] = 103.125

CPI2011 = [(10/8 × 100) × 1/4] + [(15/16 × 100) × 3/4] = 101.563

Inflation (2012) = (CPI2012 – CPI2011)/CPI2011 × 100% = (103.125 – 101.563)/101.563 × 100% = 1.538%

Generally, inflation is considered low when the general price level rises by 3 per cent or less. Singapore has a record of low inflation. Inflation that is higher than 3 per cent is called high inflation. Many developing economies such as Vietnam have high inflation. Inflation that is substantially higher than 3 per cent is called hyperinflation. An example of hyperinflation is the 6.5 × 10108 per cent inflation in Zimbabwe in 2008.

There are two types of inflation statistics. One is known as consumer price inflation or headline inflation and the other is called core inflation or underlying inflation. In the measurement of core inflation, goods whose prices are volatile or highly influenced by government policies are removed from the basket of goods and services that is used to compute consumer price inflation. Therefore, core inflation is better than consumer price inflation for forecasting the long-term trend of the general price level. Unlike most economies where energy and food are removed from the basket, in Singapore, accommodation and private road transport are removed from the basket.

Note:   Students are not required to explain the construction of the consumer price index in the examination as it has been removed from the Singapore-Cambridge GCE ‘A’ Level Economics syllabus. However, they are required to be able to explain how the consumer price index is used to measure inflation. 

4.2       Causes of Inflation

Economists distinguish between two types of inflation: demand-pull inflation and cost-push inflation.

Demand-pull Inflation

Demand-pull inflation is a sustained rise in the general price level due to an increase in aggregate demand. An increase in aggregate demand will lead to a shortage of goods and services resulting in a rise in the general price level. Furthermore, when aggregate demand rises, firms will increase production which will lead to an increase in the demand for factor inputs in the economy resulting in a rise in the prices. When this happens, the cost of production in the economy will rise which will induce firms to increase prices to maintain profitability resulting in a rise in the general price level. Given any increase in aggregate demand, the extent of the rise in the general price level will depend on the state of the economy. The nearer the economy is to the full-employment equilibrium, the smaller will be the amount of excess production capacity in the economy and hence the larger will be the rise in the general price level.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to a rise in the general price level (P) from P0 to P1. Aggregate demand may increase due to an increase in any of its components. Consumption expenditure is determined by several factors such as consumer sentiment, the wealth of households, interest rates, expectations of price changes, the availability of credit and the distribution of income. For example, when households are more optimistic about the economic outlook, they will expect their income to rise and hence increase consumption expenditure. Investment expenditure is determined by several factors such as interest rates, business sentiment, business costs, capital costs, corporate income tax, technological advancements and the availability of credit. For example, a fall in interest rates will decrease the costs of borrowing and this will lead to more profitable planned investments resulting in an increase in investment expenditure. Government expenditure on goods and services is largely determined by the objective of the government. For example, the government may increase expenditure on the infrastructure of the economy to attract foreign direct investments. Net exports are determined by several factors such as the exchange rate, domestic inflation relative to foreign inflation, domestic income and foreign income. For example, an increase in foreign income will lead to an increase in net exports.

Demand-pull inflation in Singapore is mainly due to an increase in external demand. Exports in Singapore are generally increasing as the world economy is generally expanding and hence the world income is generally rising. As Singapore is a small economy that is highly dependent on external demand with the domestic exports accounting for a large proportion of the aggregate demand, an increase in exports generally leads to a large increase in aggregate demand. For example, the increase in exports in Singapore in the global economic recovery in 2010 led to a substantial increase in aggregate demand. Demand-pull inflation in Singapore also occurs due to an increase in domestic demand but to a smaller extent. Domestic demand in Singapore constitutes a smaller proportion of aggregate demand and hence an increase in domestic demand has a smaller effect on aggregate demand. Consumption expenditure generally does not increase substantially due to the high savings rate which is a result of the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. Government expenditure on goods and services generally does not increase substantially due to the prudent fiscal policy.

To reduce demand-pull inflation, the government can use policies to reduce the growth of aggregate demand. These policies will be explained in greater detail in Chapter 12.

Cost-push Inflation

Cost-push inflation is a sustained rise in the general price level due to a rise in the cost of production in the economy, independent of demand. When the cost of production in the economy rises independently of demand, firms will increase prices at the same output levels to maintain profitability. In other words, they will decrease output at the same prices which will lead to a decrease in aggregate supply resulting in a shortage of goods and services and hence a rise in the general price level.

In the above diagram, a decrease in aggregate supply (AS) from AS0 to AS1 leads to a rise in the general price level (P) from P0 to P1. The cost of production in the economy may rise independently of demand due to several reasons. For example, workers will bargain for higher wages to maintain purchasing power when they expect prices to rise. They will also bargain for higher wages when they have greater bargaining power due to a tighter labour market. The prices of intermediate goods will rise when the world demand rises due to an expansion of the world economy. A fall in the exchange rate will lead to a rise in the prices of imported intermediate goods in domestic currency. The government may raise goods and services tax to avoid a budget deficit if it cuts corporate income tax to attract foreign direct investments. Oil prices may rise due to man-made factors or natural factors. An example is the substantial rise in the cost of production in the economy due to the sharp rise in oil prices from October 1973 to March 1974 as a result of the oil embargo imposed by the Organisation of Arab Petroleum Exporting Countries (OAPEC) against the United States, the United Kingdom, the Netherlands, Japan and Canada.

Cost-push inflation in Singapore is mainly imported in nature which is commonly known as imported cost-push inflation. As the world economy is generally expanding, the world demand for intermediate goods and hence the prices are generally rising. Due to lack of factor endowments, Singapore imports a large amount of intermediate goods and hence a rise in the prices leads to a rise in the cost of production in the economy to a larger extent. For example, the increase in the prices of imported intermediate goods in Singapore in 2010 due to the global economic recovery led to a substantial rise in the cost of production in the economy. Cost-push inflation in Singapore also occurs due to domestic factors but to a smaller extent, which is commonly known as domestic cost-push inflation. Wages in Singapore generally do not rise substantially due to the loose foreign worker policy. Furthermore, labour productivity in the economy is generally rising which will cushion the effect of an increase in wages on the labour cost in the economy. Although an increase in goods and services tax will lead to a substantial rise in the cost of production in the economy, the government has raised the tax only three times since it was introduced in 1994.

To reduce cost-push inflation, the government can use policies to increase aggregate supply or reduce the growth of aggregate demand. These policies will be explained in greater detail in Chapter 12.

Imported Inflation

Imported inflation is a sustained rise in the general price level due to a rise in the prices of imports. There are two types of imported inflation: direct imported inflation and indirect imported inflation. A rise in the prices of imported consumer goods will directly lead to a rise in the general price level resulting in direct imported inflation. A rise in the prices of imported intermediate goods will not directly lead to a rise in the general price level. However, when the prices of imported intermediate goods rise, the cost of production in the economy will rise. When this happens, firms which produce consumer goods will increase prices to maintain profitability and this will lead to a rise in the general price level resulting in indirect imported inflation.

Monetarist View (Optional but good to know)

Monetarists believe that inflation is always and everywhere a monetary phenomenon. By this, they mean that inflation can only be produced by a more rapid increase in the money supply than in output. This view is an outgrowth of the study of the historical relationship between the money supply and prices done by the leader of the Monetarist school of thought, Milton Friedman. His study indicated a strong positive relationship between the money supply and prices (A Monetary History of the United States, 1867 – 1960). Monetarists believe that in addition to money and financial assets such as bonds, people hold their wealth in the form of physical assets such as cars, televisions and other consumer goods. If the money supply increases, people will find themselves holding more money than they want. Although some of this money will be used to purchase financial assets, some will be used to purchase physical assets which will lead to an increase in aggregate demand. An increase in aggregate demand will lead to an increase in nominal national output (after 6 to 9 months). Initially, the change will appear primarily in output. However, after a few months (another 6 to 9 months), prices will rise and output will fall back. Therefore, an increase in the money supply will only lead to higher prices in the long run (after 12 to 18 months). The hyperinflation of 6.5 × 10108 per cent in Zimbabwe in 2008 was an extreme monetary phenomenon. The central bank of Zimbabwe was compelled by the government to purchase the bonds that it issued. As a result, the money supply in Zimbabwe increased rapidly. However, as the amount of goods produced in Zimbabwe did not increase at the same rate, the rapid increase in the money supply led to a situation of ‘too much money chasing too few goods’ which resulted in hyperinflation.

Note:   Students are not required to explain the Monetarist view on inflation in the examination as it has been removed from the Singapore-Cambridge GCE ‘A’ Level Economics syllabus. Nevertheless, it is good for them to have a basic understanding of the Monetarist view on inflation in order to have a better understanding of the causes of inflation. 

A substantial rise in the cost of production in the economy is likely to lead to stagflation. Stagflation is a situation where there is high inflation and economic stagnation which leads to high unemployment. The world first experienced stagflation in October 1973 when the Organisation of Arab Petroleum Exporting Countries (OAPEC) imposed an oil embargo against the United States, the United Kingdom, the Netherlands, Japan and Canada which led to a large decrease in the supply of oil resulting in a sharp rise in the prices. 

Although the Neoclassical model is more realistic than the Keynesian model, students are allowed to use either model to illustrate inflation in the examination.

The Principal Economics Tutor will discuss the causes of inflation in greater detail in the economics tuition class.

4.3       Costs and Benefits of Inflation

Costs of Inflation

Fall in the Real Value of Savings

High inflation will reduce the real value of savings. When inflation is high, nominal interest rates on savings will not fully compensate for the substantial rise in the general price level. When this happens, the same amount of savings will allow individuals to buy only a smaller amount of goods and services which will reduce the real value of savings. This is undesirable particularly if the savings rate in the economy is high. For example, the savings rate in Singapore is high due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system.

Fall in Net Exports

High inflation may lead to a decrease in net exports resulting in a deterioration in the balance of payments, a decrease in national output and hence national income and a rise in unemployment. When inflation is high, domestic goods and services may become relatively more expensive than foreign goods and services. If this happens, net exports will fall. The balance of payments is a record of all the transactions between the residents of the economy and the rest of the world over a period of time and is made up of the current account and the capital and financial account. A decrease in net exports will lead to a deterioration in the current account and hence the balance of payments, assuming the demand for exports is price elastic. Furthermore, a decrease in net exports will lead to a decrease in aggregate demand which will induce firms to decrease production resulting in a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income. A decrease in national output will lead to a fall in the demand for labour in the economy resulting in a rise in unemployment.

Fall in Investment Expenditure

High inflation may lead to a decrease in investment expenditure resulting in a decrease in national output and hence national income and a rise in unemployment. As high inflation tends to be unstable due to the high variance, it will make it harder for firms to estimate the costs and the revenues of planned investments. When this happens, firms will be less certain about the expected returns on planned investments which will lead to a decrease in investment expenditure resulting in a decrease in aggregate demand. This will lead to a decrease in national output and hence national income resulting in a rise in unemployment.

High Shoe-leather Cost of Inflation

High inflation will lead to a high shoe-leather cost of inflation. High inflation will lead to high interest rates. Metaphorically, when interest rates are high, the transactions demand for money will be low. Therefore, people will make frequent trips to the bank to withdraw small amounts of money which will cause their shoes to wear out rapidly resulting in a high shoe-leather cost of inflation. In reality, the idea of wearing out your shoes rapidly implies more than making frequent trips to the bank. Rather, when interest rates are high, people will devote more time to managing money rather than spend more time on producing goods and services.

High Menu Cost of Inflation

High inflation will lead to a high menu cost of inflation. When prices of goods and services rise, firms have to reprint price labels. For example, restaurants have to reprint menus to reflect the higher prices of meals. When inflation is high, prices of goods and services will rise frequently and hence firms will need to reprint price labels frequently which will lead to a high menu cost of inflation.

Haphazard Redistribution of Real Income and Wealth (Unanticipated Inflation)

Unanticipated inflation will lead to a haphazard redistribution of real income and wealth. Consider a wage contract that specifies a wage increase of 3 per cent on the assumption that the general price level will remain constant. If inflation unexpectedly turns out to be 10 per cent, the 3 per cent increase in nominal wages will mean a 7 per cent decrease in real wages. In this case, real income will be haphazardly redistributed from workers to firms. Furthermore, unanticipated inflation will decrease the liabilities of debtors and the assets of creditors in real terms. In other words, when there is unanticipated inflation, debtors will owe creditors less in terms of goods and services. In this case, wealth will be haphazardly redistributed from creditors to debtors.

Haphazard Redistribution of Real Income (Anticipated Inflation)

Anticipated inflation will also lead to a haphazard redistribution of real income. Some private pension plans are stated in nominal terms and others compensate for up to only 5 per cent inflation. Therefore, even if inflation had been anticipated, people who live on fixed nominal income will see their real income erode away over time. In this case, real income will be haphazardly redistributed from pensioners to firms.

Benefits of Inflation

Although high inflation is undesirable for the economy, low inflation is desirable. Low inflation is desirable for the economy as it injects some downward flexibility into real wages which leads to fewer firm closures and hence fewer job losses resulting in lower unemployment. Due to several reasons such as falling sales, firms may need to cut real wages to avoid closure. In the absence of inflation, they will need to cut nominal wages in order to cut real wages. However, as cutting nominal wages is difficult due to factors such as the existence of employment contracts and trade unions protecting the standards of living of their members, this means that the absence of inflation will make it harder for firms to cut real wages which will lead to more firm closures and hence more job losses resulting in higher unemployment. In contrast, if there is some inflation, say 2 per cent, firms will be able to cut real wages without cutting nominal wages. This is because when firms keep nominal wages constant at a time when the prices of goods and services are rising, they are effectively cutting real wages. This means that the presence of some inflation will make it easier for firms to cut real wages which will lead to fewer firm closures and hence fewer job losses resulting in lower unemployment. Another way to understand why some inflation is necessary for achieving low unemployment is through the short-run Phillips curve. If people are willing to bear with some inflation, unemployment may be kept at a low rate. In contrast, the cost of eliminating inflation may be an intolerably high unemployment rate. Recall that the inverse relationship between inflation and unemployment can be shown with the short-run Phillips curve.

In the above diagram, the short-run Phillips curve (SRPC) is downward sloping due to the short-run inverse relationship between inflation and unemployment. When the inflation rate is p0, the unemployment rate is m0, which may be low. At a zero per cent inflation rate, the unemployment rate is m1, which may be intolerably high.

Note:   A nominal value is measured in terms of money. A real value is measured in terms of goods and services. Suppose that a firm pays a worker a monthly income of $1000. Further suppose that the only good in the economy is lipstick which costs $20 each. In this case, the nominal income of the worker is $1000 and the real income is 50 lipsticks. Firms and workers are concerned with real income. Similarly, lenders and borrowers are concerned with real interest rate. Suppose that a lender charges a borrower an interest rate of 7 per cent. Further suppose that inflation is 3 per cent. In this case, the real interest rate is 4 per cent. This means that although the borrower will pay back 7 per cent more to the lender in terms of money, the lender will only receive 4 per cent more from the borrower in terms of goods and services.

The Principal Economics Tutor will discuss the costs and benefits of inflation in greater detail in the economics tuition class.

4.4       Costs and Benefits of Deflation

Deflation is a sustained fall in the general price level.

Benefits of Deflation

Rise in the Real Value of Savings

Deflation will increase the real value of savings. Deflation will allow individuals to buy a larger amount of goods and services with the same amount of savings which will increase the real value of savings. This is desirable particularly if the savings rate in the economy is high. For example, the savings rate in Singapore is high due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system.

Rise in Net Exports

Deflation may lead to an increase in net exports resulting in an improvement in the balance of payments, an increase in national output and hence national income and a fall in unemployment. When deflation occurs, domestic goods and services may become relatively cheaper than foreign goods and services. If this happens, net exports will rise. Recall that the balance of payments is a record of all the transactions between the residents of the economy and the rest of the world over a period of time and is made up of the current account and the capital and financial account. An increase in net exports will lead to an improvement in the current account and hence the balance of payments, assuming the demand for exports is price elastic. Furthermore, an increase in net exports will lead to an increase in aggregate demand which will induce firms to increase production resulting in an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

Costs of Deflation

Deflationary Expectations

Deflation may lead to deflationary expectations resulting in a decrease in national output and hence national income and a rise in unemployment. When the general price level falls, households may expect it to fall further. If this happens, consumption expenditure will fall which will lead to a decrease in aggregate demand. This will lead to a decrease in national output and hence national income resulting in a rise in unemployment. This is undesirable particularly if the deflation was caused by a fall in aggregate demand. For example, the Japanese government was concerned about deflation in the late 1990s due to the prospect of deflationary expectations.

Widespread Bankruptcy

Deflation may lead to widespread bankruptcy resulting in a decrease in national output and hence national income and a rise in unemployment. Firms are generally in debt. As deflation will increase the real value of debts, it may lead to widespread bankruptcy. If this happens, investment expenditure will fall which will lead to a decrease in aggregate demand. This will lead to a decrease in national output and hence national income resulting in a rise in unemployment. For example, in the Great Depression of 1930s, many farmers in the United States lost their farms through foreclosures as a result of rising debt burden due to falling prices.

Rise in Interest Rates

Deflation may lead to a rise in interest rates resulting in a decrease in national output and hence national income and a rise in unemployment. Deflation is a return on holding money as it will increase the real value of money. Therefore, if deflation leads to deflationary expectations, the demand for money will increase which will lead to a rise in interest rates. Higher interest rates will increase the incentive to save and the costs of borrowing and this will lead to a decrease in consumption expenditure. Furthermore, an increase in the costs of borrowing will lead to fewer profitable planned investments resulting in a decrease in investment expenditure. A decrease in consumption expenditure and investment expenditure will lead to a decrease in aggregate demand which will lead to a decrease in national output and hence national income resulting in a rise in unemployment.

Redistribution of Wealth from Debtors to Creditors

Unanticipated deflation will redistribute wealth from debtors to creditors resulting in a decrease in national output and hence national income and a rise in unemployment. Unanticipated deflation will increase the liabilities of debtors and the assets of creditors in real terms. In other words, when there is unanticipated deflation, debtors will owe creditors more in terms of goods and services. When this happens, wealth will be redistributed from debtors to creditors. As debtors have a higher marginal propensity to consume out of wealth than creditors, this redistribution of wealth from debtors to creditors will lead to a decrease in consumption expenditure resulting in a decrease in aggregate demand. This will lead to a decrease in national output and hence national income resulting in a rise in unemployment.

Note:   Although deflation brings about both benefits and costs to the economy, it is a serious concern in reality due to the potential deflationary expectations which could be very detrimental to the economy.

The Principal Economics Tutor will discuss the costs and benefits of deflation in greater detail in the economics tuition class.

5          THE BALANCE OF PAYMENTS

5.1       Components of the Balance of Payments

The balance of payments is a record of all the transactions between the residents of the economy and the rest of the world over a period of time. In other words, the balance of payments records all the money flows between the economy and the rest of the world. The balance of payments is made up of the current account and the capital and financial account.

Current Account

The current account is the part of the balance of payments which records exports and imports of goods and services, income remittances and current transfers. The current account balance is the sum of the goods balance, the services balance, the primary income balance and the secondary income balance.

Goods Balance

The goods balance, which is also known as the balance on trade in goods or the visible balance, is the exports of goods minus the imports of goods.

Services Balance

The services balance, which is also known as the balance on trade in services, is the exports of services minus the imports of services.

Primary Income Balance

The primary income balance, which is also simply known as the income balance, is the inward income remittances minus the outward income remittances. Income refers to wages, rent, interest and profits.

Secondary Income Balance

The secondary income balance, which is also known as the net current transfers, is the inward current transfers minus the outward current transfers. Current transfers are government contributions to and receipts from other economies and international transfers of money by private individuals and firms.

Capital and Financial Account

The capital and financial account is made of the capital account and the financial account. The capital account is the part of the balance of payments which records capital transfers such as the transfers of funds by migrants, development aid funds, the acquisition and disposal of non-produced, non-financial assets such as land, patents, copyrights and franchises, etc. The capital account balance is the inward capital transfers minus the outward capital transfers. The financial account is the part of the balance of payments which records changes in the holdings of shares, government securities, corporate bonds, deposits, loans, official reserves, etc. The financial account balance is the sum of direct investment (net), portfolio investment (net), other investment (net) and official reserves (net).

Direct Investment (Net)

Direct investment refers to investment made with the objective of obtaining a lasting interest in an organisation and exercising a significant degree of influence in its management. This is defined as ownership of at least 10 per cent of ordinary shares. Direct investment (net) is the inward direct investment minus the outward direct investment.

Portfolio Investment (Net)

Portfolio investment refers to investment in paper assets such as shares of less than 10 per cent of ordinary shares, government securities and corporate bonds. Portfolio investment (net) is the inward portfolio investment minus the outward portfolio investment.

Other Investment (Net)

Other investment consists mainly of short-term investments such as loans and deposits. Other investment (net) is the inward other investment minus the outward other investment.

Reserve Assets (Net)

Reserve assets refer to the central bank’s holdings of foreign exchange reserves, gold, Special Drawing Rights and reserves with the International Monetary Fund. Reserve assets (net) are the change in reserve assets.

By design, the balance of payments which is the current account balance minus the capital and financial account balance is equal to zero. This will be explained in greater detail in Section 5.4.

Note:   Students are not required to explain the construction of the balance of payments in the examination as it has been removed from the Singapore-Cambridge GCE ‘A’ Level Economics syllabus. They are only required to be able to explain the main items which are recorded in the main accounts. 

The sum of the goods balance and the services balance is referred to as the balance on goods or services, the balance of trade or simply the trade balance. It is the exports of goods and services minus the imports of goods and services. The sum of the services balance, the primary income balance and the secondary income balance is referred to as the invisible balance. 

In some countries such as the United Kingdom, the change in reserve assets is recorded in the financial account which is the case presented in this book. However, in Singapore and some other countries, the change in reserve assets is recorded separately in the reserve assets account which is also known as the official financing account. In addition, the capital account used to be recorded separately from the financial account in Singapore. However, the government has recently consolidated the capital account under the financial account.

5.2       Total Currency Flow

Although the balance of payments is equal to zero, it may not necessarily be in equilibrium. Whether the balance of payments is in equilibrium depends on the total currency flow. The total currency flow is the current account balance minus the capital and financial account balance excluding the change in reserve assets. When the total currency flow is positive, the balance of payments is in surplus and that occurs when money inflows exceed money outflows. When the total currency flow is negative, the balance of payments is in deficit and that occurs when money outflows exceed money inflows. Economists refer to these as balance of payments disequilibria. When the total currency flow is zero, the balance of payments is in equilibrium and that occurs when money inflows are equal to money outflows. Economists refer to this as a balance of payments equilibrium. Under the floating exchange rate system, the balance of payments is in equilibrium. Under the fixed exchange rate system, the balance of payments is in disequilibrium, unless by chance. This will be explained in greater detail in Section 5.4.

5.3       Net Errors and Omissions

Errors and omissions, which are also known as balancing item or statistical discrepancy, are bound to occur in the process of constructing the balance of payments as the data for the current account and the capital and financial account are obtained from diverse sources. Since errors and omissions always occur, the current account balance minus the capital and financial account balance is not equal to zero. Rather, it is the current account balance minus the capital and financial account balance plus net errors and omissions which is equal to zero. It follows that the balance of payments is the current account balance minus the capital and financial account balance plus net errors and omissions. Similarly, the total currency flow is the current account balance minus the capital and financial account balance excluding the change in reserve assets plus net errors and omissions.

5.4       Total Currency Flow and the Exchange Rate System

Floating Exchange Rate System

Under the floating exchange rate system, the total currency flow is equal to zero which means that the balance of payments is in equilibrium. This is because any balance of payments disequilibrium will be automatically corrected through an adjustment of the exchange rate. If the balance of payments is in deficit, which means that money outflows exceed money inflows, the supply of domestic currency will exceed the demand which will lead to a downward pressure on the exchange rate. Under the floating exchange rate system, domestic currency will depreciate. When this happens, domestic goods and services will become relatively cheaper than foreign goods and services which will lead to an increase in net exports. Assuming the sum of the price elasticities of demand for exports and imports is greater than one, an increase in net exports may improve the current account and hence correct the balance of payments deficit. Similarly, if the balance of payments is in surplus, which means that money inflows exceed money outflows, the demand for domestic currency will exceed the supply which will lead to an upward pressure on the exchange rate. Under the floating exchange rate system, domestic currency will appreciate. When this happens, domestic goods and services will become relatively more expensive than foreign goods and services which will lead to a decrease in net exports. Assuming the sum of the price elasticities of demand for exports and imports is greater than one, a decrease in net exports may worsen the current account and hence correct the balance of payments surplus.

Fixed Exchange Rate System

Under the fixed exchange rate system, the total currency flow is not equal to zero which means that the balance of payments is in disequilibrium, unless by chance. This is because any balance of payments disequilibrium will not be automatically corrected through an adjustment of the exchange rate. If the balance of payments is in deficit, which means that money outflows exceed money inflows, the supply of domestic currency will exceed the demand which will lead to a downward pressure on the exchange rate. Under the fixed exchange rate system, the central bank will intervene in the foreign exchange market to eliminate the downward pressure on the exchange rate. In other words, the central bank will buy domestic currency and sell foreign currency in the foreign exchange market to prevent domestic currency from depreciating. Therefore, net exports will not rise and hence the balance of payments will remain in deficit. Similarly, if the balance of payments is in surplus, which means that money inflows exceed money outflows, the demand for domestic currency will exceed the supply which will lead to an upward pressure on the exchange rate. Under the fixed exchange rate system, the central bank will intervene in the foreign exchange market to eliminate the upward pressure on the exchange rate. In other words, the central bank will sell domestic currency and buy foreign currency in the foreign exchange market to prevent domestic currency from appreciating. Therefore, net exports will not fall and hence the balance of payments will remain in surplus.

Singapore has been experiencing a healthy BOP over the last few decades. Although Singapore was experiencing a persistent current account deficit before 1985 mainly due to high imports of capital goods as a result of industrialisation, the deficit was more than offset by the persistent surplus on the capital and financial account due to high foreign direct investment. Singapore has been experiencing a persistent capital and financial account deficit since 1993 mainly due to high outward portfolio investment. However, the deficit has not led to a persistent BOP deficit due to the larger persistent surplus on the current account due to high exports. Although Singapore has been experiencing a persistent BOP surplus, the surplus has been modest and hence has not caused problems in the economy.

Note:   When the total currency flow is negative which means that the balance of payments is in deficit, it will be matched by a decrease in reserve assets, which is recorded with a positive sign. Therefore, the current account balance minus the capital and financial account balance plus net errors and omissions is equal to zero. Similarly, when the total currency flow is positive which means that the balance of payments is in surplus, it will be matched by an increase in reserve assets, which is recorded with a negative sign. Therefore, the current account balance minus the capital and financial account balance plus net errors and omissions is equal to zero. When the total currency flow is equal to zero which means that the balance of payments is in equilibrium, there will be no change in reserve assets. Therefore, the current account balance minus the capital and financial account balance plus net errors and omissions is equal to zero.

5.5       Adverse Effects of a Persistent Balance of Payments Deficit

Floating Exchange Rate System

Under the floating exchange rate system, a persistent balance of payments deficit may lead to high imported inflation and currency instability resulting in lower national output and hence national income and higher unemployment. When money outflows persistently exceed money inflows, the supply of domestic currency will persistently exceed the demand which will lead to a persistent downward pressure on the exchange rate. Under the floating exchange rate system, this will cause domestic currency to depreciate persistently. For example, the U.S. dollar which is allowed to float freely has depreciated against the major currencies in the world over the last few decades due to the persistent balance of payments deficit mainly caused by the persistent trade deficit in the United States.

High Imported Inflation

A persistent depreciation of domestic currency will lead to a persistent rise in the prices of imported consumer goods in domestic currency. This may directly lead to a substantial rise in the general price level resulting in high direct imported inflation. Furthermore, the persistent rise in the prices of imported intermediate goods in domestic currency will lead to a persistent rise in the cost of production in the economy. This may indirectly lead to a substantial rise in the general price level resulting in high indirect imported inflation or imported cost-push inflation. If high imported cost-push inflation occurs, domestic goods and services may become relatively more expensive than foreign goods and services which will lead to a decrease in net exports resulting in a deterioration in the current account and hence the balance of payments, assuming the demand for exports is price elastic. This may lead to a vicious cycle of balance of payments deficit and high imported cost-push inflation.

Currency Instability

A persistent depreciation of domestic currency may induce people to sell the currency in anticipation of further falls in the exchange rate. If this happens, domestic currency will depreciate at a faster rate and hence may become unstable which will lead to capital flight and a fall in foreign direct investments. Capital flight will lead to a fall in asset prices resulting in a fall in the wealth of households and hence consumption expenditure. When consumption expenditure and investment expenditure fall, aggregate demand will fall which will induce firms to decrease production resulting in a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income. A decrease in national output will lead to a fall in the demand for labour in the economy resulting in a rise in unemployment.

Fixed Exchange Rate System

Under the fixed exchange rate system, a persistent balance of payments deficit may lead to rising foreign debt and rising interest rates resulting in lower national output and hence national income and higher unemployment.

Rising Foreign Debt

Under the fixed exchange rate system, when money outflows persistently exceed money inflows, the central bank will continually intervene in the foreign exchange market to eliminate the persistent downward pressure on the exchange rate. More specifically, the central bank will continually buy domestic currency and sell foreign currency in the foreign exchange market to prevent domestic currency from depreciating. For example, from 1984 to 2 July 1997, the Thai baht was pegged to the U.S. dollar at 25 Thai bahts to one U.S. dollar and the Bank of Thailand continually bought Thai bahts and sold U.S. dollars to eliminate the persistent downward pressure on the exchange rate due to the persistent balance of payments deficit mainly caused by the persistent trade deficit. However, in time to come, the central bank will deplete its foreign exchange reserves and hence will need to start borrowing foreign currency which will lead to rising foreign debt. When the foreign debt rises to a critical level, the central bank will lose its ability to borrow foreign currency and hence will have to allow domestic currency to depreciate. When this happens, domestic currency may become unstable as it may be subject to speculative attack which will lead to capital flight and a fall in foreign direct investments. Capital flight will lead to a fall in asset prices resulting in a fall in the wealth of households and hence consumption expenditure. When consumption expenditure and investment expenditure fall, aggregate demand will fall which will lead to a decrease in national output and national income resulting in a rise in unemployment.

Rising Interest Rates

If the central bank continually buys domestic currency in the foreign exchange market, the money supply will fall continually which will lead to rising interest rates resulting in falling consumption expenditure and investment expenditure. When this happens, aggregate demand will fall continually which will lead to falling national output and hence national income resulting in rising unemployment.

Non-persistent Balance of Payments Deficit

A non-persistent balance of payments deficit will not cause problems in the economy and may be desirable. If a balance of payments deficit occurs due to an increase in imports of capital goods, the production capacity in the economy will increase. When this happens, aggregate supply will rise which will lead to higher economic growth resulting in a rise in the standard of living. A balance of payments deficit may occur due to an increase in imports of consumer goods. Although this will not lead to an increase in economic growth, it will also lead to an increase in the amount of goods and services available for consumption resulting in a rise in the standard of living. If the economy is overheating where aggregate demand is rising rapidly relative to aggregate supply resulting in high inflationary pressures, a balance of payments deficit which occurs due to a decrease in net exports will reduce the growth of aggregate demand and this may cool down the overheating economy resulting in lower inflation. If a balance of payments deficit occurs due to an increase in capital outflows such as hot money outflows or outward foreign direct investments, the resultant increase in inward income remittances in the form of interest and profit in the long run will lead to an improvement in the current account and hence the balance of payments.

Note:   Foreign debt, or external debt, refers to the amount of money that a country owes to foreign creditors. 

Overheating is a situation where aggregate demand is rising rapidly relative to aggregate supply resulting in high inflationary pressures.

The Principal Economics Tutor will discuss the adverse effects of a persistent balance of payments deficit in greater detail in the economics tuition class.

5.6       Adverse Effects of a Persistent Balance of Payments Surplus

Lower Standard of Living

A persistent balance of payments surplus may occur due to imports of consumer goods being persistently lower than exports of consumer goods. If the surplus had been used to purchase more imports of consumer goods, the amount of goods and services available for consumption would have increased which would lead to a higher standard of living.

Retaliation

When an economy has a persistent balance of payments surplus, its trading partners may be experiencing a persistent balance of payments deficit. If this happens, in time to come, the deficit trading partners may use protectionist measures to correct their persistent balance of payments deficits which will reduce the exports of the economy.

Persistent Appreciation of Domestic Currency and hence Falling Export Competitiveness

Under the floating exchange rate system, a persistent balance of payments surplus will lead to a persistent appreciation of domestic currency. When domestic currency appreciates persistently, domestic goods and services will become increasingly more expensive than foreign goods and services resulting in falling export competitiveness.

Persistent Increase in the Money Supply and hence High Inflationary Pressures

Under the fixed exchange rate system, a persistent balance of payments surplus will require the central bank to continually sell domestic currency and buy foreign currency in the foreign exchange market to prevent domestic currency from appreciating. When this happens, the money supply will rise continually which may lead to a situation of ‘too much money chasing too few goods’ resulting in high inflation.

Note:   Although a persistent balance of payments surplus is undesirable for the economy in theory, it is much less of a concern than a persistent balance of payments deficit in reality.

The Principal Economics Tutor will discuss the adverse effects of a persistent balance of payments surplus in greater detail in the economics tuition class.

5.7       Measures to Correct a Persistent Balance of Payments Deficit

There are three main types of policies to correct a persistent balance of payments deficit: expenditure-switching policies, expenditure-reducing policies and supply-side policies. Expenditure-switching policies are policies that are used to induce domestic households and firms to switch from imports to domestic goods and services and foreign households and firms to switch from foreign goods and services to the country’s exports. They include devaluation and protectionism. Expenditure-reducing policies are policies that are used to reduce consumption expenditure and hence imports. They include contractionary fiscal policy and contractionary monetary policy.

Devaluation (Expenditure-switching Policy)

To correct a persistent balance of payments deficit, the central bank can use exchange rate policy. Exchange rate policy is a policy that is used to control the exchange rate through central bank intervention in the foreign exchange market. The central bank can devalue domestic currency by selling domestic currency and buying foreign currency in the foreign exchange market. A fall in the exchange rate will make domestic goods and services relatively cheaper than foreign goods and services. When this happens, net exports will rise which may lead to an improvement in the current account and hence the balance of payments, assuming the sum of the price elasticities of demand for exports and imports is greater than one. However, if the sum of the price elasticities of demand for exports and imports is less than one, which may happen in the short run, a devaluation of domestic currency will lead to a deterioration in the current account and hence the balance of payments resulting in a larger deficit. Furthermore, a fall in the exchange rate will lead to a rise in the prices of imports in domestic currency which may lead to high imported inflation. The rise in the prices of imported intermediate goods may also lead to high cost-push inflation which may reduce export competitiveness and hence render devaluation an ineffective measure for correcting a persistent balance of payments deficit. Devaluation will be explained in greater detail in Chapter 12.

Protectionism (Expenditure-switching Policy)

To correct a persistent balance of payments deficit, the government can engage in protectionism. Protectionism is the use of measures by the government to protect domestic industries from foreign competition. For example, the government can protect domestic industries by increasing tariffs to increase the prices of imports. When this happens, households and firms will switch from imports to domestic goods which will lead to a decrease in import expenditure resulting in an improvement in the current account and hence the balance of payments. However, protectionism through some measures such as increasing tariffs will lead to higher prices for consumers. Furthermore, protectionism will reduce competition which may foster inefficiency. Protectionism will be explained in greater detail in Chapter 13.

In addition to the limitations of devaluation and protectionism discussed above, the policies are criticised on other grounds. First, if the trading partners retaliate, export revenue will fall which will worsen the current account and hence the balance of payments. Second, export revenue may also fall in the absence of retaliation if devaluation and protectionism lead to a fall in the national incomes and hence the imports of the trading partners. Third, if the persistent balance of payments deficit is due to a high cost of production or low product quality in the economy, devaluation and protectionism will not solve the root cause of the problem.

Contractionary Fiscal Policy (Expenditure-reducing Policy)

To correct a persistent balance of payments deficit, the government can use contractionary fiscal policy. Fiscal policy is a demand-side policy that is used to control government expenditure or taxation to influence aggregate demand. The government can decrease expenditure on goods and services. It can also decrease disposable income to decrease consumption expenditure by increasing direct taxes such as personal income tax and corporate income tax or decreasing transfer payments. In addition to a decrease in consumption expenditure, an increase in corporate income tax will lead to lower expected after-tax returns on planned investments resulting in a decrease in investment expenditure. A decrease in consumption expenditure, investment expenditure and government expenditure on goods and services will lead to a decrease in aggregate demand which will induce firms to decrease production resulting in a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income. When national income falls, imports will fall which will lead to an improvement in the current account and hence the balance of payments. A decrease in aggregate demand will also lead to a fall in the general price level which may make domestic goods and services relatively cheaper than foreign goods and services resulting in an increase in net exports. If this happens, assuming the demand for exports is price elastic, the current account and hence the balance of payments will improve. However, as discussed earlier, contractionary fiscal policy will lead to a decrease in national output and hence national income. A decrease in national output will lead to a fall in the demand for labour in the economy resulting in a rise in unemployment. Furthermore, if the marginal propensity to import is small, the effect of a fall in national income on the balance of payments may not be significant. In addition, contractionary fiscal policy may be subject to limitations such as a small multiplier and inflexibility of government expenditure and taxation. Contractionary fiscal policy will be explained in greater detail in Chapter 12.

Contractionary Monetary Policy (Expenditure-reducing Policy)

To correct a persistent balance of payments deficit, the central bank can use contractionary monetary policy. Monetary policy is a demand-side policy that is used to control the money supply and hence interest rates to influence aggregate demand. The central bank can decrease the money supply by conducting an open market sale. When the money supply decreases, the amount of reserves in the banking system will fall. When this happens, interbank rates will rise which will lead to a rise in the level of interest rates in the economy. Higher interest rates will increase the incentive to save and the costs of borrowing and this will lead to a decrease in consumption expenditure. Furthermore, an increase in the costs of borrowing will lead to fewer profitable planned investments resulting in a decrease in investment expenditure. A decrease in consumption expenditure and investment expenditure will lead to a decrease in aggregate demand which will induce firms to decrease production resulting in a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income. When national income falls, imports will fall which will lead to an improvement in the current account and hence the balance of payments. A decrease in aggregate demand will also lead to a fall in the general price level which may make domestic goods and services relatively cheaper than foreign goods and services resulting in an increase in net exports. If this happens, assuming the demand for exports is price elastic, the current account and hence the balance of payments will improve. However, as discussed earlier, contractionary monetary policy will lead to a decrease in national output and hence national income. A decrease in national output will lead to a fall in the demand for labour in the economy resulting in a rise in unemployment. Furthermore, if the marginal propensity to import is small, the effect of a fall in national income on the balance of payments may not be significant. In addition, contractionary monetary policy may be subject to limitations such as a small multiplier and low interest elasticity of investment and consumption. Contractionary monetary policy will be explained in greater detail in Chapter 12.

Supply-side Policies

To correct a persistent balance of payments deficit, the government can use supply-side policies. Supply-side policies are policies that are used to increase the production capacity in the economy and hence aggregate supply. For example, the government can use education and training and research and development to increase the production capacity in the economy and hence aggregate supply. Education and training will lead to greater human capital which will increase the skills and knowledge of labour in the economy. The government can provide education and training directly, by setting up educational institutes, or indirectly, by giving subsidies or tax incentives to firms to encourage them to send their workers for education and training. Research and development will lead to technological advancement which will increase the efficiency of capital in the economy. The government can engage in research and development directly, by setting up research institutes, or indirectly, by giving subsidies or tax incentives to firms to encourage them to engage in research and development. In addition to an increase in aggregate supply through increasing the production capacity in the economy, an increase in the skills and knowledge of labour or the efficiency of capital in the economy will lead to an increase in aggregate supply through increasing labour productivity and hence decreasing the cost of production in the economy. Assuming aggregate demand is rising which is the normal state of the economy, an increase in aggregate supply will lead to a smaller rise in the general price level resulting in lower inflation and if this makes domestic goods and services relatively cheaper than foreign goods and services, net exports will increase which will lead to an improvement in the current account and hence the balance of payments. However, an increase in the production capacity in the economy and hence aggregate supply will lead to an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. When national income rises, imports will increase which will lead to a deterioration in the current account and hence the balance of payments. Furthermore, the effects of supply-side policies will be realised only in the long run. Therefore, they are ineffective for correcting a persistent balance of payments deficit in the short run. Supply-side policies will be explained in greater detail in Chapter 12.

Note:   The J-curve effect is the effect of a devaluation of domestic currency first causing the balance of trade to worsen and then to improve. Therefore, the graph of the balance of trade over time looks like the letter J. This occurs because the sum of the price elasticities of demand for exports and imports is less than one in the short run and greater than one in the long run. 

Although contractionary fiscal policy and contractionary monetary policy to correct a persistent balance of payments deficit have both expenditure-reducing effect and expenditure-switching effect, they are called expenditure-reducing policies rather than expenditure-switching policies as the expenditure-reducing effect is the primary objective of the policies. 

Although supply-side policies to correct a persistent balance of payments deficit work through expenditure switching, they are not called expenditure-switching policies as the effectiveness time lag is longer than that of expenditure-switching policies which include devaluation and protectionism.

The Principal Economics Tutor will discuss the measures to correct a persistent balance of payments deficit in greater detail in the economics tuition class.

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