(2019) A Level H2 Econs Paper 2 Essay Q4

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4. In 2017, the annual rate of inflation in Singapore was significantly lower than the average rate for Southeast Asia.

(a) Explain a possible demand side reason and a possible supply side reason for a rise in the rate of inflation. [10]

Possible demand side reason 

1. Demand pull inflation can be caused by an increase in aggregate demand 

2. Aggregate Demand (AD) = Consumption + Investment + Government expenditure + Net exports or C+I+G+(X-M) 

3. Therefore, factors that could cause an increase in any components of AD can cause inflation 

4. For example, positive sentiments of the economy could lead to consumers feeling more confident about spending while investors may also also increase investments → increasing C& I → increasing AD 

5. As seen in Figure 1, if AD increases from AD0 to AD1 while the economy is operating at near full or at full employment level, there will be increase in general price levels from P0 to P1 → causing demand pull inflation 

Possible supply side reason 

1. A decrease in short run aggregate supply can be a supply side reason for a rise in the rate of inflation. 

2. An increase in prices of factor inputs, without any impact on the ability of the economy to produce, can shift the SRAS curve to the left. 

3. Oil is an important factor input in the production of goods & services as oil is used to generate electricity, power vehicles & used in the production of many goods & services. An increase in the price of oil will result in an increase in the cost of production for producers in the economy → this will cause a leftward shift of the SRAS curve 

4. As seen in Figure 2, if SRAS decreases from AS0 to AS1, there will be an increase in general price levels from P0 to P1 → causing cost push inflation 

(b) Assess whether policies designed to prevent a large and continuing rise in inflation in Singapore are the most appropriate policies for all economies. [15]

Modest and gradual appreciation of the exchange rate 

How appreciation of the SGD help prevent a large and continuing rise in inflation in Singapore 

1. MAS uses exchange rates instead of interest rates as a monetary policy instrument 

2. The SGD is allowed to float based on free market forces but is a ‘managed float’ where there are bands imposed. If the SGD falls outside the range of these bands, MAS will intervene through the buying and selling of currencies to bring it back to within the range. 

3. In general, the MAS targets a modest and gradual appreciation of the SGD as 

4. A stronger SGD will make imported goods cheaper. Given that Singapore has no natural resources and is highly dependent on the rest of the world for necessities such as food, a stronger SGD will make such imports cheaper, reducing imported inflation. 

5. A stronger SGD will also make imported inputs cheaper. Given that Singapore has a lack of natural resources such as oil and commodities, a stronger SGD will make such imported inputs such as oil cheaper, reducing cost of production for firms, shifting SRAS to the right and reducing cost push inflation. 

6. A stronger SGD will also make prices of our exports more expensive. As exports become less competitive, demand for our exports will fall → fall in (X-M) → fall in AD → if economy is operating at full or near full employment level → fall in general price level from P0 to P1 → fall in demand pull inflation 

Is this appropriate for all economies? 

1. Using exchange rates as a policy instrument may only be appropriate for highly trade oriented countries such as Singapore 

2. For countries with a large domestic market, it may be more appropriate to use interest rates as a policy instrument as interest rates can help to influence the level of Consumption & Investments which may take up a larger % of the economy. 

Supply side policies 

How diversification of import sources help prevent a large and continuing rise in inflation in Singapore 

1. Singapore diversifies its import sources, especially in relation to food. 

2. This ensures that supply side shocks associated with a single source country will have only a limited impact on prices 

3. For example, Singapore has been increasingly diversifying its sources of imports of food  

4. An example would be that Malaysia used to be the largest import source for eggs and chicken but as an export ban by Malaysia led to an increase in prices of eggs & then subsequently chicken, Singapore diversified its import sources to also purchase from other countries to reduce reliance on a single source which could have a disproportionate effect on prices in the event of any supply shock. 

Is diversification of import sources appropriate for all economies 

1. Such a policy may only be appropriate for economies where are reliant on import sources such as Singapore 

2. For economies which are able to supplement imports with domestic production may simply seek to increase domestic production through subsidies to encourage producers to step up production 

How increasing productivity help prevent a large and continuing rise in inflation in Singapore 

1. The Singapore government encourages firms to increase productivity through provision of subsidies for firms seeking to implement measures to raise productivity levels such as the use of automation, software, consultancy services & upgrading of workers skills.  

2. Examples of policies include the Productivity Solutions Grant where the government provides up to 70% subsidy 

3. As productivity increases, cost of production falls → this increases the productive capacity of the economy → shifting LRAS to the right from AS0 to AS1 → fall in general price levels 

Is increasing productivity appropriate for all economies 

1. Encouraging firms to increase productivity is usually a costly endeavor which require a substantial amount of government funding to provide substantial incentives for firms to do so → this will worsen the government’s budget position → countries with large and persistent budget deficits may find it difficult to fund such policies 

2. For larger economies such as the U.S. and China, trying to come up with a generic policy across different industries across the country can be difficult compared to a small country like Singapore. Different states/provinces, different types of industries may require more targeted approaches to increase productivity but implementing such supply side policies may be hard to achieve at a national level. 

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