H2 Economics Prelim

Q5a) Explain why a country may experience a persistent rise in its general price level.(10) b) To what extent is reducing inflation often the most important macroeconomic goal for a government? (15)

Part a

Introduction

Define inflation: Inflation can be defined as a sustained increase in the general price level or sustained increase in overall prices in the economy. Inflation causes the value of money to fall. It reduces the purchasing power of money.

Define persistent inflation: A persistent inflation is said to have lasted for more than three quarters.

Body Causes of inflation

The level of prices in an economy is determined by the interaction of aggregate demand and aggregate supply. For prices to rise either aggregate demand or aggregate supply must change. Hence inflation can be caused by either demand or supply issues.

Demand Pull Inflation

Results when persistent increase in aggregate demand cannot be matched by aggregate supply. Firms therefore respond by increasing prices. Firms therefore respond by increasing prices.

A persistent increase in aggregate demand can result from factors like income rise, population growth, excessive investment, government expenditure and so on.

When full employment is reached, aggregate supply cannot be increased as the economy is at its maximum productive capacity.

If aggregate demand increases, (due to increases in consumption and investment from a post war boom, increase in foreign demand, government expenditure financed by borrowing) and if aggregate supply remains the same, prices will rise.

This will continue due to increase in production costs as firms try to meet the increased demand by bidding up the prices of scarce labour and materials in order to attract them from their existing jobs.

The higher cost will be passed on to the consumers in the form of higher prices. Workers demand higher wages and this results in further increase in aggregate demand. The process continues as prices in factor and product markets are pulled upwards. (Diagram)

Cost Push Inflation

This is caused by an increase in the costs of production within the economy. As a result of an increase in cost which will be passed on in the form of increase in prices

of goods and services, trade unions ask for higher wages in the absence of higher demand

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or increase in productivity. This will in turn further increase the cost for the firms which will push the increased wage costs on to the consumers by raising prices of their goods setting in motion a wage price spiral.

When there is an increase in the cost of production, AS fall and is shifted to the left resulting in an increase in the general price level. This type of inflation is called cost push inflation. (Diagram)

Imported inflation

This is inflation caused by higher import prices. Singapore imports all her raw materials, food and many products. When prices of food and oil rise in other countries, importers will face higher cost and will pass on the cost to the consumers in Singapore.

Structural Inflation

At times there may be changes in demand or supply in an economy or sectors of the economy may be facing different changes. Due to structural changes, supply may not be responsive enough to changes.

Assume that resources are either geographically or occupationally immobile and wages and prices tend to be sticky downwards following a fall in demand while they tend to rise following a rise in demand.

As a result of such immobility, the costs of production rise. In declining industries wages remain high or do not change as people remain in the industry. In rising industries, due to lack of labour resources as workers do not shift to such industries, wages rise as firms compete for the limited pool of labour. Overall costs of production increase and inflation occurs. This is the structural view of inflation.

Conclusion

In the real world, it may not be easy to identify the primary cause of inflation. Demand pull and cost push inflation can occur simultaneously. For example, when excessive aggregate demand in a specific industry brings about increases in prices, structural inflation can occur as supply cannot adjust to the new situation. The resulting demand for higher wages by workers can cause cost push inflation.

Level 1 Explain at least one cause of inflation which may be brief and not elaborated with no diagrams.

1 – 4 marks

Level 2 Explain the main causes of inflation with some elaboration with or without diagrams

5 – 6 marks

Level 3 Detailed explanation of the interaction of various causes of inflation with diagrams

7 – 10 marks

b) To what extent is reducing inflation often the most important macroeconomic goal for a government (15)

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IntroductionGovernments concerned as inflation may bring adverse effects. The effects depend on the causes, the rate of inflation and whether inflation is anticipated or unanticipated. Inflation has desirable and undesirable effects. Low inflation promotes economic growth to some extent. High inflation rate produces some serious (both internal and external) and social problems. It may also result in misallocation of resources that diminishes productivity and economic growth.

BodyThesis: Yes it is important to reduce inflation because of its undesirable effects. What are they?

Internal effects: IndividualRedistribution of income:

Fixed vs variable income earners: Those whose income are relatively fixed (e.g. pensioners) will suffer a fall in real income. Inflation penalizes this group in favour of those whose income are linked to price movements and wage earners with strong trade union.

Debtors vs creditors: Redistribution occurs from creditors to debtors when a fixed interest rate charged is less than inflation rate.

Profit: The effects on income derived from profits largely depend on the kind of inflation being experienced. During mild demand pull inflation, profits tend to rise. The businessmen gain because while product prices are rising, production costs usually lag behind. Conversely when there is cost push inflation, profits may be squeezed. When there is no excess demand, some firms may find it rather difficult to pass on the full effects of rising costs in the form of higher prices to consumers.

Internal Effects: Domestic economy

Production and Investment: Favourable- Mild demand pull inflation associated with excess demand results in product

prices rising more than factor prices. There will be prospects of higher profits which will stimulated production and investment.

- In the case of cost push inflation, firms will be more competitive and cut down on inefficiency to save costs.

Production and investment: Unfavourable- leads to complacency and lack of incentive to improve and therefore not

conducive for growth- There will be inefficient allocation of resources. If producers are unable to

distinguish between a rise in price caused by an increase in demand for their goods or inflation this can lead to overproduction.

- Creates unemployment and lowers growth in the long run. The level of investment and level of employment will fall as there is greater uncertainty of future demand. Firms also tend to divert funds out of investment into non-productive assets.

Savings and consumption- Income that is not spent is saved. This depends on the rate of inflation.- Savings may increase. Greater uncertainty encourage people to save more to

restore the relative value of accumulated savings or

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- However savings may also decrease. As the value of money falls with rising prices people rather invest in appreciating assets or spend more rather than save.

External effects: Balance of payment

If a country’s inflation rate is greater than that of its foreign competitors (relative rate of inflation) the country’s exports will be more expensive compared to the competitors’ output and hence less competitive.

At the same time, imports into the country will be relatively cheaper than domestically produced goods.

If the Marshall-Lerner condition is present the BOP on current account will be adversely affected.

However, if the demand for exports is inelastic, then it would lead to increase in export earnings. If the demand for imports is inelastic then it would lead to insignificant change in import expenditure. Whether the BOT will be in deficit will depend on the net effect of the changes in export earnings and import expenditure.

External effects: Exchange rate and export competitiveness

A fall in the internal value of money will lead to a fall in the external value of money i.e. depreciation of the exchange rate. This brings about further inflation in the domestic country as depreciation makes import prices higher. If most of the imports are raw materials and capital equipments this will further increase production costs and thereby reduce export competitiveness.

As a result of a fall in exchange rate, foreign investors may find their investments in that country worth less n terms of foreign currency causing investments to be withdrawn.

However if a country is overheated and has adverse BOP depreciation may help the country to improve the BOP by reducing demand for imports.

External effects: capital flight:

If the internal value of money falls persistently, people will lose confidence in the currency, Capital flight will take place as people move their money out of the country facing high inflation into countries where inflation is low.

This will result in less funds in the country for investments and infrastructure development. Moreover, the trading conditions may become so uncertain such that the conduct of business is impaired.

Antithesis

Reducing inflation is important. However there are other macroeconomic goals such as low unemployment, BOP equilibrium and Economic Growth which are also deemed important for the government to achieve as failure to achieve them will also result in adverse effects in the economy.

Unemployed resources imply waste of resources and financial and social hardship to the unemployed. Since the level of economic activity tend to fluctuate from boom to depression, it has become the responsibility of government to smooth them out to keep aggregate demand on a stable growth path and achieve full employment.

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To achieve equilibrium in the balance of payments over the long term is also important since chronic deficits or surpluses bring their own adverse consequences, like inability to import or losing competitiveness of exports and increase in import prices leading to inflation. External stability also seeks to maintain the foreign exchange rate at an appropriate level.

The government will also aim to increase the output of goods and services to reach full employment level (i.e. points on the PPC) (actual growth) and have measures to increase the potential to produce more output (push the PPC outwards) (potential growth). With Economic growth there will be higher income, more goods and services to enjoy and potentially lower unemployment, which ultimately contributes to a higher standard of living for the people.

ConclusionHence a prolonged period of high inflation leads to economic slowdown and unemployment. In the US about 30 years ago, a prolonged period of high inflation was remedied by going through a painful period of high unemployment and lost production as potential capacity remained idle. So inflation needs to be controlled and rather quickly. Achieving all macroeconomic goals will have trade-offs and therefore the government must prioritize as to which are the important goals to achieve first.

Level 1 Skimpy explanation of internal effects of inflation or list 1 or 2 internal effects and external effects with very vague explanation

1 – 4 marks

Level 2 Explain at least 2 internal effects and an external effect quite clearly

5 – 8 marks

Level 3 Antithesis: Analyse that reducing inflation is not the most important macroeconomic goal of the government. Bring out the other macroeconomic goals as well

9 – 12 marks

Evaluation 1 Some vague evaluation of results of the effects mentioned 12 - 13 marksEvaluation 2 Evaluate the instances of favourable effects of inflation 14 - 15 marks

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