Economics Model Essay 18

(a)  Explain the causes of inflation. [10]
(b)  Discuss the adverse effects of a rise in inflation in Singapore on the domestic sector and the external sector. [15]

Introduction

(a)  Inflation is a sustained rise in the general price level. Inflation can be classified into demand-pull inflation and cost-push inflation.

Body

Demand-pull inflation is a sustained rise in the general price level due to an increase in aggregate demand. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. An increase in aggregate demand will lead to a shortage of goods and services resulting in a rise in the general price level. Furthermore, 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 smaller will be the amount of excess production capacity in the economy and hence the larger will be the rise in the general price level.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to a rise in the general price level (P) from P0 to P1. Aggregate demand may increase due to an increase in any of its components. Consumption expenditure is determined by several factors such as consumer sentiment, the wealth of households, interest rates, expectations of price changes, the availability of credit and the distribution of income. For example, when households are more optimistic about the economic outlook, they will expect their income to rise and hence increase consumption expenditure. Investment expenditure is determined by several factors such as interest rates, business sentiment, business costs, capital costs, corporate income tax, technological advancements and the availability of credit. For example, a fall in interest rates will decrease the costs of borrowing and this will lead to more profitable planned investments resulting in an increase in investment expenditure. Government expenditure on goods and services is largely determined by the objective of the government. For example, the government may increase expenditure on the infrastructure of the economy to attract foreign direct investments. Net exports are determined by several factors such as the exchange rate, domestic inflation relative to foreign inflation, domestic income and foreign income. For example, an increase in foreign income will lead to an increase in net exports.

Cost-push inflation is a sustained rise in the general price level due to a rise in the cost of production in the economy, independent of demand. Aggregate supply is the total supply of goods and services in the economy over a period of time and is determined by the production capacity and 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 shortage of goods and services and hence a rise in the general price level.

In the above diagram, a decrease in aggregate supply (AS) from AS0 to AS1 leads to a rise in the general price level (P) from P0 to P1. The cost of production in the economy may rise independently of demand due to several reasons. For example, workers will bargain for higher wages to maintain purchasing power when they expect prices to rise. They will also bargain for higher wages when they have greater bargaining power due to a tighter labour market. The prices of intermediate goods will rise when the world demand rises due to an expansion of the world economy. A fall in the exchange rate will lead to a rise in the prices of imported intermediate goods in domestic currency. The government may raise goods and services tax to avoid a budget deficit if it cuts corporate income tax to attract foreign direct investments. Oil prices may rise due to man-made factors or natural factors. An example is the substantial rise in the cost of production in the economy due to the sharp rise in oil prices from October 1973 to March 1974 as a result of the oil embargo imposed by the Organisation of Arab Petroleum Exporting Countries (OAPEC) against the United States, the United Kingdom, the Netherlands, Japan and Canada.

Conclusion

In conclusion, high inflation has adverse consequences for the economy. Therefore, the government should achieve low inflation to avoid the adverse effects of high inflation on the economy.

Introduction

(b)  The adverse effects of a rise in inflation in Singapore on the domestic sector and the external sector can be discussed in terms of the adverse effects on consumption expenditure, domestic investment, foreign direct investment, net exports and the exchange rate.

Body

A rise in inflation in Singapore will cause problems for the domestic sector. Higher inflation in Singapore may reduce the real value of savings. When inflation is higher, nominal interest rates on savings may not fully compensate for the rise in the general price level. If this happens, the same amount of savings will allow individuals to buy only a smaller amount of goods and services which will reduce the real value of savings. This may induce households to increase savings in order to restore the real value of their savings. Given any amount of disposable income, an increase in savings will lead to a decrease in consumption expenditure. As higher inflation in Singapore tends to less stable due to the higher variance, it will make it harder for firms to estimate the costs and the revenues of planned investments. When this happens, firms will be less certain about the expected returns on planned investments which will lead to a decrease in domestic investment.

A decrease in consumption expenditure and investment expenditure in Singapore will have an adverse effect on national output and hence national income, unemployment, inflation and the balance of payments. The decrease in consumption expenditure and domestic investment in Singapore will lead to a decrease in aggregate demand which will induce firms to decrease production resulting in a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income.

In the above diagram, a decrease in aggregate demand (AD) from AD0 to AD1 leads to a decrease in national output and hence national income (Y) from Y0 to Y1. When firms decrease production in response to a decrease in aggregate demand due to a decrease in consumption expenditure and domestic investment, they will employ less factor inputs from households and hence will pay them less factor income. When households’ income falls, they will further decrease consumption expenditure which will lead to a further decrease in aggregate demand and this will induce firms to further decrease production. When this happens, firms will employ even less factor inputs from households and hence will pay them even less factor income. The further decrease in households’ income will induce them to further decrease consumption expenditure resulting in a further decrease in aggregate demand. Therefore, the initial decrease in aggregate demand due to the decrease in consumption expenditure and domestic investment will lead to further decreases in consumption expenditure and hence further decreases in aggregate demand resulting in a larger decrease in national output and hence national income. This is commonly known as the reverse multiplier effect. A decrease in national output will lead to a fall in the demand for labour in the economy resulting in a rise in unemployment. A decrease in domestic investment will lead to a less rapid increase in the production capacity in the economy in the long run, assuming net investment remains positive. Therefore, aggregate supply will rise at a slower rate in the long run. When this happens, assuming aggregate demand is rising which is the normal state of the economy, national output and hence national income will rise at a slower rate which may increase unemployment. Furthermore, the general price level will rise at a faster rate resulting in higher inflation and if this makes Singapore’s goods and services relatively more expensive than foreign goods and services, net exports will decrease which will worsen the current account and hence the balance of payments, assuming the demand for exports is price elastic. The balance of payments is a record of all the transactions between the residents of the economy and the rest of the world over a period of time and is made up of the current account and the capital and financial account.

A rise in inflation in Singapore will not only cause problems for the domestic sector, it will also cause problems for the external sector. When inflation in Singapore is higher, Singapore’s goods and services may become relatively more expensive than foreign goods and services. If this happens, net exports in Singapore will fall which will lead to a deterioration in the current account and hence the balance of payments, assuming the demand for exports is price elastic. A rise in inflation may be due to a rise in the cost of production in the economy which is commonly known as a rise in cost-push inflation. A rise in the cost of production in the economy will lead to a decrease in expected returns on planned investments resulting in a decrease in foreign direct investment. When this happens, the capital and financial account and hence the balance of payments will worsen. A decrease in net exports and foreign direct investment in Singapore will not only lead to a deterioration in the balance of payments, it will also decrease aggregate demand which will lead to a fall in national output and hence national income resulting in a rise in unemployment. Furthermore, aggregate supply will rise at a slower rate in the long run resulting in lower economic growth, higher unemployment and higher inflation. A fall in exports and a rise in imports in Singapore will lead to a decrease in the demand for Singapore dollars and an increase in the supply resulting in a fall in the exchange rate. When this happens, the value of external debt in domestic currency will rise. Furthermore, when the Singapore dollar depreciates, the prices of imports in domestic currency in Singapore will rise which will lead to a rise in imported inflation.

Evaluation

In the final analysis, the problems for the external sector caused by a rise in inflation in Singapore are likely to be more severe than those for the domestic sector. Consumption expenditure and domestic investment on domestic goods and services are small components of aggregate demand in Singapore. Furthermore, Singapore has a high savings rate of close to 50 per cent due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. Therefore, any increase in savings and hence decrease in consumption expenditure is likely to be small. It follows that the effect of a decrease in consumption expenditure and domestic investment on aggregate demand is likely to be small. In contrast, as Singapore is a small economy that is highly dependent on external demand with the domestic exports accounting for a large proportion of the aggregate demand, a fall in exports is likely to lead to a substantial decrease in aggregate demand. Furthermore, domestic firms in Singapore are small and hence have limited financial resources for investment and research and development and this constrains the growth of the production capacity in the economy and hence economic growth. Therefore, a decrease in foreign direct investment which will lead to a less rapid increase in the production capacity in the economy and hence lower economic growth is likely to be very detrimental to the economy. This is particularly true in view of the fact that foreign direct investments are generally made by multinational corporations which typically have high-end production technologies, apart from their substantial financial resources. The imports in Singapore are high due to lack of factor endowments and the embracement of free trade. Therefore, a fall in the exchange rate which will increase the prices of imports in domestic currency is likely to lead to a substantial rise in imported inflation.

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