Discuss the effectiveness of government policies that could be used to tackle China’s inflation. [25] (rephrased Economics question)

“In 2003, China achieved an impressive growth rate of about 9%. Domestic consumption and investment formed the dominant source of her growth, and her inflation rate was above 5%. The economy was overheated.”

Adapted from The Straits Times, 2004

Discuss the effectiveness of government policies that could be used to deal with China’s ‘overheated economy’. [25]

Introduction

China is facing massive demand-pull inflation because of her rapid actual economic growth in recent years. Inflation can be defined as a persistent and sustained increase in the general price level, and can be classified as demand-pull or cost-push. In the context of China, because domestic consumption and investment forms the dominant source of China’s actual economic growth, the likely cause of China’s “overheated economy” is demand-pull inflation, which has to be countered using either demand-management or supply-side policies, or a combination of such measures by the Chinese government. This paper discusses contractionary demand-management policies, such as fiscal and monetary policies, and supply-side policies, in China’s context, and discusses the effectiveness of the suggested policies.

Demand-Pull Inflation

Insert Economics diagram here. What Economics diagram should go here?

In the diagram above, it is clear that increases in consumption (C) and investment (I) have led aggregate demand (AD) to shift to the right, which constitutes in this case actual economic growth, and thus inflation has resulted because the economy is near the full employment level. With a burgeoning middle class in China wanting to spend on consumer goods and other luxuries, and with domestic and foreign firms wanting to capitalise on the rising middle class in China, there has been a huge increase in AD. These collectively lead to demand-pull inflation because AD = C + I + G + (X-M), and therefore there is a need for the Chinese government to utilise either contractionary demand-management policies or increase the AS through supply-side policies.

Effectiveness of Government Policies

In the short run, contractionary demand management policies such as fiscal policy, monetary policy, or exchange rate policy can be used, to shift AD to the left and thus reduce inflationary pressures. In the longer term, supply-side policies can be used to increase the AS and thus reduce inflationary pressures.

What is the effectiveness of demand-side policies in China’s context? First and foremost, it is clear that any contractionary demand-side policy will reduce AD and tackle the problem directly. For instance, fiscal policy dictates that government spending should be reduced or taxes raised, and this would shift AD to the left, ameliorating inflationary pressures. Monetary policy used in this context would raise interest rates, reducing C and I because borrowing costs have increased, and therefore AD would also shift to the left. Appreciating the currency or revaluing the country’s currency would make exports look relatively expensive whilst imports look relatively cheaper, thus shifting AD to the left as well, directly addressing demand-pull inflation. In China’s case, a combination of fiscal policy and revaluation would make sense by reducing AD, directly addressing the issue.

What is the effectiveness of supply-side policies in China’s context? There are many supply-side measures that can be taken, for instance improving the efficiency of the labour market, via reducing frictional unemployment; increasing human capital training and development via training, retraining, and upgrading; and increasing labour productivity through capital and technological increases. These measures would be effective in the long run when AS shifts to the right and thus reduces the general price level in the intermediate and long term.

Ineffectiveness of Government Policies

On the other hand, the Chinese government has to be aware of possible limitations of such policies. First, contractionary fiscal policy might lead to unemployment and political problems if Chinese State Owned Enterprises laid off staff or if military spending were to be cut. Rising income taxes could hinder productivity and labour incentives because people might not work as hard. Corporate taxes, when raised, might affect the profitability of firms. These might lead to unemployment or lower actual economic growth.

Secondly, monetary policy could be highly ineffective in China’s case. This could be due to a variety of reasons. First, if business confidence is high, increasing interest rates would not dampen consumption and investment much. Secondly, China operates a fixed exchange rate and therefore the economic “trilemma” should apply to China. According to theory, a country cannot have free flowing capital, a fixed exchange rate, and yet pursue monetary policy using interest rates, because of the impossible economic “trilemma”. Thus, it is more likely that China uses exchange rate policy rather than depending mainly on interest rates.

Thirdly, supply-side policies operate in the long run but inflation affects China now. Furthermore, supply-side policies operate indirectly rather than tackling the root of the problem which is demand-pull inflation, which affects AD. Also, the Chinese government would have to invest in costly, expensive, and difficult long-term training, retraining, and upgrading for the workforce, and all this spending would have opportunity costs in terms of healthcare, defence, and education.

Conclusions

In conclusion, the Chinese government can use fiscal, monetary, or exchange rate policies in conjunction with longer term supply-side policies to tackle demand-pull inflation. However, multiple management policies would probably have to be implemented in order to successfully counteract the “overheated economy”. Also, there are trade-offs in that an excessive handling of inflation could lead to unemployment and slower actual economic growth, and governments should be aware of the trade-offs and their implications.

JC Economics Essays – Tutor's Commentary: The above Economics essay is on the interesting and current topic of inflation in China and government macroeconomic policies that could tackle this inflation. Instead of me telling you the grade that this paper would get – instead, let’s do another thinking exercise. Put yourself into the role of an Economics examiner looking at this piece of work. Once again, think about how your Economics tutors in Junior College, or university, for that matter, would rate this essay. Try to put yourself into your Economics tutor’s shoes. What would he or she say, and why? Also, try another exercise: try to draw out the diagram that would have been in this post if I had been less of a luddite and more of a techie. What would the diagram be, and why? Hint: you might want to use an AD-AS diagram - how would it look like? Thanks for reading and cheers. 

(b) To what extent is fiscal policy the most effective measure to lower the unemployment rate in Singapore? [15]

Singapore’s unemployment rate could surge to a 20-year high of 5 percent next year. This would be the highest level of unemployment since 1986.

Adapted from The Straits Times, February 2009

(b) To what extent is fiscal policy the most effective measure to lower the unemployment rate in Singapore? [15]

Fiscal policy is the use of government spending and taxes to affect the AD of an economy in order to pursue the macroeconomic goals of governments. In the case of unemployment, expansionary fiscal policy can be used – where the government increases government spending and lowers taxes (both personal income and corporate) in order to boost AD. This essay argues that to a large extent, while fiscal policy has the potential to work in Singapore, it is not the most effective measure to lower the unemployment rate and there are many other measures which are more effective given Singapore’s context.

Fiscal policy

It is clear that on the one hand fiscal policy in theory can reduce cyclical unemployment. With an increase in government spending and lowering of income taxes and corporate taxes, C, I and G increase and thus AD shifts to the right. Due to the multiplier effect, real national income would increase, and as real output increases, there would be a need for more workers. This would overcome cyclical unemployment.

Also fiscal policy, if spent on infrastructure and other areas such as skills upgrading, can lead to solving structural unemployment. For instance, the Singapore government spends a lot of money on the Workforce Development Agency. If the fiscal policy is directed towards increasing the supply side (supply side policy), then the skills gap between workers and those required by industries might be solved and thus structural unemployment might not be a problem. Hence, fiscal policy does have some strengths and could be used as a viable policy.

Limitations of fiscal policy

On the other hand, there are limitations of fiscal policy given Singapore’s context. The multiplier effect is small, given Singapore’s high MPM and MPS (marginal propensity to import and save). Alternatively, it can be said that there are many leakages given Singapore’s context – as it is small and open. Also, a cut in taxes may lead to a small shift in C and I if there is widespread economic pessimism, and a reluctance to spend more money. In addition, there is a time lag effect where it takes a long time to formulate policies to decide on the appropriate tax cuts and which type of government spending to raise.

Other policies might work better

Furthermore, fiscal policy may not be the most effective policy to reduce cyclical unemployment. There are two other policies that might be able to reduce unemployment better in Singapore’s context. The first is exchange rate policy and the second is signing of new FTAs (Free Trade Agreements).

First, given that Singapore is a small and export oriented economy, where the total value of exports and imports comprise more than her GDP, an exchange rate policy could be implemented. In Singapore’s case, due to the classic trilemma, Singapore does not pursue monetary policy but instead pursues an exchange rate policy through the use of a managed float system (dirty floating). Depreciating the Singapore dollar would lead to an increase in (X-M) and thus increase real output and lower unemployment in Singapore by shifting AD to the right to the full employment level. At the same time it should also be noted that there is no perfect policy because cost push inflation could be a result of this exchange rate policy as the higher prices of imported raw materials into Singapore could lead to higher prices. Given that Singapore imports a lot of her raw materials and goods and services, this is a distinct possibility.

Second, by signing more FTAs Singapore has more access to international, foreign markets. This will help Singapore reduce her reliance on major trading partners if those countries experience recession. Thus, if X goes up, then AD will also increase, and thus cyclical unemployment will be lowered as the economy experiences actual growth if the FTAs are successful. On the other hand there are also search costs and increased competition with local producers in Singapore which might not be politically acceptable, and Singapore might also become more susceptible to external shocks to her economy.

Third, by increasing information available to workers, the government can reduce frictional unemployment. This is a simple solution that does not involve fiscal spending or exchange rates or FTAs, and should be used to reduce frictional unemployment.

Conclusions

In conclusion, the dominant cause of unemployment in Singapore is likely to be cyclical unemployment because the economy is dependent heavily on external markets, and therefore while fiscal policy can be used, it is not effective to a large extent, given the small multiplier effect. Given the changing dynamic comparative advantage of Singapore’s economy, it is imperative that policies to lower structural unemployment have to be considered seriously as well. In the final conclusion, both fiscal and other policies have to be used together to reduce the various types of unemployment in Singapore.

JC Economics Essays - Tutor's Commentary: This H2 Economics essay is also very well written, and addresses the question pertinently. The usual questions are: what can I do better, what I can improve on, and what have I learnt from reading this essay? This essay and the previous part were both very professionally written and specially designed and targeted specifically to answer the question. Yes, there can be alternative views, and there should be different approaches - but what is the strength of this approach? What have you learnt from here?

*PS I have had the sudden and rather zany idea that I should indeed try to make this site the most popular free Economics website for students reading the A levels ... and why not? I shall just do my best. Special thanks to my wonderful and encouraging students (you guys know who you are) who have complimented me on my Economics website. I will do my best. Cheers :) *

(b) What can the government do to increase Economic Growth? [15]

(b) What can the government do to increase Economic Growth? [15]

There are many policies a government could undertake to increase economic growth. Economic growth is measured by percentage increase in real Gross Domestic Product (GDP). There are two main aspects to economic growth. Actual and potential growth. Actual growth (AG) measures the rate of change in the volume of output produced within the country in a year. Potential growth (PG) is the percentage annual increase in the economy’s capacity to produce. Economic growth can be increased via increasing aggregate demand and increasing aggregate supply. Thus, the government may introduce demand management policies, such as monetary and fiscal policy as well as supply-side policies in order to aid economic growth.

Monetary policy is the manipulation of monetary variables such as money supply, interest rate and the exchange rate to achieve macroeconomic policy objectives such as steady and sustained economic growth, low and stable inflation, a healthy Balance of Payment (BOP) and full employment. Expansionary Monetary Policy may be employed to promote economic growth. It involves, raising monetary supply, reducing interest rates (as seen from Figure 1 - think of WHAT diagram and HOW to draw the diagram) where the reduction of interest rates leads to an increased supply of goods or reducing the external value of the currency. A reduction in interest rates will increase consumer spending on consumer durables. It may also encourage spending at the expense of saving. It also increases the amount available to spend after people have paid less for loans with low interest rates. A lowered interest rate will also encourage investment. This is shown in Figure 2 as AD0 increases to AD1 as AD is made up of C + I + G + (X-M). Hence, when C and I increase, AD shifts to the right. A lower cost of borrowing will increase the incentive for investment as now the returns would be greater. The increase in both consumption expenditure (C) and investment expenditure (I) will cause the AD to rise and thus, promote actual growth. A reduction in exchange rate is often used by governments of open economies that operate a fixed exchange rate system. By depreciating their domestic currency, a country would be more export competitive as their exports to other countries will be cheaper. Assuming the Marshall-Lerner condition is satisfied, net exports as well as AD will rise. This, in turn, will cause output and employment to increase.

Fiscal policy refers to the use of government spending and taxation to achieve the macroeconomic objectives. To promote economic growth, boost output and employment, a government can also employ an expansionary fiscal policy. With reference to Figure 3, the economy initially operates at A which is below the full employment level Yf. The government could adopt an expansionary fiscal policy. The government can increase government expenditure (G) or reduce taxes. An increase in G will cause an increase in aggregate demand directly since AD = C + I + G + (X-M). A reduction in personal income tax would raise consumption as it would further increase the disposable income of households and thus their ability to spend. Moreover, a decrease in corporate tax will increase profits and hence raise the level of investment in the economy. An expansionary fiscal policy thus raises AD and hence, output, employment and thus promotes actual growth.

To promote potential growth, the government may adopt supply-side policies. Supply-side policies are designed to shift the AS curve to the right by increasing the quantity and quality of resources via improving the efficiency in product and labour markets, and also by improving the level of technology. A reduction in labour market rigidities can be carried out via provision of education and training, reduction in direct taxes, cut in unemployment benefits, reforming trade unions and wage and price policies. Education and training can raise labour productivity and mobility and thus increase productive potential of the country. Labour productivity or the efficiency of labour is measured by output per hour worked. Reducing personal income tax and corporate tax rates can raise the productive capacity of a country by increasing the quantity and quality of labour and capital available to a country. A lower income tax rate would create incentive for work as now there is as expansion in the amount of disposable income. A lower corporate tax rate would also increase investment as the businessmen would be able to keep a larger share of profits. The cut in unemployment benefits will also increase the incentive to work as the unemployed would be disadvantaged if they are not engaged in productive labour. The power of trade unions can also be reduced by the government as this would result in a reduction of wages of labour. This, in turn, will increase employment, labour markets flexibility and efficiency. Thus, if labour costs to employers are reduced, their profits will probably rise. This would encourage and enable more investment and economic growth.

Pro-business policies are designed to promote greater private investments in the country. These include building world-class infrastructure, investing in R&D and tax reforms to ensure greater compatibility with international trends in taxes. The government can also increase Aggregate Supply via the adoption of more pro-competitive policies such as the passing of anti-monopoly laws, removal of barriers to entry to certain regulated industries, eliminating tariffs as well as other restrictions on imports.

However, both demand and supply side policies have their share of limitations. Reducing interest rates may cause the country’s currency to depreciate as it encourages hot money outflows. A lower exchange rate will make the exports of a country more competitive whereas imports will be dearer. Moreover, if consumer and business outlook is gloomy, a fall in interest rate may not encourage firms and households to increase borrowing because firms’ profits are falling and consumers may be expecting lower wages and lower year-end bonuses. When exchange rate is reduced, if the economy is operating near or at full employment, inflation will result. If the demand for exports and imports is price inelastic, net exports and AD will fall. This, in turn, will cause output and employment to fall. Hence, inflation can annul the price advantage resulting from a reduction in the external value of the currency. Fiscal policy may conflict with other macroeconomic goals as if AD increases by too much; economic growth will be achieved at the cost of inflation. Also, if the government has to borrow in order to increase spending, it may result in a BOP deficit. The decrease in tax rates may not bring about the desired increase in consumption and investment if households and businesses are pessimistic about future prospects. Moreover, a cut in personal income tax may induce an increase in the amount that they save rather than spend. The full effects of an expansionary fiscal policy may only be felt after a considerable time period. Thus, its effectiveness may not be realised in the short term. Supply-side policies such as education and training take time to have an effect and are also very costly. Reducing taxes may encourage some people to work fewer hours so that they can enjoy more leisure. Reducing corporate taxes may result in firms paying higher dividends rather than undertaking more investment. Cutting unemployment benefits would also not guarantee that it would reduce unemployment as jobs are not created and neither are their skills upgraded. It increases the urgency of finding a job. However, it does not increase their capability of getting a job.

Thus, economic growth ca be achieved via Fiscal Policy, Monetary Policy, Supply-side policies as well as by pro-business policies. However, it may be achieved at the expense of the limitations named above and thus, a combination of the policies could result in better economic growth rather than them being utilised as a stand alone measures to improve the economy.

JC Economics Essays: Tutor's Comments: A very well written essay, which was composed under examination conditions. Total Marks: 20.5/25. 

Further Economics tutor's comments: think of how you could work on this Economics paper to make it better, tighter, clearer, or worth more marks. Also, think of how the conclusion could be made more evaluative, interesting, and readable. Do think of how to draw the relevant and proper Economics diagrams for this essay as well. Thanks for reading and cheers!

(a) What can the government do to reduce unemployment? (10)

(a) What can the government do to reduce unemployment? (10)

The unemployed refers to the people in the working population who are available for work and are actively looking for a job but cannot fid a job. The unemployment rate can be measured via this formula: Unemployment Rate (%) = {[unemployed ÷ (employed + unemployed)] × 100%}. The types of unemployment include demand-deficient unemployment, frictional unemployment, structural unemployment and seasonal unemployment. Thus, in order to reduce demand-deficient unemployment, demand management policies are implemented by the government. To reduce frictional, structural and seasonal unemployment, supply-side policies can be utilised by the government.

An expansionary monetary policy aids in increasing Aggregate Demand (AD) in order for the economy to reach full employment level. With reference to Figure 1, the economy initially operates at A, which is below full employment level Yf. The Central Bank can adopt an expansionary monetary policy. An increase in money supply will lead to a decrease in interest rates. Since, the cost of borrowing is now lower, households and firms will borrow more for consumption and investment. This increase in consumption (C) and investment (I) expenditure will cause an increase in aggregate demand from AE0 to Ae1 as shown in Figure 1 as AE=C+I+G+(X-M). This raises national output form OY1 to OYf and employment via the multiplier process. Hence, expansionary monetary policy brings the economy to full employment.An expansionary fiscal policy also aids in increasing Aggregate Demand (AD). With reference to Figure 2, the economy initially operates at A which is below the full employment level Yf. The government could adopt an expansionary fiscal policy. The government can increase government expenditure (G) or reduce taxes. An increase in G will cause an increase in aggregate demand directly since AD= C + I + G + (X-M). Alternatively, the government can also reduce taxes. For example, if the government can also reduce taxes. For example, if the government reduces corporate tax rates, investment (I) would increase and thus cause an increase in AD. The increase in AD as shown from AD0 to AD1 in Figure 2 will raise national output from Y0 to Yf. Hence, employment will also increase and the economy is at full employment.

However, expansionary monetary policy and fiscal policy may be ineffective due to certain reasons. Expansionary monetary policy may be ineffective if consumption (C) and investment (I) are interest elastic. In times of severe recession, even though interest rates are attractive, businessmen may not invest due to the gloomy business outlook. Inflation may also result in both cases when the increase in AD overshoots.

Supply-side policies that the government can adopt to reduce unemployment include reducing labour market rigidities as well as establishing pro-business policies. With reference to Figure 3, the economy initially operates at the level of Y0, which is at the full employment level. There is equilibrium unemployment. The supply-side policy aids to increase the labour market flexibility. The increase in aggregate supply from AS0 to AS1 as shown in Figure 3 will raise the national output from 0Y0 to 0Y1 without an increase in GPL. Hence, employment will also increase.

To solve search unemployment, better job information can be provided via mass media and job agencies. This would thus enable unemployment to decrease as the unemployed workers will be matched to jobs that suit their capabilities effectively. By also providing more education and opportunities to upgrade the skills of workers, it increases the employability of workers by equipping workers with the relevant skills to switch between jobs. Moreover, pro-business policies such as tax holidays for companies and having a good infrastructure would reduce unemployment as other firms would find the host country attractive and thus increases employment. However, supply-side policies are costly, have large time-lags and have unpredictable outcomes.

Thus, in conclusion, a combination of demand and supply-side policies can be used in order to reduce unemployment. Thus, when aggregate demand rises by too much, aggregate supply can also be increased to effectively curb the onset of inflation. And, also, when AS increases by too much, AD can also be increased to curb unemployment.

JC Economics Essays: Tutors/ Examiner's Comments: Good! Well-written paper that addresses the question requirements. 9/10