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How far are a government’s macroeconomic policy decisions affected by the extent to which the economy is open? Discuss. [25]

This economics essay question is adapted from an actual past year H2 economics essay question but modified to focus on economic decision-making

Generally, governments will face trade-offs when making decisions to choose between different macroeconomic policy objectives. How far are a government’s macroeconomic policy decisions affected by the extent to which the economy is open? Discuss. [25]

Governments often face challenging trade-offs when making macroeconomic policies. When they aim to promote high or steady economic growth, low unemployment, low inflation (or stable prices in the economy), and a healthy balance of payments, and sometimes even promote equity, there may be trade-offs, especially when economic policies are used. A trade-off is when one policy objective conflicts with another, and a choice has to be made between the two conflicting objectives - in other words, one cannot have one's cake and eat it too. 

In this paper, there are clearly defined trade-offs that we could discuss to illustrate the arguments. First, there is a trade-off between inflation and unemployment (often taught in schools in the form of the Phillips Curve); second, there is a trade-off between demand-pull inflation and actual economic growth; third, there are trade-offs between promoting economic growth and equity; and finally there may be economic conflicts in dealing with internal as opposed to external stability. 

This paper argues that policy decisions are affected by the extent to which an economy is open, but are also affected by other factors like the size of the economy and the stage of its development, which also need to be considered by governments when making economic policy. 

To achieve these objectives, macroeconomic policies are used - for example, fiscal, monetary, and exchange rate policies, and supply-side policies. Each of these economic policies affects the parameters that governments are trying to address. For instance, expansionary fiscal policy which involves increasing government spending and reducing direct taxes would lead to an increase in AD, which would increase the level of prices in an economy, if AD were near or at the full employment level. 

However, while this would raise inflation, it would reduce demand-deficient unemployment. In fact, expansionary monetary and devaluations of the exchange rate would also likely cause governments a trade-off between promoting economic growth, which tends to lower unemployment, and demand-pull inflation in general. The government of an open economy would need to take into account the fact that choosing exchange rate policy may lead to such a trade-off. 

An open economy would also face issues of internal and external stability - for example, to maintain a healthy balance of payments, for instance, a devaluation or depreciation of the currency would be useful. But this choice would need to take into consideration the fact that economic growth may increase and unemployment may fall, but inflation may rise! Therefore, it is quite clear that governments' policies are limited by the openness of their economy. 

However, openness is only factor. Other factors that have to be seriously considered are the size of the economy and the level of development of the economy. First, taking Singapore as an example - as Singapore is a small and open economy - Many of the demand-management policies, like fiscal and monetary policies, cannot be used. With a small multiplier (k = 1/mpw), and a relatively large external sector, exchange rate policies are more useful. In addition, supply-side policies - which may not address every economic problem we are facing - could be used, sparingly. 

Yet, this is not to say that larger economies can easily use economic policies as well - they would also face limitations to each policy, such as the Keynesian liquidity trap and interest insensitivity for expansionary monetary policy, and the crowding out effect for larger economies which would lead to a countervailing reduction in C and I for a rise in G. 

Development is important as well. Macroeconomic policies to achieve competing objectives do not have to be limited to traditional fiscal, monetary, exchange rate, and supply side policies - with globalisation, protectionist measures, the promotion of free trade through FTAs, and the use of international and regional institutions to promote growth and development also matter. A smaller, less developed country, for instance, when faced with openness could even use a range of policies - Import Substituting Industrialisation (ISI) at first and then maybe Export Oriented Industrialisation (EOI) later on. 

In the final analysis, to a large extent the state of an economy - being open, small or large, or developed - does affect a government’s macro policy decisions. In Singapore's case, policymakers must always take into account the fact that we are small and open, and therefore need to understand what policies we can and should take. At the end of the day, there will always be trade-offs, and a rational decision has to be made. 

JC Economics Essays - Economics editor's comments: A few years ago, I worked out some draft answers and responses with some of my former economics students. This piece was one of the economics essays that we had worked out for the 2012 H2 A level economics paper. However, because it is a draft, there are a few questions that students or readers should ask: How can this be improved? Other than examples from Singapore, what other countries could be used as examples? Always remember to give relevant examples that fit the question's requirements. Also, this paper is very strong in economic theory as my former students were good in theory - but moving beyond economic theory, could there be greater relevance to the question? The evaluation could also be much improved - while it makes the required moves by signposting and giving a few opinions, it could have a lot more detail. All considered, for a 25 mark economics essay, this answer is quite good as a response by a team of students. Thank you for reading and cheers! 

This is an economics blog that deals with economics views, perspectives, and opinions, as well as a range of economics essays aimed at A level economics students and IB students, even undergraduate economics students. There is a wide-range of materials on many economics topics and themes. Thank you for reading and cheers. 

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