Model essay (a): two tools against inflation

What this lesson teaches

• I can explain fiscal, monetary and supply-side policy and judge how well each works.

  Syllabus 9570, 3.2.3(b). Macroeconomic Policies: Policy measures and their effectiveness in achieving macroeconomic objectives:; Fiscal policy - How discretionary fiscal policy can influence the level of economic activities and living standards through government spending and taxation; Monetary policy - How monetary policy can influence the level of economic activities and living standards through the management of exchange rates (case of Singapore) and interest rates; Supply-side policies - How supply-side policies can improve quantity, quality and mobility of factors of production to increase the productive capacity of an economy and hence affect living standards

Make a guess

An essay asks how fiscal policy AND exchange rate policy can each reduce inflation. A student writes a full page on fiscal policy and one line on the exchange rate. What is the likely mark?

1. Full marks, because the fiscal part is excellent and detailed.
2. Zero, because the answer is unbalanced.
3. Capped below the top band, however good it is.

The answer to part (a)

Introduction

Inflation is a sustained rise in the general price level. It can come from demand-pull, when aggregate demand (AD) grows faster than the economy's capacity, or from cost-push, when firms' costs rise. Fiscal policy and exchange rate policy both reduce inflation mainly by slowing the growth of AD. Exchange rate policy also lowers the cost of imports, which matters a great deal for Singapore.

Paragraph 2: fiscal policy cuts AD

Fiscal policy is the use of government spending (G) and taxes to influence AD. To reduce inflation, the government uses contractionary fiscal policy. It can delay public building projects, which cuts G directly. It can also raise income tax. Households then have less disposable income, so consumption (C) falls. Since G and C are parts of AD, AD falls from AD0 to AD1 in Figure 1.

Paragraph 3: why prices fall near full employment

The multiplier makes the fall larger. Firms that sell less cut output and hire fewer workers, so incomes fall and households spend even less. In Figure 1 the economy starts at E0, close to full employment (Yf), where the AS curve is steep. Here firms could not raise output much, so they raised prices instead. As AD falls, the pressure on scarce workers and materials eases. The price level ends at P1 instead of P0, so inflation slows. Because the AS curve is steep near Yf, real output falls only a little, from Y0 to Y1.

Paragraph 4: the exchange rate cuts import costs

Exchange rate policy is Singapore's main monetary tool. The Monetary Authority of Singapore (MAS) manages the Singapore dollar (S$) within a policy band, and it can let the S$ appreciate faster. An appreciation reduces inflation in two ways. First, imports become cheaper in S$. Singapore imports most of its food, energy and production inputs, so firms' costs fall and the SRAS curve shifts down. Imported consumer goods also become cheaper, which directly lowers the consumer price index. This tackles imported cost-push inflation at its source.

Paragraph 5: the exchange rate cuts AD

Second, Singapore's exports become dearer in foreign currency, while imports become more attractive to Singapore buyers. Export revenue falls and spending on imports rises, so net exports (X - M) fall. AD shifts left, just as in Figure 1, and the multiplier spreads the effect, easing demand-pull inflation. MAS used this tool when inflation rose: it tightened monetary policy five times between October 2021 and October 2022, letting the S$ appreciate faster.

Conclusion

Both policies reduce inflation by lowering AD, so both also slow growth and may raise unemployment. Exchange rate policy also cuts costs directly, which is why it suits Singapore, where much inflation is imported. Fiscal policy suits inflation caused by strong spending at home.

Margin notes: how each paragraph scores

Introduction

Defines inflation and its two causes, then says how each tool works. This tells the examiner both requirements will be answered, which L3 needs.

Paragraph 2

Names the instruments (G and income tax) and links each to a part of AD. Every step is a cause and its effect, with no jumps.

Paragraph 3

Uses Figure 1 with its labels (E0, AD1, P1, Yf). It explains why prices fall near full employment, not just that they fall. This is the 'rigour, with the aid of diagrams' that L3 asks for.

Paragraph 4

Starts the second requirement with the same depth as the first. Singapore's reliance on imports is used as the reason the tool is strong: context used as analysis, not decoration.

Paragraph 5

Completes the second channel and reuses Figure 1 instead of drawing it again. Ends with real evidence: MAS tightened five times in 2021 and 2022.

Conclusion

Short. A 10-mark part has no evaluation marks, so one line on which tool suits which cause is enough.

Overall: L3, 9 or 10 marks

Both tools are explained with complete chains, a correct labelled diagram and real examples. With only one tool explained, or no diagram, the same script would be capped at L2 (5 to 7 marks).

Worked example: A 3-minute plan

Before writing, jot a plan like this. It keeps the two requirements equal in length.

1. Intro: define inflation; demand-pull and cost-push; both tools cut AD.
2. Fiscal: cut G, raise income tax; G and C fall; AD left; multiplier; Figure 1 near Yf.
3. Exchange rate: S$ appreciates; import prices fall, so SRAS shifts down; net exports fall, so AD shifts left.
4. Close: both slow growth; the exchange rate also cuts costs, so it suits imported inflation.

Watch out for this

For part (a), I'll explain fiscal policy in detail and add one line saying the exchange rate works the same way.

The question has two requirements. Explaining only one in depth caps the answer at L2, however good that half is. Give each tool its own full chain.

Check your understanding

A student explains both tools well but draws no diagram. Which band is the answer most likely to reach?

1. L3, because both tools are explained with complete chains and real Singapore examples.
2. L2, because L3 needs both tools explained with the aid of a relevant diagram.
3. L1, because leaving out a diagram counts as a major error in the analysis.