Singapore's inflation: Explain, using relevant examples, the causes of inflation. [10] (Rephrased Economics Question)

(a) Singapore’s inflation remains high, at 5.7% in November 2011 from a year ago, because of higher rentals, private transport costs, and recreation costs.  Explain, using relevant examples, the causes of inflation. [10]

Inflation can be defined as a persistent and sustained increase in the general price level of an economy. Most commonly, the Consumer Price Index (CPI) is used as a barometer to measure inflation, measuring the price of a basket of commonly used goods and services; a persistent and sustained rise in the CPI can be considered inflation. The causes of inflation can be attributed to demand-pull and cost-push inflation, one affecting the aggregate demand (AD) and the other the aggregate supply (AS) of the economy.

Demand-Pull Inflation

The AD-AS diagram below demonstrates demand-pull inflation.

AD comprises C + I + G + (X-M), which are consumer spending, investment spending, government spending, and net exports. In the diagram, if any of the components increases, AD shifts rightwards to AD’ and then AD’’, causing the general price level to rise over a period of time, and inflation results, if the economy is near or at the full employment level.

On the consumption side, for instance, if consumers spend more because of low interest rates encouraging borrowing for consumption, for example on recreational activities, then AD will shift to the right, thus contributing to demand-pull inflation. If firms feel positive about the future economic outlook, and invest more, then AD will also shift to the right. If governments spend more on the military or police forces, or pursue a Keynesian fiscal policy of government spending, then AD will shift to the right, thus contributing to demand-pull inflation. If there is an export boom for local products exported overseas, or there is a softening of local demand for imported goods from overseas, then AD will also shift to the right. Hence, it is clear that excessive C, I, G, or increasing X with decreasing M, will lead to demand-pull inflation if the economy is near or at the full employment level.

Cost-Push Inflation

On the other hand, there is cost-push inflation as well, where AS moves upwards from AS’ to AS’’ and to AS”’. This is demonstrated in the diagram below:

This is mainly due to rising costs, and since the aggregate supply of goods and services is made up of various inputs, increases in the costs of the various factors of production lead to inflation. The supply of goods and services result from the factors of production of labour, capital, land, and entrepreneurship.

There are internal cost-push factors: rising wages or the rising power of trade unions demanding higher salaries, rising capital costs, and increasing scarcity of land and various input resources make cost-push inflation a pertinent possibility. For instance, demands for higher wages can lead to a wage cost spiral, which will raise the general price level. Higher capital costs will lead to a higher production cost for firms that produce capital-intensive goods as well. Increases in the levels of rentals in Singapore, for instance, will also lead to cost-push inflation.

There are also external cost-push factors. Exchange rates and the foreign sector can also lead to inflation if many goods produced use foreign inputs; hence there might be imported price-push causing cost-push inflation as well. In Singapore’s case, goods are usually produced using inputs from other countries due to our lack of natural resources; if those resources become more expensive overseas or if the Singapore dollar depreciates vis-à-vis those other countries’ currencies, then imported inflation will result.

Thus, inflation can be caused by demand-pull factors, cost-push factors, or a combination of both. 

JC Economics Essays: Tutor's Comments - This is a very well written examination piece, but right off the bat one possible improvement to this Economics essay is that it could do a lot better with more specific contextual examples. It does have examples, yes, and there are indeed some specifics inside this essay paper. However, it could have more specific examples. For instance, increases in the levels of rentals in Singapore could be enhanced with the use of industrial/ residential/ properties/ or businesses such as REITS, etc, etc. The usual tutor's comments also apply here: think of the other ways in which you could improve this essay. If you  were an Economics tutor marking this Economics paper, what would you comment on and why? Note that there is no need here for an evaluative conclusion simply because this question is only worth 10 marks, and it is only the 15 mark and 25 mark questions that require a proper evaluation with justification and evaluative comments and professional opinions. 

Explain carefully what causes inflation [10]

Explain carefully what causes inflation. [10]

Inflation is a persistent and sustained increase in the general price level, or also defined by a persistent and sustained rise in the consumer price index. Inflation is caused by demand side factors or supply side factors, and these are called demand-pull inflation and cost push inflation respectively. A concatenation of increasing aggregate demand and rising costs cause inflation, although it is possible to have entirely demand pull inflation or cost push inflation. This paper discusses all these.

The AD-AS diagram below demonstrates demand pull inflation.

Insert diagram, AD-AS diagram: showing only demand pull inflation

AD comprises C + I + G + (X-M), which are consumer spending, investment spending, government spending, and net exports. If consumers spend more because of low interest rates encouraging borrowing, or if firms feel positive about future economic outlook, or if governments spend more money on military forces, or there is an export boom for local products exported overseas, then AD will shift to the right. Therefore, AD moves to AD’ and then AD’’, causing an upward shift in the general price level and therefore inflation, ceteris paribus. Hence, it is clear that excessive C, I, G or high exports with low imports will lead to demand pull inflation.

On the other hand, there is cost push inflation as well, where AS moves upwards from AS to AS’ and to AS”. This is demonstrated in the diagram below:

Insert AD-AS diagram showing cost push inflation

This is due to rising costs, and since the aggregate supply of goods and services in the economy is made up of various inputs, increases in the various inputs lead to rising costs. The supply of goods and services result from labour, capital, land and entrepreneurship. There are internal cost push factors. Rising wages or the rising power of trade unions demanding higher salaries, rising capital costs, and increasing scarcity of land and various input resources make cost push inflation a pertinent possibility. There are also external cost push factors. Exchange rates and the foreign sector can also lead to inflation if much of the goods produced use foreign inputs; hence there might be imported price push and exchange rate depreciations causing cost push inflation as well.

Thus, inflation can be caused by demand pull factors, cost push factors, or most probably and most conceivably, a combination of both. It depends on the particular situation.

JC ECONOMICS ESSAYS

PS Tutor's Note: Some Keynesian economists argue that it is primarily excess demand for goods and services that lead to such demand pull inflation, and other economists, namely the monetarists, claim that demand pull inflation is caused by excess money supply.

Tutor's Comments: A very well written essay! Well developed and relevant materials. Note: This economics essay paper was also written under examination conditions.