(a)
Economic growth comprises of both actual and potential growth. Actual growth can be defined as the increase in real national income of the economy; potential growth can be defined as the increase in productive capacity of the economy. The key determinants of actual and potential economic growth can be related to determinants of aggregate demand (AD) and aggregate supply (AS) respectively.
Actual economic growth is achieved when AD increases in an economy below full employment. AD comprises of consumption, investment, government expenditure, and net exports. Hence, any factor affecting the components of AD will have impact on actual growth. For instance, if there is a decrease in the interest rate, the cost of borrowing falls and the opportunity cost of consumption falls. Hence, more people will be willing to take loans to finance their consumption, increase consumption level. Likewise, some marginal projects which were unprofitable at higher interest rates will become profitable, increasing investment as the amount of projects undertaken increases. If the government decides to increase spending in infrastructure development projects, education, and healthcare, government expenditure will increase. If exports become more competitive in the international arena leading to increase in export revenue and assuming import expenditure remains constant, net exports will increase. Ultimately, AD increases as C, I, G, and (X-M) increases. As shown in the diagram above, an increase in AD from AD1 to AD2 will increase real national income from Y1 to Y2. This achieves actual economic growth.
Actual economic growth can also be affected by short run aggregate supply (SRAS) factors. If there is a sudden increase in cost of production affecting most of the economy such as an increase in oil price in 2008, there will be a fall in SRAS. As shown in Figure 2, a fall in SRAS from SRAS1 to SRAS2 will lead to a fall in real national income from Y1 to Y2. This leads to negative actual economic growth.
Potential economic growth is achieved when there is an expansion of the productive capacity of the economy, due to increase in quantity and quality of resources and advancement in technology. Resources refer to land, labour, capital, and entrepreneurship. For instance, when technology improvement leads to the technique of fracking for oil, the quality of capital increases as the efficiency and productivity of the drilling machineries increases and the quantity of land increases due to the ability to tap into previously unreachable natural resources. Improvement in the quality of labour can arise from government policies encouraging further education and retraining. Increase in quantity of entrepreneurship can be due to governments’ policy in encouraging and supporting start-ups. Ultimately, the increment in the quantity and quality of the factors of production will allow higher production level at increased efficiency. These increase the long run aggregate supply, achieving potential economic growth as the economy’s productive capacity is increased. This is represented diagrammatically by an outward expansion of the PPC or a rightward shift of the LRAS. Sustained economic growth can only be achieved with both actual and potential growth. As shown in the diagram below, increase in AD from AD1 to AD2 and AS from AS1 to AS2 will lead to an increase in national income from Y1 to Y2 while maintaining price stability. In conclusion, the key determinants of actual and potential growth are factors affecting AD and AS respectively. Actual and potential growth are achieved when AD and AS increases.
(b)
It is important to achieve a sustained rate of economic growth in order to increase the living standards of the people and achieve more equitable income distribution. Sustained economic growth can only be achieved with both actual and potential economic growth. The Singapore government could adopt supply side policy and demand management policies such as expansionary fiscal policy and exchange rate policy to maintain a sustained rate of economic growth into the future.
The government can adopt an expansionary fiscal policy and plan for a budget deficit by increasing government expenditure and reducing taxation. Government expenditure can be increased through increased spending on infrastructure projects such as building more houses and roads or in areas such as healthcare and education. The government can also reduce personal income tax in order to increase personal disposable income and hence increase purchasing power. Indirect tax can also be reduced so that the affordability of goods and services increases with a given disposable income. This will stimulate consumer’s spending, increasing consumption. Corporate tax can also be reduced to increase investment due to an increase in after-tax profits for producers. The increase in C, I, and G will increase AD. Furthermore, an expansionary fiscal policy can also have supply side effects as well. Government’s expenditure on economic infrastructure will increase the country’s quantity and quality of capital. Labour quality will also increase through government’s expenditure on education and healthcare and tax incentives given to firms to encourage sending workers for retraining. On the other hand, reduction in personal income tax will increase the quantity of labour due to the increased incentive to work. As the quantity and quality of the factors of production increases, the productive capacity and LRAS of Singapore will increase. With reference to figure 4, an increase in AD from AD1 to AD2 and an increase in AS from AS1 to AS2 will lead to an increase in real national income from Y1 to Y2 with a small increase in general price level from P1 to P2. This allows economic growth to be achieved.
However, the sustainability of this economic growth is doubtful in the long term as an expansionary fiscal policy will likely lead to inflation as evident from Figure 4. This is because the main objective of the policy is to stimulate AD, resulting in a relatively larger increase in AD than AS. With a constant stronger increase in AD, the economy will reach a point whereby there is no further increase in output even as demand increases as there is full and efficient employment of resources. Any extra demand will only push up the general price level. Furthermore, despite Singapore government having large reserves due to fiscal prudence, constant planning for a budget deficit will likely lead to erosion of the reserve and lead to government debt. Growth financed by debt is not sustainable as future generations may have difficulty repaying the loans. In Greece, inability to repay debt has forced austerity measures on the country, leading to massive protests, social unrest, and instability throughout Greece. There is also widespread loss of confidence in the Greece economy, causing long-term interest rates of their government bond to reach an all-time high of almost 30% in early 2012. Hence, the Singapore government should not adopt an expansionary fiscal policy as the main method to achieve sustained economic growth. Instead, it should only be used during recession where there is a demand deficiency, such as during the global financial crisis when the government introduced a massive S$20.5billion Resilience Package. A large increase in government expenditure is required due to Singapore’s small multiplier. Hence, to prevent erosion of reserves, the expansionary fiscal policy should only be adopted when necessary. The Singapore government must also aim to increase net exports as Singapore is heavily dependent on trade. Total trade was around 300% of Singapore’s GDP in 2011. To maintain a stable price level and increase net exports, the government can adopt an exchange rate policy. This is done via a slow and gradual appreciation of the Singapore dollar (SGD). As SGD appreciates, imports will be relatively cheaper in terms of local currency. As the demand of imports is price inelastic due to the lack of raw materials in Singapore, the decrease in price will lead to a less than proportionate increase in quantity demanded. This leads to a fall in import expenditure, reducing cost of production and also maintains price stability. At the same time, the fall in cost of production will lead to a lower price of exports if the producers pass on the cost savings. This will help offset partially the increase in price of exports in terms of foreign currency due to a stronger SGD. Assuming the demand for Singapore’s export to be price elastic, there will be a more than proportionate decrease in the quantity demanded causing export revenue to fall. However, if the fall in export revenue is lesser than the fall in import expenditure, net exports will increase. This will increase AD leading to a multiple increase in national income. With price stability and actual economic growth achieved, Singapore will be able to maintain a sustained rate of economic growth. However, the extent of success of this policy will depend on Singapore’s government accuracy on the analysis of the level of world inflation and likely movements of other exchange rates. Furthermore, the constant intervention to appreciate the value of SGD may deplete the foreign reserves. Thus, there must be strong economic fundamentals that cause an increase in demand for SGD, reducing the need for Singapore government’s constant intervention. Moreover, this policy is not suitable during a recession as it risks affecting the export price competitiveness of Singapore, which will decrease AD and worsen the negative economic growth. Hence, an exchange rate policy should be adopted only in times of positive economic growth when imported inflation is of concern. During a recession, the government should pursue a zero-appreciation policy, or allows for mild depreciation, in order to boost exports. When flexibly and accurately implemented, exchange rate policy is crucial to maintain a sustained rate of economic growth. It does not, however, increase the productive capacity of the economy. The Singapore government can also adopt supply-side policies to achieve sustained economic growth. This can be done via encouraging more research and development in specific fields deemed important to the economy. For example, biotechnology, maritime, and aerospace industries are considered beneficial to the Singapore economy and are given more tax incentives and R&D support. This increases the efficiency of production processes and technological advancement. The Singapore government can also increase spending on education and training and set up more training schemes or increase the number and quality of educational institutions. For example, the Continuing Education and Training (CET) plan is in place to maintain the competitiveness of the Singapore workforce and prepare for the future. This will improve the quality of the workforce leading to greater productivity and higher efficiency. By improving the quantity and quality of resources and achieving technological advancement, Singapore’s productive capacity will increase. With reference to figure 5, an increase in LRAS from AS1 to AS2 will lead to an increase in real national income from Y1 to Y2 and a fall in general price level from P1 to P2. This achieves sustained economic growth.
However, supply side policies tend to be long-term growth measures and their effects can only be felt in the long run. Furthermore, it is usually costly to implement and can lead to a budget deficit. Moreover, the success of the workforce to skills retraining is heavily dependent upon the receptiveness of the workforce. In conclusion, the Singapore government must adopt a multi-pronged approach in order to maintain a sustained rate of economic growth into the future. This is done by adopting appropriate policies to increase both the AD and AS. As such, the government should be constantly investing in supply-side policies as its impact takes time to manifest. In the short run, the government should switch between a gradual and modest appreciation during times of economic boom and during a recession, a zero appreciation policy coupled with expansionary fiscal policy. This will allow Singapore to enjoy sustained economic growth regardless of prevailing economic conditions. |
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