ACJC Macro Policies Suggested Essay Answers

1 © ACJC/Econs Department/2024 H2 Macro Policies Suggested Answers Macroeconomic Policies Tutorial Suggested Answers for SECTION A: ESSAY QUESTIONS Question 1 The recent worldwide recession caused many governments to re- assess their use of fiscal policy in order to stimulate their stagnating economies. (a) Explain the possible demand-side and supply-side reasons for a recession in an economy. [10] (b) Assess the relative importance of fiscal policy and exchange rate policy to manage Singapore economy when faced with a worldwide recession. [15] (a) Explain the possible demand -side and supply- side reasons for a recession in an economy. [10] Question analysis Concepts Cause: • Demand factor - AD • Supply factor - AS Effect: • “Recession” – fall in RNO Context • General Command Word Explain: Use economic analysis to explain cause and effect No evaluation or balance in positions needed. Introduction A technical recession is defined as two consecutive quarters of negative actual economic growth, measured by a negative real GDP growth rate. This implies a fall in RNO. Requirement 1: Demand reasons A recession experienced by major trading partners is one possible demand-side reason for a recession in an economy. A recession in the economies of the major trading partners implies a fall in household incomes for trading partners. Assuming the exports of the economy are normal goods (YED > 0), there will be a fall in the demand for the economy’s exports. This causes the

2 © ACJC/Econs Department/2024 H2 Macro Policies Suggested Answers price and quantity of exports to fall, resulting in a fall in export revenue (X). Hence, there will be a fall in AD (AD0 to AD1), ceteris paribus. At the same time, weak confidence on the future economic outlook could prompt consumers to save more, rather than consume, leading to a fall in consumption expenditure (C). Firms may also expect a fall in profitability on investments in the future, hence less willing and able to invest, fall in investment expenditure (I). (Reverse multiplier process) The fall in X, C and I will likely lead to a fall in AD. Assuming the economy is currently NOT at full employment, the fall in AD causes an unplanned rise in inventories stocks, signaling firms to decrease output, this results in a fall in RNO (Y0 to Y1). The fall in RNO implies a fall in economic activity, reducing the derived demand for factors of production, causing prices of factor of productions to be bid downwards. This means household incomes fall, inducing a fall in consumption expenditure by the amount equal to the marginal propensity to consume (MPC). This causes AD to fall again (AD1 to AD2), resulting in another fall in RNO (Y1 to Y2). This process repeated until RNO falls by a multiplied extent equal to the original fall in (C, I and X) x 1/(1-MPC). The fall in RNO implies negative economic growth. If this is sustained for two or more quarters, the economy will experience a recession. Requirement 2 / Topic Sentence 2: Supply-side reasons A sudden increase in the price of a majority commodit ies such as crude oil is a possible supply-side reason causing a recession in the economy. This sudden increase in price could be due to natural disasters or a war, causing a fall in its supply. Given that crude oil is an essential factor of production for most goods and services, a rise in crude oil price causes a rise in unit cost of production for firms. This reduces their profitability from production of final output, making firms less incentivized to produce final goods and services, reducing SRAS (SRAS0 to SRAS1).

3 © ACJC/Econs Department/2024 H2 Macro Policies Suggested Answers The higher unit COP is passed on to consumers in terms of higher GPL. The fall in production hence leads to a fall in household incomes, since the demand for FOPs are now lower. Coupled with the rise in GPL, this results in lower purchasing power, reducing consumption. The higher prices also affects the economy’s exports, worsening its price competitiveness. Assuming the demand for exports are price elastic (|PED|>1), a rise in price leads to a more than proportionate fall in quantity demanded of exports and hence, a fall in export revenue. As a result, due to the higher GPL, there is a fall in C and X, as seen by a movement along the AD curve. This causes an unplanned rise in inventory stocks, signaling firms to reduce output, as seen by the fall in RNO from Y0 to Y1. Level Descriptor Marks L3 • Rigorous explanation on how demand and supply factors cause a recession, using AD/AS framework. • Answer includes rigorous explanation of the (reverse) multiplier process • Best quality answer should include AD/AS diagram. 8 – 10 L2 • Missing any L3 criteria 5 – 7 L1 • Significant conceptual errors • Lacking in relevant economic analysis. 1 – 4

4 © ACJC/Econs Department/2024 H2 Macro Policies Suggested Answers (b) Assess the relative importance of fiscal policy and exchange rate policy to manage Singapore economy when faced with a worldwide recession. [15] Concepts • Fiscal and Monetary policies. Context • Due to worldwide recession • Singapore Command Word Discuss (…the relative importance) Cause: • 1: Fiscal Policy • 2: Monetary policy Effect: • “manage the economy” – macroeconomic goals (RNO, unemployment, deflation and BOT) Introduction: In the context of a worldwide recession, the Singapore government’s immediate priority would be to adopt expansionary fiscal and monetary policies to increase the RNO, hence achieving actual economic growth and reduce demand deficient unemployment. This is so that the overall SOL can be improved. Requirement 1: Expansionary FP can be effective to help manage Singapore economy in times of worldwide recession Expansionary fiscal policies would be an extremely effective policy to help achieve actual economic growth in the context of a worldwide recession. This can take two forms. Firstly, the government can increase government expenditure (G) such as developmental expenditure on infrastructures, which is a direct component of AD. Secondly, the government could lower direct taxes. Lowering personal income tax would result in higher disposable household income, increasing consumers’ purchasing power and hence ability to consume. This increase C. Lowering corporate income tax increases firms’ after -tax profits, allowing them more funds and ability to invest. Also, it increases the expected returns to investment after taxes for firms, incentivizing them to invest. This increases I. The rise in C, I and G increases AD (AD0 to AD1), ceteris paribus.

5 © ACJC/Econs Department/2024 H2 Macro Policies Suggested Answers Assuming the economy is operating below the full employment output, the rise in AD causes an unplanned fall in inventories stocks, signaling firms to increase output . Given firms require more factors of production (e.g. labour) to increase output, this increases the derived demand for labour, causing firms to hire more and layoff fewer workers. This helps to reduce unemployment rate. At the same time, with higher derived demand for labour, their incomes rise. Assuming the rise in income exceeds the rise in GPL, this causes a rise in purchasing power, allowing households to consume more, prompting a further injection of induced consumption, hence AD rises again from AD1 to AD2. The cycle continues until there is no further injection and the RNY increased by a multiplied amount from Y0 to Y1 and then to Y2, achieving actual economic growth. Since household incomes rise more than the rise in GPL, the consumers are able to consume better quality, and greater variety of goods and services. This increases material standard of living. Evaluation of R1: Fiscal policy is extremely effective given it is performed by the government indepen