Introduction
Singapore has a small population of about 5 million people as well as a small geographical area of only 704 km sq. This disadvantaged her in terms of the availability of resources and size of domestic market. Due to these constraints, the Singapore economy has to be open which means that the country is highly dependent on trade, foreign investments as well as labour.
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Being open make Singapore most vulnerable to supply shocks such as increase in the price of oil and other raw materials cause by the booming economies of China and India, higher prices of food due to bad weather, and higher foreign inflation.
As a result of higher cost of production due to higher import prices, ceteris paribus, profits fall and producers cut back on production causing the AS curve shifts to the left from AS0 to AS1. This results in shortages and causing upward pressure on prices and prices increase from P0 to P1.
Since the root cause of the inflation is higher import prices, exchange rate policy would be an appropriate choice. To fight such inflation, the Singapore government can allow the Singapore dollar to appreciate. This lowers the prices of imported final goods and services in SGD. This immediately reduces the rate of inflation. Prices of imported inputs and raw materials in SGD will also be lowered which in turn lower the firms’ cost of production. Ceteris paribus, this increases profits and firms increase production and the AS curve shifts back to the right again, hence lowering the rate of inflation as prices fall from P1 to P0.
When the world economy booms, Singapore will enjoy higher net exports as rising world incomes will encourage greater consumption which benefits Singapore’s export sector.
Ceteris paribus, AD increases sharply as net exports is a big component of AD as explained earlier. Ceteris paribus, this will cause shortages as the economy faces capacity constraints in the short run due to insufficient labour and capital goods. Costs will then increase which will eventually cause prices to increase.
Once again, exchange rate policy in the form of appreciation can be considered as it will target the root cause, which is net exports, to reduce the rise in AD.
Although a strong Singapore dollar may be effective in maintaining a low rate of inflation, it also exerts a contractionary effect on real national output and hence, economic growth and employment. Thus in the short run, the government may face with the problem of achieving lower inflation at the expense of increased unemployment.
A contractionary monetary policy may be used to reduce the rate of inflation. The government reduces the money supply to bring down the rate of inflation. When money supply falls, interest rates will go up, increasing the cost of borrowing. Hence, firms and consumers will reduce their quantity demanded for funds for investment and consumption purposes respectively. These will result in a fall in investment and consumption, reducing aggregate demand, ceteris paribus, and the general price level.
In the case of Singapore, using interest rates to affect the level of economic activity is of limited effectiveness due to Singapore’s small size and its high degree of openness to trade and capital flows.
To reduce the inflation rate, the government can cut back on its own expenditure. Since government expenditure is a component of aggregate demand, this action will immediately reduce aggregate demand.
- Likewise, government can increase G and reduce taxes if the objective is to achieve full employment.
- However the small domestic market relative to external demand means that the reduction or increase in domestic demand via the use of fiscal policy will only affect AD by a limited extent as compared to a policy instrument that targets external demand such as the exchange rate policy.
Being small and open has also contributed to a large extent the priority given to the use of supply side policies in Singapore to achieve both the goals of price stability and full employment.
Except for the crisis years like 2003 and 2009, Singapore was at operating close to full employment as one can see that the AD curve cuts at the vertical section of the AS curve. There is therefore a high risk of demand pull inflation due to a lack of capacity to increase output as our labour force is small.
But with the use of supply side policies, land is reclaimed from the sea, transport network widens, number of industrial sites increase and so does labour productivity. This increase in productive capacity enables firms to increase output to meet the rising AD during economic booms without firms having to incur higher costs.
The root cause of cyclical unemployment tends to be a fall in external demand (e.g. due to global economic recession) for a small and open economy → in achieving full employment, being small and open sees the use of depreciation to target export demand to reduce cyclical unemployment.
Government may allow the currency to depreciate to increase (X-M). Since net exports increase, AE also increases, ceteris paribus. The rise in AE would bring about a shortage of goods and services. Hence, there is an incentive for firms to increase production, leading to a multiple increase in national output, national income and employment, thus reducing cyclical unemployment.
1) If the global economic sentiment is pessimistic such that consumers around the world are not responsive to changes in prices, depreciation will not bring about an increase in (X-M) and thus the required AD to generate employment opportunities. Thus, government would need to consider other supplementary policy options to reduce cyclical unemployment.
Conclusion:
Being small and therefore the need to be open has provided many constraints for the Singapore government in its use of policies. Often, the cause of the problem is affected by the fact that Singapore is small and open. Although it is an important consideration, there are other factors that the policy makers need to take into consideration for sound policy decisions.