2012 A Level H2 Economics Review: Macroeconomics Qn 4

  1.  Governments generally face trade-offs between different macroeconomic policy objectives. Discuss how far a government’s macroeconomic policy decisions when faced with these trade offs are affected by the extent to which the economy is open. [25]

The basic premise behind this question is that governments are faced with trade-offs between low inflation and full employment and growth in the short run as well as trade off between a healthy balance of trade and strong domestic growth. The question then wants us to look at how governments can approach these trade-offs (so a good answer should first illustrate the kind of trade-offs that are present), and evaluate the role of the openness of the economy in affecting the kind of macroeconomic policy decisions that governments make.

To answer this question, I have come up with a basic venn diagram.venndgm

The degree of openness, if we take it as a given, will restrict the set of policy tools available to a government, in the sense that some policies become impossible (interest rate policy for an open economy like Singapore) and some just become plain ineffective (i.e. fiscal policy for open economies that floats its exchange rate). This in itself, will restrict and affect policy options and a good answer should then go on to explain how such a constraint works.

An excellent answer will then explore the other factors that could weigh into this decision making process. The three circles I have drawn represent other possible constraints that can play a role in restricting policy options. For example, like in Europe, a budget problem or a debt issue can affect the viability of choosing fiscal policy, because the poor fiscal health of the country can worsen the crowding out effect or lead to even higher borrowing costs as investors bet against the country. Global demand and monetary conditions can affect a country like Singapore which relies heavily on external demand and foreign investment for growth – an unstable global demand environment will favour a more free-floating approach to the exchange rate so that the slowdown in growth from a fall in exports can be cushioned with a depreciation of the exchange rate; or like what we see now, cheap money from Japan and USA can create inflation in other open economies around the world as investors borrow cheaply to search for returns in other open fast growing economies thus exacerbating the painfulness of the trade-off between unemployment and inflation. The nature of the economic problems confronting the country can also dictate the sort of policy choices a government is able to select. Some examples: Structural rigidities in an economy might call for better microeconomic policies and supply side policies and restrict the effectiveness of any fiscal or monetary policy; a pessimistic investment environment can mean that monetary policies might not work as intended as investment is not responsive to interest rate changes.

An excellent answer should also look at the difference between the short run and the long run, and point out that it is possible that the trade-offs become less painful over time as a country works on improving its productivity and rate of technology growth.

Beyond that, you might want to question the idea of openness being an exogenous constraint. Could openness be a policy choice in itself? If we think about the impossible trinity theorem, which states that a country can only choose to control two out of the trio of interest rate, exchange rate and capital flows, it seems that for some countries, the degree of openness could be a policy choice in itself.

Two things you can do right now after reading this:

  1. Come up with a stand to the question. Write it out clearly and think about how you will argue your stand. If you are not clear how to formulate a stand, do look at my free e-book on essay writing for tips on how to do so.

  2. What are the examples you can think of for this question? Are they recent and varied? If not, read up on current issues and find out more about the examples that you can use. You can check out my free newsletter which will be of help.

Till next time, dream economics.