Multiplier, Balance of Payments and the Trilemma — Short-Answer Practice
Case
This is a short-answer practice set spanning three macroeconomic topics — the multiplier process, the structure of the balance of payments, and the policy trilemma facing a small open economy such as Singapore. No data stimulus is attached; each part is a self-contained directed question.
Questions
Q1(a) Using the multiplier effect, explain how an increase in investment in Singapore affects national income. [7] (command: explain)
Q1(b) Explain how an increase in government expenditure on railways in China will influence national income. [6] (command: explain)
Q2(a) Define balance of payments. [1] (command: define)
Q2(b) State two components of the current account. [2] (command: state)
Q3 Using the trilemma of international finance, explain briefly why Singapore does not manage interest rates. [4] (command: explain)
Answers
Q1(a) How an increase in investment raises national income [7] — explain
An autonomous increase in investment (I) sets off the multiplier effect. The injection generates additional profits for domestic firms, which raise output. To do so they employ more factors of production (labour, land, capital, enterprise), which generates more disposable income for households.
Households spend a proportion of that extra income on induced consumption and withdraw the rest as saving, taxes and import expenditure. The proportion spent is the marginal propensity to consume (MPC); the proportion withdrawn is the marginal propensity to withdraw (MPW).
This re-spending becomes income for households in other sectors, who again consume a proportion of it — a second round of induced consumption — and the cycle of spending and re-spending continues until the increments become negligible.
Numerical illustration. If MPC = 0.5 and the initial injection is $10 million, the first round adds $5 million of induced consumption, the second adds $2.5 million, and so on. Summing the geometric series, the $10 million injection raises national income by a total of $25 million — a multiplier of applied to the injection.
Q1(b) How higher government expenditure on railways raises national income [6] — explain
An increase in government expenditure (G) on railways works through the same multiplier process. The spending generates additional profits for firms in the construction industry, which raise output and employ more factors of production, generating more disposable income for households.
Households spend a proportion of the extra income on induced consumption — the share given by the MPC — and withdraw the rest. The induced consumption becomes income for households in other sectors, who consume a proportion in turn, and the cycle of spending and re-spending continues until the increments are negligible. National income therefore rises by a multiple of the initial increase in G.
Q2(a) Define balance of payments [1] — define
The balance of payments is the record of all economic transactions between the residents of a country and the rest of the world over a period of time.
Q2(b) State two components of the current account [2] — state
Any two of the components of the current account:
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Balance of trade (export revenue − import expenditure; may be split into trade in goods and trade in services);
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Net primary income;
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Net secondary income.
Q3 Why Singapore does not manage interest rates — the trilemma [4] — explain
The trilemma of international finance holds that an economy cannot simultaneously control its exchange rate, control its interest rate, and maintain free capital mobility — at most two of the three are attainable. Singapore’s choices follow from its structure:
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It manages the exchange rate, because it lacks natural resources and has a small domestic market, making it heavily import- and export-dependent — so the exchange rate is the most effective lever over imported inflation and external competitiveness (see exchange-rate-centred monetary policy).
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It allows free capital mobility, since its small domestic savings pool means it relies on inward foreign investment.
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It therefore does not manage the interest rate. Given the trilemma, controlling both the exchange rate and capital mobility forecloses an independent interest rate; this is acceptable because Singapore’s small domestic consumption means interest-rate changes would move aggregate demand less than proportionately in any case.