Many economists argue that achieving a low and stable rate of inflation is the single most important macroeconomic objective for governments. Explain how a high rate of inflation can be caused. [10]

High inflation as a problem is essentially is a persistent, sustained, and inordinate increase in the general price level (GPL) of an economy. Alternatively, however, inflation can be thought of as a percentage increase year-on-year in the GPL, commonly measured using the Consumer Price Index (CPI), which measures the changes in the price level of a weighted basket of goods and services consumed by an average household. This paper argues that a high rate of inflation can be caused by demand-pull and cost-push inflation. Demand-pull inflation occurs where aggregate demand (AD) rises when the economy is near or at full employment, while cost-push inflation occurs when production costs rise, independently of aggregate demand. 

First, let us address demand-pull inflation. Figure 1 shows demand-pull inflation where persistent, sustained, and inordinate increases in AD, near or at the full employment level, causes prices to rise persistently from P1 to P4. When AD increases, as depicted by a rightward shift of the AD curve, both output and prices increase when there is idle resources, or unemployment. Nearer and at the full employment level, there is no increase in real output as AD increases from AD3 to AD4 as existing resources are fully employed.

THINK: how do you represent demand pull inflation on an AD-AS diagram? 

Demand factors that could possibly contribute to this form of inflation include both non-monetary and monetary factors. Non-monetary factors include an increase in either components of AD, namely consumption (C), investment, (I), government expenditure (G), or net exports (X-M), because AD = C + I + G + (X-M), or a combination of both whereas monetary factors include a rise in the money supply, leading to a fall in interest rates.

First, expectations about the economic outlook, such as optimism about the health of the economy or a rising stock market, could also affect households and firms’ consumption and investment, with C and I increasing if the overall economic outlook is positive. 

Second, and more importantly, in the case of a rise in money supply, this would lead to lower interest rates and exchange rates to promote economic growth and employment. A lower interest rate would cause the cost of borrowing to decrease, and households would find it cheaper to borrow to consume, and firms would find it cheaper to borrow to invest, thus both C and I would rise, at the expense of savings. Since AD = C + I + G + (X-M), the increase in both C and I would cause AD to increase and shift to the right, hence promoting actual growth. Lower interest rate would also cause depreciation in the country’s currency and an increase in net exports (X-M), also promoting economic growth.

Third, rising AD could also arise due to an excessively expansionary monetary or fiscal policy as countries pursue macroeconomic goals such as high and sustained economic growth or low unemployment. In terms of expansionary monetary policy, governments could get too ambitious in adopting such policies and end up creating inflation by having drastic decreases in interest rates, or rapid depreciation of exchange rates for instance. In terms of expansionary fiscal policy, excessive increases in government spending could also increase G, and thus AD increases and shifts to the right.

On the other hand, cost-push inflation; a persistent rise in costs causing a sustained increase in the general price level is shown below:

THINK: how do you represent cost push inflation on an AD-AS diagram? 

A persistent, sustained, and inordinate increase in production costs causes aggregate supply (AS) to shift upwards, from AS to AS1. Producers respond partly by raising prices, partly by passing the costs on to consumers, and partly by cutting back on production. Real output falls while prices rise to P1. Possibly due to supply shocks such as increases in import prices, AS could fall further and prices would rise to P2, while real output falls further to Y2.

Factors that cause cost-push inflation could include, first, the phenomenon when wages rise faster than productivity, called wage-push inflation. When very strong trade unions demand an increase in wages that exceeds current productivity, unit costs of production and hence general prices of goods and services increase. The cost of living thus increases and trade unions in turn ask for higher wages to maintain their real income. In doing so, the cost of production rises further and the higher cost is passed on to consumers simultaneously, thus leading to a development of a wage price spiral.

Secondly, another major supply factor is imported inflation. For countries that heavily import raw materials and necessities, such as Singapore, a small and open economy which is heavily dependent upon imports, an increase in the world price of these goods is a significant source of inflation. Higher world prices can be caused by a decrease in supply due to poor crops, for example, or even from the actions of producers who restrict supply. Oil prices for example rose due to OPEC’s restriction of oil supply to the world market.  These higher prices are passed onto the consumers of countries importing these inflated raw materials and necessities, hence resulting in imported cost-push inflation.

Finally, cost-push inflation also results when the government raises indirect taxes such as GST for example. A firm’s cost of production would increase hence pushing up the general price level, and causing inflation.

In reality however, these causes of inflation may not be discrete and inflation could be multi-causal. In conclusion, there are many causes of inflation but they can be classified mainly in terms of demand-pull and cost-push inflation. 

JC Economics Essays: This economics essay is a contribution to an H2 A Level Economics essay question on explaining the causes of inflation with economics tutors' comments. Inflation is an important economics topic, especially because often times the A level examination can test students to explain the causes of a macroeconomic problem. The causes of a macroeconomic problem help governments find solutions to these economic issues.

What do you think were the strengths of this economics essay, and did the economics student explain the economic concepts of demand pull and cost push inflation effectively, accurately, and with real world examples to illustrate his point? Do you know what economics diagrams you could have drawn to ensure that the points and arguments are well illustrated? What do you think of this economics paper? How would you improve further on it? Overall, this is a well-crafted economics paper that explains inflation very carefully and accurately, using solid economic analysis.

Thank you for reading, and cheers. 

Discuss the likely causes of inflation in Singapore. [15]

Introduction: Causes of Inflation in Singapore

This Economics paper discusses the likely causes of  inflation in Singapore. First, a few definitions are in order. 

What is inflation? Inflation occurs when there is a persistent and sustained rise in the general price level of goods and services, and is a macroeconomic problem when the rise in general price level is persistent and inordinate. With inflation, a given amount of nominal income buys fewer goods and services than before, which poses socio-political problems in countries that suffer from inflation. 

Inflation caused by the demand-side is known as demand-pull inflation while inflation caused by the supply-side is known as cost-push inflation. This paper argues that both demand-pull and cost-push inflation are present in Singapore, but cost-push is far more important to the Singapore economy, especially when it comes to imported inflation in Singapore's case. 

Demand Pull Inflation in Singapore 

What is demand pull inflation? Firstly, demand-pull inflation occurs in Singapore when Aggregate Demand (AD) rises as the economy is at or near the full employment level of national income. 

Why would AD rise, or what are the factors causing AD to rise? There are many reasons why AD will rise, but they can all be attributed to the components forming AD, which are C, I, G, and (X-M), as AD = C + I + G + (X-M). 

[Tutor's Note: Draw and explain the correct AD/AS diagrams. Think also - where do the diagrams fit in, have I labelled them correctly, and what do these economics diagrams show the reader?]

First, it can be argued that AD will rise if there is a decrease in interest rate as when there is a decrease in interest rate, it becomes cheaper and easier for people to consume and invest causing consumption and investment to increase. However, this is not that likely in Singapore's case, given her unique context. 

Secondly, AD will also rise when there is a decrease in personal income tax as people will tend to have more disposable income and this increases their purchasing power and will cause consumption to increase. Since AD comprises C + I + G + (X-M), which are consumer spending, investment spending, government spending, and net exports, a rise in consumption and investment spending will cause AD to rise. This is slightly more likely in Singapore's case. 

Lastly, factors like increases in government spending (G), for instance on the Singapore Armed Forces or Singapore Police Force, and increases in net exports (X-M), due to foreigners buying more of our domestically produced exports, will also cause AD to rise, leading to demand-pull inflation in Singapore as the GPL increases. This is also quite likely in Singapore, but there are also supply side factors to inflation to consider. 

Cost Push Inflation in Singapore

On the other hand, demand is not the full picture when it comes to inflation. 

What is cost push inflation? Cost-push inflation occurs when Aggregate Supply (AS) rises due to economy-wide rises in production costs. As labour cost is often the largest component of total costs in Singapore, a sudden rise in wages can cause significant cost-push inflation in Singapore. 

However, having said that, rising food, fuel, property prices, exchange rates and the foreign sector are also factors that cause AS to rise, leading to cost-push inflation as the general price level increases when the AS curve shifts upwards. 

[Tutor's Note: Draw and explain the correct AD/AS diagrams. Think also - where do the diagrams fit in, have I labelled them correctly, and what do these economics diagrams show the reader?]

Imported Inflation in Singapore

Imported inflation can lead also lead to cost push inflation. As Singapore is a small and open economy with limited natural resources (factors of production), she has to depend heavily on imports from other countries for both her consumption goods and factor inputs. In fact, Singapore's exports are made from imported inputs. Thus, the biggest threat to inflation in Singapore would be the depreciation of the Singapore Dollar (SGD). This could be due to lack of export competitiveness which lowers the demand for Singapore's currency, or this could also be due to Singapore dollars flooding the foreign exchange market. 

If the Singapore dollar depreciates too quickly, it causes severe imported inflation which impacts households directly through rising goods, food, and energy prices. Imported inputs also become more costly, thus raising production costs and product prices, and since Singapore's exports depend on imported inputs this has a massive knock on effect on Singapore's exports.

With small domestic market, highly export-oriented Singapore is dependent on external rather than domestic demand. If the Singapore dollar were to appreciate too quickly, her exports and hence AD would plummet and this potentially could trigger a recession. Hence, Singapore’s central bank, the Monetary Authority of Singapore (MAS) has a primary objective to promote price stability through Singapore's version of monetary policy, which is a kind of exchange rate policy. 

[NOTE: In order to effectively manage Singapore’s exchange rate, the MAS could potentially buy back its own currency from the foreign exchange market which reduces the money supply to raise the Singapore exchange rate. Conversely, the MAS also could sell domestic currency on the foreign exchange market which raises the money supply to lower the Singapore exchange rate.]

Conclusion

Hence, imported inflation is the most important factor affecting Singapore's economy and is the most likely cause of inflation in Singapore, along with cost push inflation, and with demand pull inflation being the least likely form of inflation in Singapore. 

JC Economics Essays: Tutor's Comments - This Economics essay is approached in a rather different way from this other essay, also here on this site, on inflation in Singapore's case: Singapore's Inflation: Explain the causes of inflation in Singapore. Compare and contrast. Why is this the case, which economics essay approach is better, and how could you improve on either of these papers? Do also think about why the approaches from different students can vary considerably when answering or responding to the same question. Which approach or angle is more useful and relevant in crafting an excellent economics essay, especially when under time pressure? Also, there are a few small problems with this economics essay - can you spot these small errors or mistakes, and improve on these flaws or inadequacies? Think about it for a moment. If you can identify the mistakes or the small inadequacies, plus suggest improvements upon them, then clearly you are in a good position and have really understood the material. This economics essay is a contribution from my companion website and has been adapted and amended a bit. Thanks for reading and cheers! 

Explain possible causes of stagflation in the USA.

Explain possible causes of stagflation in the USA.

Introduction - Possible Causes of Stagflation in the USA

Stagflation, as the name suggests, refers to the macroeconomic situation of low economic growth and high inflation – stagnation and inflation occurring at the same time. The background to this essay is that from 2008-2010 due to the housing bubble crisis in 2007/2008 in the USA, there have been massive rates of unemployment, raising the jobless rate.

This Economics essay argues that the possible causes of stagflation in the USA can be traced to mainly cost-push inflation.

Cost Push Inflation?

First, general cost push inflation could have resulted in stagflation in the United States. Inflation can be defined as a sustained increase in the general price level (GPL), and it could be a problem when the increase in the GPL is sustained, persistent, and inordinate.

Inflation can be both demand pull and cost push, the first affecting the aggregate demand (AD) which equals consumption, investment, government spending, and net exports or C + I + G + (X-M), by shifting it to the right, and the second affecting the aggregate supply (AS) curve, which is affected by the factors of production which are land, labour, capital, and enterprise.

For cost push, increases in unit input costs in the factors of production will lead to the AS shifting upwards, lowering employment, and simultaneously raising the rates of inflation. This can be explained using the AD/AS diagram demonstrating cost push inflation.

For example, first, higher costs of inputs such as oil could have contributed to this situation, because oil is fast running out, and the demand for oil is relatively inelastic, which could lead to high volatility and high prices. Second, wage costs could possibly have spiralled in the USA. Third, capital costs could have increased, but this is highly unlikely given that this is the USA with its technological advantages and its huge supply of capital.

Imported Inflation?

Imported inflation, which generally also leads to cost push inflation, but can also lead to demand pull inflation in some instances, might not have been a major influence of stagflation in the United States. This is because while the USA might accuse China of artificially having low exchange rates, thus increasing their imports of Chinese goods and probably causing some unemployment in sunset industries in the USA, the decreasing AD that results from this situation would actually ease inflation, and not cause stagflation. 

Furthermore, the United States of America is a large country and does not depend on imported inputs that much for the production of her own products or exports. Possibly, the rise in global food and oil prices (commodity prices have been rising internationally) could lead to some imported inflation in the USA, which would have possibly also contributed to shifting the AS curve upwards, increasing GPL.

Quantitative Easing (QE)?

Second, excessive printing of money from the QE exercises (quantitative easing), from around 2008 to 2012, by the USA Federal Reserve (USA’s central bank) could have also led to stagflation in the USA because there could be the case of too much money chasing too few real goods. Also, it can be argued that according to the Fisher Equation, where MV = PT, increases in the money supply cause inflation to occur, corroborating Milton Friedman’s famous statement that “inflation is always and everywhere a monetary phenomenon”.

This might have contributed to the high inflation in the USA because low interest rates encourage borrowing for consumption and investment, which would have caused demand pull inflation to also occur; also, according to the classical direct transmissions mechanism, more money in the hands of consumers and firms would lead to higher C and I, thus boosting AD, which might have contributed to inflation. This could have led to AS shifting upwards due to asset bubbles, which raise the costs of production.

Conclusion

Hence, in conclusion, cost push inflation is likely to be the main cause of stagflation in the USA. 

JC Economics Essays: Tutor's Comments - This Macroeconomics essay is about the causes of low economic growth and high unemployment in the USA, and is clearly in reference to recent events, in recent years (around 2007 - 2012). There are many good points about this Economics essay, such as its references to Milton Friedman and the many excellent, relevant, real world examples. However, put yourself into the shoes of an Economics tutor - what would you say were the weaknesses of this Economics paper, and how would you remedy them? Other than the fact that an Economics diagram could have been used (the AD/AS diagram which is already highlighted and put in bold fonts in the essay), what else could have been done better? While this Economics paper is good, how can it be made even better? Thanks for reading and cheers!

(b) "Fiscal policy works best to achieve price stability in a small and open economy like Singapore." To what extent do you agree with this assertion? [17]

(b) "Fiscal policy works best to achieve price stability in a small and open economy like Singapore." To what extent do you agree with this assertion?

Inflation brings about some adverse effects to the economy and hence it is important for governments to implement policies to curb inflation. The policies used would differ according to the type of inflation as well as the nature of the economy. This paper discusses if fiscal policy works best to achieve price stability in a small and open economy, and uses Singapore as a case study in particular. First, it should be noted that Singapore is a small and open economy with no natural resources, relying heavily on trade, international capital flows, and foreign direct investments to drive growth. This paper argues that fiscal policy can be used, but its impacts are massively limited given Singapore’s context.

What is fiscal policy?

Fiscal policy refers to the manipulation of government expenditure and taxation to achieve macroeconomic goals. A contractionary fiscal policy could be used to curb inflation. Government expenditure could be reduced or taxation could be increased. With a lower government expenditure, this would translate to a lower aggregate demand (AD) which consists of AD = Consumption + Government expenditure + Investment + Net Exports, or AD = C + I + G + (X-M).

Through the multiplier process, a fall in G would lead to a multiple fall in AD. With a fall in AD, firms would accumulate inventories and this would be a signal to reduce production and output. Firms will reduce their number of workers hence resulting in a fall in output and a rise in unemployment and a fall in national income. With a fall in household incomes, there is a fall in spending and hence through the multiplier process, this would result in a contractionary effect on the economy. Hence, AD would shift to the left as shown, resulting in a fall in the general price level.

With higher taxes such as income taxes, this would reduce the disposable incomes of consumers and hence this would also reduce consumption expenditure, shifting the AD curve to the left, and, hence, also resulting in a fall in the general price level.

Limitations of Fiscal Policy in Singapore’s Context

However, the effectiveness of fiscal policy would depend on the size of the multiplier. In the case of Singapore, the size of the multiplier is small due to the high marginal propensities to save and import. This is firstly due to compulsory savings such as the Central Provident Fund (CPF), and, secondly, a high marginal propensity to import, among other factors. Because Singapore is a small and open economy that relies heavily on foreign trade, there would be high leakages from the economy. Also, it would also be difficult to reduce government expenditure for long-term, major projects. Increasing personal income tax could also result in a disincentive to work and a higher corporate tax could drive businesses away from Singapore.

Other Possible Solutions

On the other hand, the Singapore government can also use contractionary monetary policies (in Singapore’s case, an exchange rate policy), or supply-side policies instead to tackle inflation, rather than just fiscal policy.

Monetary Policy, in Singapore’s Context

Monetary policy refers to the use of interest rates to achieve macroeconomic objectives. In Singapore’s case, her monetary policy is tied to exchange rates, and Singapore uses a form of exchange rate policy because Singapore is dependent on external demand. Therefore, it is more effective to control exports and imports in Singapore’s context. Hence, the exchange rate is used as a tool of monetary policy in Singapore instead.

In Singapore, a managed float system is adopted where the Singapore dollar is allowed to fluctuate within a band against a basket of currencies of her trade partners. The central bank will then intervene in the foreign exchange market to move the exchange rate to a desired level by buying up or selling the Singapore dollar using her foreign reserves, when the currency level approaches the bands. For instance, to curb inflation, the Singapore central bank (the MAS) could buy up the Singapore dollar, resulting in an appreciation of the Singapore dollar. This appreciation of the Singapore dollar would lead to a fall in the price of imports in terms of Singapore dollars. This would lead to a lower cost of living as the price of imported products would be lower. With a lack of natural resources, Singapore depends heavily on imports as inputs to manufacture our exports. Therefore, the fall in the price of imports would lead to a fall in the cost of production.

The lower price of imports would also mean that consumers switch away from local goods and purchase more imports instead, assuming they are substitutes. With an appreciation of the Singapore dollar, this would mean that Singapore’s exports are more expensive in foreign currency terms and hence less price-competitive. Assuming demand for exports to be price-elastic, this would lead to a more than proportionate fall in quantity demanded of exports from Singapore. If the Marshall-Lerner condition holds, this would lead to a fall in net exports and hence a fall in AD. The AD curve would shift to the left, resulting in a fall in the general price level, ceteris paribus.

Limitations of Singapore’s Exchange Rate Policy

However, there are limitations to the effectiveness of Singapore’s exchange rate policy. Intervention in the foreign exchange market to generate an appreciation of the currency would require Singapore to maintain significant reserves. A fall in export earnings through an appreciation of the dollar would also lead to a worsening of the current account.

On the other hand, besides fiscal and monetary policies, the Singapore government could also use supply-side policies to tackle both demand-pull and cost-push inflation. With supply-side policies, the aggregate supply (AS) could be increased through labour retraining and education. By increasing the productivity of workers, in the long run, the cost of production would fall, resulting in a rightward shift of the LRAS curve, leading to a fall in the general price level, ceteris paribus. Cost-push inflation can also be curbed using wage and income policies. For instance, a flexible wage structure would enable wages to be adjusted downwards. In Singapore, the National Wages Council (NWC) recommends the level of wage increases. This could control labour costs and ensure that wage increases do not outstrip productivity increases.

However, supply-side policies would not work effectively if AD continues to increase. Therefore, there is a need to use both contractionary fiscal or monetary policy to reduce AD to reduce the upward pressure on prices. In the long run, supply-side policies are important to curb inflation.

Conclusions

In concluding, it should be mentioned there could also be considerable time lags involved in the implementation of policies. It takes time for policymakers to gather data. There could also be implementation lags due to the time taken to implement suitable policies. Once policies are implemented, there could also be impact lags as it takes time for policies to take effect. Also, due to the characteristics of the Singapore economy, it is arguably better to adopt contractionary monetary policy using exchange rates to curb inflation, as Singapore’s monetary policy is in the form of exchange rate policy. This poses a tricky problem, in that, with a small multiplier in Singapore’s context, the effectiveness of fiscal policy is limited, yet the benefits of supply-side policies might only be reaped in the long run. However, it should also be noted that curbing inflation could lead to a trade-off with another macroeconomic objective of unemployment. By curbing inflation, a fall in national output will occur and that might lead to an increase in unemployment. In the final analysis, fiscal policy is only one of many solutions and its impact is massively limited in Singapore, and as such as plethora of policies should be used instead of one single policy.

JC Economics Essays: Tutor's Comments - This paper was written by an Economics tutor friend of mine, who was my former classmate at the NIE (National Institute of Education), doing PGDE (Postgraduate Diploma in Education, JC, Economics specialisation). For part (a) of this question, see the suggested "model" Economics answer why low inflation is an important macroeconomic aim of the Singapore government.  My usual tutor's comments and questions apply here to this essay: what do you like about this paper, and what have you learnt here? Also, what have you studied that is different or similar to what is written in this Economics paper? Using your knowledge of macroeconomics, what diagram must you use here to explain the words? Remember, although this was written under simulated examination conditions by an Economics tutor, you can always think of other ways to improve it, refine it, and make it better suit the context. Also remember that you should know how and when to apply your Economics concepts and theories, rather than just merely memorising and regurgitating. Be sure to think hard, clearly, and properly when writing your Economics essays, especially during examination conditions. Thanks for reading, and cheers!

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. 

Discuss if an increase in inflation is more likely to impact the domestic or the external sector of Singapore’s economy. [25]

Discuss if an increase in inflation is more likely to impact the domestic or the external sector of Singapore’s economy. [25]

Inflation is defined as a continuous and sustained increase in the general price level, and can be analysed as cost push or demand pull inflation, or a combination of such effects. Inflation causes problems for both the domestic and external sector of Singapore’s economy. However, it is more likely that the external sector of the economy will be worse hit, since Singapore is small and open. Inflation hurts the domestic sector because of the redistribution of income and lower economic growth and higher unemployment, which may lead to negative social issues. Yet, inflation also hurts the external sector because it hurts Singapore's export competitiveness and worsens the current account. In addition, we can expect a depreciation in the Singapore dollar, which hurts us even more because most if not all of Singapore’s inputs are imported from overseas.

Inflation hurts the domestic sector because of the redistribution of income and the impact on economic activity leading to lower economic growth and higher unemployment. First, the redistribution of income is in favour of variable income earners and not fixed income earners, and therefore many Singaporeans will suffer as they are wage earners. Borrowers will benefit from inflation and lenders will lose from inflation, and this will lower investment lending. Finally, people who hold Singapore government bonds will lose out because their Singapore government bond income cannot buy much due to inflation. In all, inflation hurts fixed income earners who are the bulk of Singapore’s workers, hurts banks and other lenders, and hurts people who own government or corporate bonds. Hence, inflation is damaging domestically due to the redistribution of income.

Secondly, if the inflation in Singapore is due to cost push inflation, unemployment will result, which hampers economic growth.

Insert cost push inflation diagram. Why does the author do this? Why this particular diagram? Think through the process of this essay to yourself. You can also try to draw out the diagram yourself from memory rather than referring to your Economics lecture notes. 

According to the diagram above, increasing costs push the general price level upwards, while reducing employment from the full employment level. This is because consumption falls due to rising costs, and investment falls because of the uncertain market outlook. Singapore might face this problem if, for example, workers producing manufacturing goods for exports are laid off due to rising costs due to increased wage push. Furthermore, Singapore’s export oriented firms might face the need for retrenchments if there is imported inflation, since inputs used locally come from overseas. Thus, Singapore might face unemployment and dampened economic growth if there is cost push inflation, which might be likely as Singapore is a small and open economy that relies on foreign inputs to make goods.

On the flip side, inflation hurts the external sector as well because it hurts export competitiveness and hence worsens the balance of payments. In addition, we can expect the Sing dollar to depreciate, which hurts Singaporeans even more because most of inputs are imported from overseas. First, why would the current account worsen? This is because when there is inflation in Singapore, goods and services become more expensive relative to other countries’ goods and services, decreasing export competitiveness. This causes other countries to demand less of Singapore goods and hence the current account worsens, since it is (X – M), where X is falling. One can also argue that the capital account worsens, since due to worsening economic conditions, capital flight might occur and foreigners might pull capital out of Singapore. Therefore, the balance of payments worsens when inflation occurs.

Secondly, when other countries demand less of Singapore’s goods, this lowers the demand for the Singapore dollar and hence the Singapore dollar depreciates vis-à-vis other currencies. Even though the government uses a managed floating exchange rate system, the lack of demand for the Singapore currency will still lead to depreciation and a rise in the inputs that are imported. When inputs that are imported are more expensive, export competitiveness is once again further worsened in some kind of a spiraling effect and that makes the current account worsen even further. Thus, depreciation due to inflation is not a positive impact.

In conclusion, which hurts the most – the domestic or foreign? To a large extent, the external sector of the Singapore economy will be worse hit, as Singapore is a small and open economy and therefore reliant on imports and exports. The local domestic sector is also hit, but nonetheless the external sector is linked with the domestic sector, and problems with BOP and depreciation will also lead to unemployment and cost push inflation as well as lack of economic growth. Therefore, in the final analysis, the external sector is always worse hit than the domestic sector in Singapore as a general rule, but the two are actually closely and intimately allied, and eventually their impacts are almost always intertwined and interacting.

JC ECONOMICS ESSAYS Economics Tutor's Comments: An excellent and very well-written economics exam paper. This student answered the question well. Note: this Economics essay was written under model examination conditions. 

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.