2010 Essay Question 5

Question

When there are large increases in the prices of oil and other primary products, they are usually expected to lead to rising inflation through the world’s economies.

Discuss the extent to which these factors are likely to affect the rate of inflation in Singapore. [25]

Answer

Students should explain the causes of inflation in Singapore and why one cause may be more or less significant than other causes in affecting the rate of inflation.

An increase in the prices of oil and primary products will lead to a rise in the cost of production in the economy. When the cost of production in the economy rises independently of demand, firms will increase prices at the same output levels to maintain profitability. In other words, they will decrease output at the same prices which will lead to a decrease in aggregate supply resulting in a rise in the general price level. This is known as cost-push inflation which is a sustained rise in the general price level due to a rise in the cost of production in the economy, independent of demand. As Singapore virtually does not have factor endowments, it imports oil and many other primary products. Therefore, such cost-push inflation in Singapore is called imported cost-push inflation.

Increases in the prices of oil and other primary products which will lead to higher imported cost-push inflation in Singapore may lead to high inflation. This is particularly true if the increases are large. Furthermore, oil is an essential factor input which is used in the production of many goods. Therefore, a rise in oil prices may lead to a substantial rise in the cost of production in the economy. In addition, when oil prices rise, the cost of transporting goods from the factory to the marketplace will rise which will lead to a rise in the cost of production in the economy.

Although increases in the prices of oil and other primary products will lead to higher imported cost-push inflation in Singapore, it may not lead to high inflation as imported cost-push inflation may be less significant than domestic cost-push inflation and demand-pull inflation in affecting the rate of inflation in Singapore .

Imported cost-push inflation may be less significant than domestic cost-push inflation in affecting the rate of inflation in Singapore
Domestic cost-push inflation is a sustained rise in the general price level due to a rise in the cost of production in the economy as a result of domestic factors, independent of demand. For example, when workers expect prices to rise, they will bargain for higher wages which will lead to a rise in the cost of production in the economy. Domestic cost-push inflation may be more significant than imported cost-push inflation in affecting the rate of inflation in Singapore due to several reasons. The labour market in Singapore is typically tight. Therefore, there is generally an upward pressure on wages. Services account for about two-thirds of the Singapore economy and services producing industries are labour intensive. Therefore, labour cost accounts for a large proportion of the cost of production in Singapore, over 40 per cent. It follows that a rise in wages may lead to a large rise in the cost of production in Singapore.

Imported cost-push inflation may be less significant than demand-pull inflation in affecting the rate of inflation in Singapore
Demand-pull inflation is a sustained rise in the general price level due to an increase in aggregate demand. When aggregate demand rises, firms will increase production which will lead to an increase in the demand for factor inputs in the economy resulting in a rise in the prices. When this happens, the cost of production in the economy will rise which will induce firms to increase prices to maintain profitability resulting in a rise in the general price level. Given any increase in aggregate demand, the extent of the rise in the general price level will depend on the state of the economy. The nearer the economy is to the full-employment equilibrium, the larger will be the rise in the general price level. Demand-pull inflation may be more significant than imported cost-push inflation in affecting the rate of inflation in Singapore due to several reasons. Exports in Singapore are generally increasing as the world economy is generally expanding and hence the world income is generally rising. As Singapore is a small economy that is highly dependent on external demand with the domestic exports accounting for a large proportion of the national income, an increase in exports generally leads to a large increase in aggregate demand. For example, the increase in exports in Singapore in the global economic recovery in 2010 led to a substantial increase in aggregate demand. Furthermore, the Singapore economy is usually near the full-employment equilibrium. Therefore, an increase in aggregate demand may lead to a large rise in the general price level.

Although increases in the prices of oil and other primary products will lead to higher imported cost-push inflation in Singapore, it may not lead to high inflation due to the use of policies by the government. In the face of large increases in the prices of oil and other primary products, the MAS may intervene to curb inflation. This is because high inflation which will reduce the real value of savings is very detrimental to Singapore as the people have high savings due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. The MAS may revalue the Singapore dollar by raising the exchange rate policy band and simultaneously buying domestic currency and selling foreign currency in the foreign exchange market. A rise in the exchange rate will reduce the rise in the prices of imported oil and other primary products in domestic currency which will lead to a smaller the rise in the cost of production in the economy and hence a smaller rise in the general price level.

Evaluation

Point 1: The extent of the effect of large increases in the prices of oil and other primary products on the rate of inflation in Singapore will depend on the external demand. The stronger the external demand in Singapore, the greater the extent the MAS is able to revalue the Singapore dollar and hence the smaller the  effect of large increases in the prices of oil and other primary products on the rate of inflation. The converse is true.

Point 2: Students can suggest the use of a policy mix by the Singapore government to curb inflation in the face of large increases in the prices of oil and other primary products. They should provide a justification for the use of a policy which may be general or specific.

A more elaborate answer to 2010 Essay Question 5 will be provided in the economics tuition class.

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