What this lesson teaches
I can explain fiscal, monetary and supply-side policy and judge how well each works.
Syllabus 8843, 3.2.3(b). Macroeconomic Policies: Policy measures and their effectiveness in achieving macroeconomic objectives:; Fiscal policy - How discretionary fiscal policy can influence the level of economic activities and living standards through government spending and taxation; Supply-side policies - How supply-side policies can improve quantity, quality and mobility of factors of production to increase the productive capacity of an economy and hence affect living standards; Monetary policy - How monetary policy can influence the level of economic activities and living standards through the management of exchange rates (case of Singapore) and interest rates
Make a guess
Singapore and the US each raise government spending by the same amount. Where does national income rise more?
- The same in both, because the spending is the same.
- In Singapore, because it is richer and its people spend more.
- In the US, because less of each dollar leaks into imports.
Show the answer
In the US, because less of each dollar leaks into imports.
Singapore spends much of any extra income on imports, so its multiplier is small. The same spending has a bigger effect in a larger, less open economy.
Fiscal policy can be weakened by leakages, time lags and a lack of spare capacity.
Leakages: in Singapore, a large share of extra income is spent on imports and saved, so the multiplier is small and fiscal policy has a smaller effect than in large economies.
Time lags: it takes time to recognise a problem, approve a budget and start spending. By the time the money flows, the economy may have recovered.
Capacity: if the economy is near full employment, extra spending mostly raises prices.
Crowding out: when a government borrows heavily, it competes with firms and households for loans, which can push up interest rates. Higher rates cut private investment and consumption, offsetting part of the rise in AD. Crowding out matters most in large economies with high debt. It matters little in Singapore, where the budget is balanced over each term and interest rates follow global rates.
The multiplier works in reverse too. A cut in government spending, or a rise in taxes, lowers income by more than the first cut, because each household that loses income spends less in turn. This reverse (downward) multiplier is why cutting spending sharply in a weak economy can shrink output by more than planned.
Cost: borrowing to fund spending adds to debt, and money spent has an opportunity cost. Singapore's rules require the budget to be balanced over each term of government, which limits borrowing.
- Limits
- Leakages, time lags, capacity, crowding out, cost.
- Crowding out
- Government borrowing raises interest rates, cutting private C and I.
- Reverse multiplier
- A spending cut lowers income by a multiple of the cut.
- Singapore
- Small multiplier; balanced budget over each term.
Worked example: A project that arrives too late
A large infrastructure package is announced in a downturn. Approval takes two years, and much of the equipment is imported. By the time building starts, the economy has recovered and skilled workers are scarce.
- Time lag: the spending arrives after the downturn is over.
- Imports: much of the money goes abroad.
- Capacity: with skilled workers scarce, the spending pushes up wages and prices.
- The package still adds infrastructure, which may raise future capacity.
Watch out for this
Fiscal policy has the same effect in every economy.
Its effect depends on the multiplier, which is small in open economies like Singapore, and on spare capacity.
Check your understanding
Why is fiscal policy less powerful in Singapore than in a large economy?
- Singapore collects little tax, so it has little money to spend.
- Singapore's firms are mostly foreign-owned, so they ignore changes in the Budget.
- A large share of extra income leaks into imports, so the multiplier is small.
Show the answer
A large share of extra income leaks into imports, so the multiplier is small.
Right. Much of the extra spending raises other countries' incomes.