Question 1
You have been invited to conduct a workshop for a group of Diploma students at
your school on the topic of money and monetary policy that can be adopted by a
central bank to manage an economy. You are to answer the following questions
raised by the students.
b)
Discuss the monetary policy tools which a central bank can use to stabilise
an economy.
(10 marks)
The objective of monetary policy tools is to adjust the supply of money in the market to
achieve maximum real output in the economy, low unemployment and stable price.
The different monetary tools are as follows:
•
Adjustment of required reserve ratio.
•
Adjustment of discount rate.
•
Government buying and selling of bonds and securities.
Students are expected to explain how these tools work such as how Money supply
curve shift to the right during a recession, as illustrated in the chart below.
MS1
•
MS2
As the money supply in the market is increased, there will be a shift of the money
supply curve from MS1 to MS2, as represented in the chart above.
1
•
This leads to a corresponding decrease in the real interest rate.
•
A decrease in the market interest rate will lead to an increase in planned investment
(I) as well as selected consumption (C).
•
This thus leads to increase in real output in the economy, overcoming the economic
slowdown.
b)
Explain how the monetary policy can keep the economy from becoming
inflationary. Please use the AS/AD model and explain how the effect of the
policy is transmitted to reduce the impact of inflation.
•
(10 marks)
With the reduction in money supply, the interest rate in the market will rise (left chart
below).
•
Numerous expenditures which rely on loans such as private domestic investment (I)
in housing and machineries as well as households’ consumption (C) of items such
as cars, will be reduced substantially due to the higher financing costs of loans from
commercial banks.
•
The AD in the market will reduce and the AD curve will shift left, closing the
inflationary gap. With the effect of the multiplier, the AD curve will shift further
leftward and finally achieve equilibrium on the potential GDP and at a lower price
level.
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C)
Identify and discuss two limitations of monetary policy.
(5 marks)
a)
The monetary policy transmission process is long and drawn out and does not always
respond in the same way.
b)
The response of expenditure plans to changes in the real interest rate depends on many
factors that make the response hard to predict.
c)
The response of real long-term interest rate to a change in the nominal rate depends on
how inflation expectations change.
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Question 2
Singapore was adversely affected by the Global Financial Crisis which started in the
United States of America in 2008. As a result, Singapore went into recession in the
middle of 2008. Using the AD--AS model for illustration,
a)
Discuss the view that the Singapore government should use fiscal policy to
eliminate the recessionary gap in order to reduce unemployment. Please discuss
both the supporting and opposing views.
(10 marks)
The aim of this question is to explain how fiscal policy can reduce unemployment and its
limitations.
Effect of expansionary fiscal policy,
•
Increase in government spending or reduction in tax.
•
Leads to increase aggregate demand and equilibrium output.
•
Leads to the fall in unemployment, mainly the cyclical unemployment which arises from
the economic downturn.
Fiscal policy as a demand side policy however is not effective if,
i)
There
here is high marginal propensity to import and marginal propensity to save which means
that the multiplier effect on the local economy will be low.
ii) Time lags in the implementation of fiscal policy.
iii) Possible crowding out effect, result in rise of interest rate.
iv) Rise in interest rate will lead to appreciation of foreign exchange, result in a fall in export and
an increase in import. This will lead to fall in real outpu
output.
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v) Need for funding of G if intention of government is to increase government spending.
b)
Identify the supply side policies which the government can consider implementing
and discuss the likely effectiveness of implementing such policies in overcoming
the
e recessionary economy.
•
(15 marks)
Supply side policies are policies designed to increase aggregate supply by improving the
workings of product and factor markets.
•
Such supply side policies may include,
o
Productivity training of labour.
o
Subsidising by government
overnment to encourage adoption of more advanced and productive
capital and technology.
o
Tax reduction.
Effectiveness of supply side policies
•
Through higher productivity, firms will be able to achieve lower per unit cost of production.
This will increase the international competitiveness of the products resulting in greater
exports, hence improving the Balance of Trade.
•
Increase in exports will lead to shift of AD to the right as AD increases.
•
Supply side policies help to improve the product
productive
ive capacity of the economy to cope with
rising costs of production and hence lower cost push inflation.
•
It is also able to meet increasing AD and hence lower demand
demand-pull
pull inflation and increase
actual growth in the economy.
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If implemented successfully, sup
supply
ply side policies will shift LAS and SAS to the right, increasing
the potential GDP of the economy as illustrated in the diagram below.
Some limitations of supply-side
side policies
•
Time lag, as supply-side
side policies are long
long-term
term policies with uncertain outcomes.
•
Financing of policies as most of the policies require some government financing which may
have to come from taxes or borrowing.
Conclusion,
In an attempt to boost productivity hence, potential GDP and real output of the economy, supply
side policies seem like the most appropriate. The fundamental reason for raising the level of
productivity is to ensure that the country remains competitive. Supply side policies however,
have to
o be complemented by other policies such as demand side policies to achieve the
ultimate desired outcome.
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Question 3
The simple economy of Zentoland is represented by the following model”
Consumption function:
C = 2,500 + 0.4Yd
Investment function:
I = 1,000
Government spending:
G = 6,000
Net taxes
:
T = 5,000
Export
:
X = 6,000
Import
:
M = 4,000
Disposable income :
Yd = Y - T
a)
What is the equilibrium level of income (Y) of Zentoland?
? Make sure you present
all your workings.
AE
=
C+I+G+X-M
=
2500 + 0.4(Y – T) + I + G + X – M
=
2500 + 0.4(Y – 5,000) + 1,000 + 6,000 + 6000 – 4000
=
2500 + 0.4Y – 2000 + 9000
=
0.4Y + 9500
At equilibrium,
b)
(4 marks)
Y
=
AE
Y
=
0.4Y + 9500
0.6Y
=
9500
Y
=
15833.33
Draw
raw the aggregate expenditures curve.
(4 marks)
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c)
Calculate the multipliers in this economy? Please show your working clearly.
(3 marks)
There are 3 possible multipliers in this economy namely government, tax and balanced budget
multipliers.
G multiplier
T multiplier
=
1 / MPS = 1 / (1 – MPC)
=
1 / (1 – 0.4)
=
1 / 0.6
=
1.67
=
- MPC / MPS
=
- 0.4 / 0.6
=
-0.67
Balanced budget multiplier
d)
=
1
Discuss the effect of an increase in autonomous Investment of $4,000 on the
equilibrium income.
(4 marks)
Method 1
AE
=
0.4Y + 9500
If autonomous investment increases by $4,000,
AE
=
0.4Y + 9500 + 4000
=
0.4Y + 13500
At equilibrium,
Y
=
0.4Y + 13500
0.6Y
=
13500
Y
=
22500
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Method 2
Calculation can also be done using the multiplier. With multiplier of 1.67, any increase in
autonomous investment will lead to overall increase of real output by 1.67 times.
Hence, an additional 4000 of autonomous investment leads to 1.67 X 4000 or approximately
6680 worth of additional output or new equilibrium of $22500.
e)
If $20,000 is the “full employment” level of income, and the government’s goal is
full employment, by how much must government spending (G) increase in order
for the economy to reach the ‘full employment’ level of income?
(3 marks)
If $20,000 is the full employment level of income and the additional autonomous government
spending is A,
20000
=
2500 + 0.4(20000 - 5000) + 1000 + A + 2000
20000
=
A + 11500
A
=
8500
Increase in government spending = 8500 – 6000 = $2500.
f)
Instead of increasing government spending, the government decides to lower net
taxes (T) to bring the economy to the “full employment” level of income of
$20,000.
By how much must net taxes (T) decrease in order for the government
to achieve its goal?
(3 marks)
At full employment level of income,
20000
-0.4T
=
2500 + 0.4(20000 – T) + 1000 + 6000 + 2000
=
2500 + 8000 – 0.4T + 9000
=
19500 – 0.4T
=
500
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T
=
-1250 (Give a rebate)
Decrease in net taxes
g)
=
5,000 –(-1250)
=
$6250
Explain why there are differences in the size of the change in G and change in T in
parts (c) and (d) to achieve the same ‘full employment” level of income.
(4 marks)
Multiplier for G is 1.67.
Multiplier for T -0.67.
The income multiplier effect from G spending is greater than T reduction multiplier. Hence, the
increase in G spending is lower than the tax cut required.
The reason for the lower multiplier effect of the reduction in tax is the possibility that part of the
tax reduced will be saved by household instead of being spent.
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Question 4
a)
Many Economists in the United States of America believe that the Chinese
renminbi is undervalued.
The Chinese government however, has maintained the
view that her currency is not undervalued.
Explain why the governments are
sometimes concerned about the level of exchange rate of their country’s currency
with their major trade partner.
(10 marks)
Exchange rate refers to the external value of a country’s currency. It refers to the price of one
currency in terms of another currency.
Most countries today follow the market-determined
exchange rate system, that is, the rate is determined by the market forces of demand and
supply.
Exchange rate can affect,
•
Competitiveness of exports and imports and
•
Investments in and out of the country.
Competitiveness of exports and imports
A fall in the exchange rate may have desirable effects. It makes exports cheaper in other
countries.
Hence, it typically leads to increase in exports.
Likewise, import payments fall
because the depreciation causes imports to become more expensive. The overall effect is an
improvement in trade balance causing a net injection of money into the circular flow. The
injection through the multiplier process causes a more than proportionate increase in income,
which will in turn leads to an improvement in living standards. With greater savings as a result,
there is an increase in money supply pushing down interest rate and increase in investments.
In short, the depreciation of currency is more conducive to economic growth creating increases
in income, consumption, investments and employment.
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Investments in and out of the cou
country
A fall in the exchange rate can also improve a country’s balance on capital account. It is
cheaper for foreign investment to flow in. The country will further benefit from the transfer of
technology and managerial skills.
Conclusion
There can however,
ever, be situations when a rise in the external value of a currency. Specifically,
•
A country facing full employment, hence there is a need to ease inflationary pressures.
•
A country facing imported inflation such as Singapore. The appreciation of the Singapore
dollars will help to reduce the imported inflation.
b)
Using foreign exchange market diagrams, analyse the effect on the exchange rate
between Singapore dollars (SGD) and United States dollars (USD) when the
following occurs.
i)
The United States
tes government decides to reduce tax on profit made by
foreign investors in the United States.
•
•
(5 marks)
Demand for USD by Singapore investors will increase, hence leading to a shift in
Demand curve to the right.
The USD will appreciate and the SGD will depreciate.
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ii)
The Singapore economy went through a strong recovery following the
recession in 2009, leading to significant increase in imports from USA.
(5 marks)
•
•
•
iii)
Demand for USD by Singapore investors will increase due to the increase in imports
from USA.
Supply of USD will decrease as the Americans import relatively lesser from
Singapore.
The SGD will depreciate and the USD will appreciate.
Speculators anticipate that the USD will fall in value relative to the SGD.
(5 marks)
•
•
•
Demand for USD will decrease relative to SGD, as people start to change their USD
to SGD
Supply of USD will increase as a result.
The USD will depreciate and the SGD appreciate.
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Question 5
Explain the effect on the interest rate in the money market of India for each of the
following situations below. Demonstrate your answer with the aid of suitable diagrams.
a)
The Bank
nk Negara (Central Bank of Malaysia
Malaysia)) reduces the required reserve
ratio of commercial banks by 2 percent.
•
b)
(5 marks)
As the Central Bank increases the supply of money, the interest rate in the market will fall.
The people have decided to hold more money at home as a result of several
commercial banks closing down during the economic crisis.
(5 marks)
•
As people have decided to hold more money, the demand for money will increase.
•
This leads to an increase in the interest rate in the market.
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c)
The people invest in more bond funds as they expect bond price to rise in the near
future.
(5 marks)
•
People will demand for less money as people buy bonds in expectation of their price rising.
•
The money demand curve shifts to the left.
•
The short-term
term interest rate will fall.
Ms
Interest
rate (%)
r1
r2
Md1
Md2
Quantity of money
d)
The economy is experiencing strong economic growth rate of 10% per
annum.
(5 marks)
•
As the economy is doing well, the number of transactions in the economy will increase.
•
The demand for money will increase.
•
This leads to an increase in the interest rate in th
the market.
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e)
Firms are expecting strong economic growth in the next six months.
(5 marks)
•
As firms’ expectation is positive, they are expected to invest more
more,, the demand for loanable
fund will increase.
•
This leads to an increase in the interest rate in the market.
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Question 6
Draw aggregate demand and aggregate supply (AD
(AD-AS)
AS) diagrams for each of the
following scenarios and identify in each case the impact on the price level and
real GDP on the Singapore economy.
Assume the economy begins with a full
employment level of real GDP and all other factors remains constant.
a)
Export from Singapore has increased substantially following the recession
in 2009.
(5 marks)
•
Increase in export will lead to increase in AD, shifting the AD to the right.
right
•
This will lead to a rise in real GDP and price level.
b)
Increase in productivity of the firms.
(5 marks)
•
Greater productivity will lead to increase in LAS and the SAS.
•
The potential GDP and real output will increase while the price level will decrease.
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c)
The Singapore population decline by half a million, as many young
Singaporeans emigrate to Australia and Canada in the last two years.
(5 marks)
•
The decrease
se in population will lead to decrease
crease in aggregate demand for goods
and services.
vices. The AD will shift left.
•
The decreased population
pulation would also result in de
decrease
crease in labour force in Singapore
which would reduce the LAS in Singapore. The LAS and SAS will shift left.
left
•
The real output and potential GDP will decrease
decrease.
•
The change in price is uncertain.
d)
The Singapore dollars appreciated against other major currencies.
(5 marks)
•
Appreciation
eciation of the currency will decrease export and in
increase import.
port. Hence, it will
lead to a decrease
crease in the aggregate dem
demand
and shifting the AD to the left.
left
•
Real GDP and price level will de
decrease.
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e)
More successful supply side policies implemented by the Singapore
government to improve the productivity of workers in the last five years.
(5 marks)
•
Improvement in the productivity of workers will lead to increase in LAS and the SAS.
•
The potential GDP and real output will increase while the price level will decrease.
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