Macroeconomics Concerns and

Policies
Inflation:
a sustained rise in the average price of goods over time since the General
Price Level is determined by interaction of demand and supply, AD must rise
relative to AS.
Causes
1. Demand-Pull Inflation: AD rises and is not accompanied by an increase in AS
a. An increase in demand in the real economy [C, I, G or X] due to
increases in consumer confidence, higher wages(both D-pull and Cpush), government spending, tax cuts, improved animal spirits,
growing overseas demand.
b. An increase in the Money Supply will induce more demand in the
economy
2. Cost-Push Inflation: AS falls and hence prices rise
a. Wage-Push: Wages rise disproportionately to productivity, may be
caused by Unions
b. Profit-Push: Monopoly firms may push up prices independent of
changes in demand.
i. Wage-Price Spiral can be started off by a D-pull or Cost-Push
c. Import-Price-Push: An increase in prices of imported goods, e.g. 1973
Oil Shock
d. Tax Push inducing WPS through an increase in tax
e. Fall in AS caused by exhaustion of raw materials or failure of harvests
3. Structural (Rigidity)Inflation: Imbalance in the growth of AD and AS due to
lack of flexibility in the wages and prices. As the economy changes and
demand and supply patterns shift, wages and prices move up but not down.
Ratchet effect.
4. Expectations can perpetuate inflation, but not trigger it. Wage Price Spiral.
Consequences Unanticipated Inflation
1. Interrupts Price Signals Prevents prices from conveying information, as price
increases may be rising in absolute terms (rising across the board) or relative
terms (only for that particular good)
2. Redistributes Incomes
a. Losers: Fixed Incomes, Lenders and Weak Trade Unions (or No Trade
Unions).
b. Winners: Profit Earners, Borrowers and Strong Unions
c. Rich get richer and poor get poorer
d. Governments may inflate away their debts on purpose.
3. Affects Balance of Payments a higher relative inflation rate makes exports
look more expensive, but imports will look cheaper. This can result in a
depreciating Forex rate.

4. Uncertainty Higher inflation is more volatile. Adds to uncertainty of doing

business, discourages investment and lowers trade
5. Employs Resources Firms employ financial experts, buys in future markets
and incurs menu costs.
However it can also generate the money illusion, which makes people feel
better off, and also encourage reallocation of labour.

Unemployment:
those of working age who are without work, but who are available at current
wage rates
Unemp Rate = Unemp/(Work + Unemp)*100%. Seasonally Adjusted
Measure: Those who claim unemployment benefits OR Survey of those seeking
employment.
Causes
Equilibrium
1. Frictional (Search) Unemployment: Short in duration, people temporarily out
of work, may not simply take the first job offered. Information problem, may
be resolved through increasing the quality of information through government
or private (internet) portals.
2. Structural Unemployment: Unemployment caused by changes in patterns of
demand and supply. Technological Unemployment labour replaced by
machinery. Regional Unemployment if a mono-industrial area goes into
decline. May be resolved through retraining (market) or creating jobs
(interventionist), increasing labour mobility (occupational and geographical)
3. Seasonal Unemployment: demand for labour varies with the seasons.
Disequilibrium wage rate is above or below equilibrium point (sticky) and
markets fail to clear
1. Real-wage or Classical Unemployment wages are driven up by unions or
legislated by the government. High wages may help create more jobs since
consumption will rise, but in the short term will always result in less people
being employed.
2. Demand-Deficient or Keynesian Unemployment AD falls so people lose their
jobs, a reduction in wages will reduce AD further, so solution should be to
boost AD via Fiscal Policy.
3. Growth in Labour Supply Immigration, Baby Booms or Women joining the
Labour Force (also too much of a particular kind of labour for a particular
industry)
Duration: Costs of Unemployment increase exponentially with the duration of
Unemployed. Unemployment = no. * duration.

Costs:
Private:

Financial Cost = Wage Benefits

Personal Cost: Self esteem, stress, ill-health

Social:

Output forgone with lack of employment

Loss of tax receipts
Extra spending by the Government
Loss of Profits for firms from full employment
Loss of Opportunities for Other Workers
De-skilling of Unemployed
Externalities Crime, Graffiti, etc.

Growth:
monetary phenomenon measured by increases in real GDP per capita
Actual Growth: % increase in real GDP/GNP per capita. Moving out toward the
PPC. Stems from increases in AD: Consumption, Investment (D-SR, S-LR),
Government Spending and Export Led (D-SR, nothing in the long run)
Potential Growth: Rate at which economy could grow. PPC itself moves
outwards. In line with growth rate of productivity. Stems from increases in AS:

Land reclamation, imperialism, invasion or growth triangles

Labour growing population, immigration, higher participation rate
Capital capital stock increased (Marginal Efficiency of Capital)
Investment (Savings), current consumption sacrificed
Enterprise
Productivity (Qualitative) technological progress improving the quality of
capital. May also depend on Actual Growth stimulating investment and
confidence.

How to: ensure that AG keeps pace with PG in the Short Run (D-side), and in the
Long Run ensuring an increase in the PG rate (S-Side)?
Benefits:
1. Rising GDP means a higher standard of living in material terms
2. Redistribution of incomes are easier when incomes are rising, redistribution
hence may be more equitable (not a zero sum game)
3. We may have more resources to pay attention to non-material things, like the
environment.
Costs:
1. Increased consumption does not = happiness

2.
3.
4.
5.

Investment for growth requires sacrifice of current consumption

Income may simply result in more demands
Growth uses up non-renewable materials more rapidly
Pursuit of materialism may leave society greedier, more selfish and less
caring. Violence, crime, stress, suicide, divorce may result
6. Higher levels of consumption usually lead to a decline in the environment.
7. In reality distribution of income becomes more unequal (Piketty)

Balance of Payments:
All money flowing into the country is recorded as credit and all money flowing
out is recorded as debit.
Current Account Balance

Goods Balance or Merchandise trade Export of Goods minus Import of

Goods (Balance of Trade)
Services Balance Export of Services minus Import of Services: Financial
Services, transport, tourism, government expenditure, entertainments and
wages, interest, profits and dividends
Current Transfers Private and government transfers between countries
e.g. scholarships and contributions to international organizations

Capital Account

Capital Movements into and out of the country. Loans between countries
Investments Direct Physical Investment and Portfolio Investment (shares
in foreign companies).
Short Term flows of capital (hot money) vs Long Term flows.

Surpluses are recorded as an addition to reserves whilst deficits are paid by

drawing on reserves.
Causes of BoP Disequilibrium: deficit/surplus on the Current A/C or Capital
A/C
Current A/C:

Changes in the price of exports relative to the price of imports (terms of

Trade) caused by supply or demand side factors.
Changes in foreign exchange rates
Rate of growth of domestic income relative to the worlds rate of growth
Trends in flows of investment income and transfers

Capital A/C:

In the SR hot money flows according to current interest rates, so changes

in i/r can cause an inflow (higher i/r) or outflow (lower i/r)
In the LR capital flows depend on political factors, government policy,
world sentiment, structural changes.

Consequences of BoP Disequilibrium (on domestic and external economy):

traditionally developing countries should have a deficit on Current A/C as they
import capital equipment and surplus on Capital A/C as foreign firms invest, and
is reversed for developed countries.
Internally:

Surpluses can create jobs to meet export orders, boosting output, but may
lead to inflation if this generates excess demand
In the case of a Fixed Exchange Rate Regime, Reserves and Money Supply
will increase

Externally:

Country may have to borrow to finance an overall deficit if there is a fixed

exchange rate. Interest on loans are a liability.
Country may also run down reserves of foreign currency in case of a deficit
Under a floating regime, surpluses cause the forex to appreciate, and a
deficit causes depreciation.
Surpluses may cause the terms of trade to improve whilst a deficit causes
the terms of trade to worsen.

FOREX:
nominal exchange rate: quoted on forex market for the currency, against the
USD.
real exchange rate: measures the relative price of goods from different
currencies when measured in a common currency
PPC exchange rate path is the path of the nominal exchange rate that would
keep the real exchange rate constant over a period
Singapore dirty or managed float.
Demand for Dollar: foreigners wishing to buy local goods(visible exports) and
services(invisible exports), or move capital into the country in the form of loans,
direct investment or portfolio investment (capital inflows).
Supply of Dollar: locals wishing to buy foreign goods (visible imports) and
services (invisible importsn) or move capital overseas in the form of loans, direct
investment or portfolio investment (Capital outflows)
Fixed Exchange Rates: If Supply and Demand fluctuate, the Central Bank will
buy and sell in the forex market to maintain the forex rate at a chosen level.
Floating Exchange Rates: Domestic currency is allowed to find its own level,
adjusting automatically to changes in supply and demand.
Forward rates: allows importers and exporters to remove some of the
uncertainty of floating rates by allowing rates to be fixed for future delivery.
Hedging.
Exchange Rate Band: Fixed band in which the rate can fluctuate
Joint float: a group of countries fix their rates with regard to one another, and
allows the whole band to fluctuate against the rest of the worlds currencies.

Unstable exchange rates generate uncertainty which drives businesses

away
A steadily appreciating exchange rate is attractive to foreign investment
A steadily appreciating exchange rate is also anti-inflationary and keeps
out imported inflation.

Relationships between Macroeconomic Problems:

Internal and External Value of Money:
1. Internal value of money is determined by the price level. Hence as prices
rise, the internal value of money drops. Inflation makes exports look more
expensive, and imports cheaper, so the country exports less and imports
more, hence resulting in a BoP deficit. If the exchange rate is floating, this
will cause an increase of supply of domestic currency in the forex market,
and hence cause the forex value to fall
2. This process can also work in reverse if the forex value of the currency
falls, this makes exports look cheaper and imports more expensive. Hence
causing demand-pull inflation, causing prices to rise and the internal value
of money to fall.
Inflation and Balance of Payment
1. Inflation that is relatively higher than the rate of its competitors may
cause an increase in imports and a fall in exports (depending on
elasticities of demand), hence causing a BoP deficit.
2. A BoP deficit may cause the forex rate to fall, making exports cheaper and
imports more expensive, causing domestic inflationary pressure.
Inflation and Unemployment:
Inversely related, Phillips Curve (A.W. Phillips) Reflects the Keynesian view of the
economy whereby insufficient demand causes unemployment, whereas excess
demand causes inflation.
However, according to NAIRU: Inflation and Unemployment face a trade off in the
SR, but in the LR the economy settles to a given level of unemployment
dependent on the supply-side of the economy
Money Illusion: people think wages are rising, firms think goods are becoming
popular, so AS rises with AD as people take jobs and firms step up production.
However, once the illusion is broken, jobs are lost and production falls, AS falls.
Hence, unemployment returns to its original level but inflation remains the same.
Conclusion:
Keynesians: Policies which are good for employment and growth cause an
expansion of the economy, which may lead to inflation and a BoP problem.

Conversely, policies which dampen demand and are good for inflation and BoP,
may cause unemployment and reduce growth.
Monetarists: Controlling Inflation (and hence the Money Supply) is a prerequisite
for achieving all the other targets.

Fiscal Policy:
any alteration to Taxes and Government Spending with the intention of altering
Aggregate Demand

ST fluctuations: operating G and T counter cyclically to trade fluctuations.

This is impeded by lags
Fundamental Disequilibria: caused by exogenous shocks e.g. AFC. With a
deflationary gap, FP should be expansionary, increasing G or reducing T (to
stimulate C+I). With an inflationary gap, policy should be contractionary.

Built in Stabilizers:

In a boom, government spending automatically falls (with reduced welfare

payments) and tax receipts automatically rise with higher incomes. The
budget is likely to go into a surplus and the deficit reduced.
The reverse happens in a slump. The effect is that fluctuations in the
economy are dampened
Supply side effects: High Marginal Tax Rates discourage effort and initiative,
whilst generous welfare payments encourage unemployment (and hence a
higher rate of unemployment). Economy might be more stable, but growth
may be slowed.
Fiscal Drag: Stabilize economy at current position, good if at full employment
but will slowdown any recovery from a recession.

Discretionary Policy: Government deliberately altering levels of G and T to

achieve a macro goal. Altering G will have a multiple effect on NY, whereas T will
have a smaller multiplier impact.
Effectiveness:
Requirements: 1. An accurate picture of where the economy is and where its
heading 2. To know the exact effect on AE of altering G & T, i.e. the size of the
multiplier (and accelerator), 3. The timing of effects 4. How changes in AD will
affect NY, employment, inflation and BoP, 5. Any side effects.
Problems:
1. Difficult to ascertain the magnitude of the output gap or the multiplier. Finetuning is impossible, but in major recessions exact measurements become
less of an issue

2. Crowding out of the private sector. May not increase AD, merely replace it.
Physical Crowding Out vs Financial Crowding Out.
3. Barro-Ricardian Equivalence: Suggests that changing taxes to stimulate or
discourage spending is futile. Solution: Tax Rebates?
4. Lags: timing of Fiscal Policy is a problem. FP may be destabilising by the time
it takes effect. Recognition Lag, Execution Lag, Impact Lag.
Side Effects:
1. Taxes being passed on to prices and wages in an inflationary period
2. Cuts in G may affect welfare and distributive justice (cutting down on schools
or pensions)
3. Disincentives of high tax rates and the destabilizing nature of constantly
changing tax rates.

Monetary Policy:
altering the Money Supply with the intention of influencing Aggregate Demand
For any given level of Money Supply, and a given Demand for Money, there will
be an interest rate that generates equilibrium in the money market.

MS is determined by Central Bank and Financial Sector

Demand for Money is known as Liquidity Preference. At higher rates of
interest, they would tie their money up as the return is better, at lower rates
they would hold more money in liquid form. Hence demand for money slopes
downwards.

Tight Monetary policy: If MS is reduced, borrowing is more expensive causing AD

(I+C) to fall, dampening AD.
Loose Monetary Policy: If MS is expanded borrowing is cheaper, causing AD (I+C)
to increase, and may be used to stimulate the economy.
Open Market Operations: Buy or Sell Government Bonds (Securities) to Withdraw
or Insert money into Circulation in the Economy to achieve the desired MS. (and
resulting i/r)
OR: Alter the i/r and then manipulate the MS to ensure equilibrium.
Difficulty in Controlling the MS due to difficulty in Measuring MS Goodharts
Law. An indicator ceases to be a good indicator as soon as it is targeted.
Effectiveness:
1. If the demand for loans is interest-inelastic then the i/r will have to move a
long way to achieve any change in the level of spending. Liquidity Trap.
2. Tinbergen Problem: altering i/r also affects Capital Account in the Balance of
Payment, introducing hot money and causing forex to rise. It may dampen AE
as (X-M) will also fall, however it could put the country into a deficit on the
Current Account.

3. MP is likely to be more effective in curbing inflation than in reducing

unemployment. FP and MP as complementary.
Monetarist View: i/r should be kept steady so as not to destabilize the economy,
allowing firms to make good decisions on investment. i/r is only gradually
adjusted and changes in the i/r are announced ahead of time and expected. Alan
Greenspan
Inflation Targeting: Central Banks are able to aim for a target band of inflation,
but sacrifices direct control over other macroeconomic goals.

Prices and Incomes Policy (Direct Controls):

When the government seeks to restrain price and wage increases. This may be
in the form of a voluntary agreement with firms and/or unions, or there may be
statutory limits imposed.
Mainly a policy used to control inflation, either by limiting price increases (by
monopolies) or wage increases (by unions). Ensuring an orderly rate of change
for prices should also be good for the rest of macroeconomic objectives.
Consumers Association of Singapore (CASE) and National Wages Council (NWC)
Targets symptoms (prices/wages) instead of root cause (excess demand for
goods).
Reservations: If wage differentials are frozen, then economy fails to be dynamic
and labour becomes immobile and stagnates.

FOREX Policy:
Controlling the value of currency on the Forex Market
Tinbergen Dilemma: Forex rate impacts in opposing ways on different macro
target.

Depreciating forex rates is good for BoP, making exports cheaper and
imports dearer. Unemployment will also decrease as export growth will
create jobs. However, inflation may set in if AS is not able to adjust to the
boost in AD.
Appreciating forex rate is a useful tool to hedge against inflation: import
prices appear lower which keeps down Costs of Production, especially in
an economy with high levels of imports. Cheaper imports also act as an
anchor for domestic firms as they have to compete against these imports.
A higher propensity to import also dampens AD and keeps down inflation.
However, there might be a BoP deficit.

Singapore chooses to operate FOREX policy as opposed to monetary policy as X

and M are the largest components of AD in Singapore, rather than the domestic
market.

Supply-Side Policy:
focus of policies to shift AS curve to the right (moving PPC outwards) and to
reduce the natural rate of unemployment. Note: all depends on what the
economy requires
A: Market oriented Policies

Reducing government expenditure to release resources to the general

economy (crowding-in)
Reducing taxes to increase incentives, refer to the Laffer Curve
Emasculating Unions to make wages flexible and make labour mobile
Reducing welfare benefits to discourage sloth
Reducing red tape for firms and make it easier for business to be conducted
Deregulation and privatization
Abolishing forex controls to free up the movement of Capital

B: Interventionist policies:

Government training/retraining programmes

Industrial policy (encouraging firms to move to areas of high unemployment)
Nationalisation (to organize capital, start off)
Grants (to subsidize Research and Development)
Encouraging mergers to improve efficiency
Providing information (job fairs)
Assistance to small firms (tax holidays)

Evaluation of Supply-Side Policies:

Evidence to show improved efficiency of economies that have adopted them:
higher growth, lower levels of unemployment and lower inflation. However, there
is a reduction in vertical equity, some people are better off but others are worse
off (efficiency vs equity)
Deregulation doesnt necessarily improve services e.g. trains in Britain and
electricity in California. How effective exactly is the free market?

Keynesian View:

Economy is inherently unstable due to animal spirits and changes in

investment.
Markets are sticky and hence cannot be relied on to adjust or eliminate
imbalances between AS and AD, hence requiring government intervention.
Tradeoff between inflation and unemployment, governments ought to use
Fiscal Policy (supported by Monetary Policy) to eliminate inflationary or
deflationary gap.

Unemployment should be tackled with Government spending, and MS

should be allowed to grow to accommodate this extra spending
Inflationary gap may be reduced by FP but more probably by reducing the
MS (by raising interest rates)
Demand-management policies generate actual growth, but LR potential
depends on supply side factors

Monetarist View:

Economy as inherently stable with markets clearing. Only exogenous

shocks move the economic away from equilibrium
Emphasis on Inflation if money is undermined then the rest of the
economy will collapse.
Economy settles a natural rate of unemployment (NAIRU) determined by
tax policies, welfare payments, training facilities, etc.
Growth emerges from the Supply side with policies to build infrastructure,
encourage industry and enterprise
Markets should be kept as free as possible reducing power of unions,
controlling monopolies and keeping government interference to a
minimum.
Government policy should be consistent and predictable rules not
discretion
Setting targets for inflation, keeping MS under control or balancing budget.

Graphs
Name
AD-AS
Phillips
Curve
NAIRU
Labour
FOREX
Liquidity
Preferenc
e
Laffer
Curve

Graph

Explanation

Quotes & Bits

Inflation is like tooth-paste, once its out of the tube its hard to get back in
Misery Index: Inflation + Unemployment
if you only possess a hammer, then everything begins to look like a nail.

any observed statistical regularity will tend to collapse once pressure is placed
upon it for control purposes
Unholy Trinity forex rate, MS and free flow of capital.
MAS does not have to watch the Money Supply. What does it watch? It watches
the forex rate Dr Goh Keng Swee (former Chairman of MAS)