(2020) A Level H2 Econs Paper 2 Essay Q6

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6. Singapore experienced a price deflation with the general price level falling from 2014 to 2016. In Japan, the general price level fell in 11 of the 14 years from 1998 to 2012.

Source: OECD data, accessed 21 June 2019 

(a) Explain one possible demand-side cause and one possible supply-side cause of price deflation for an economy such as that of Singapore or Japan. [10]

Demand side cause of deflation 

Pessimistic outlook / expectations of consumers 

1. Deflation can be caused by a decrease in AD 

2. In the case of Japan, consumers formed expectations of persistent deflation, expecting prices to drop, many consumers may also be relatively pessimistic about the economy and potential wage increases → this caused consumers to hold back on Consumption, causing Consumption to fall → fall in AD 

3. A fall in AD is reflected by a leftward shift of AD from AD0 to AD1, assuming that the economy was operating at near full employment level, a fall in AD can result in a fall in general price levels → causing deflation 

Supply side cause of deflation 

Falling oil & commodity prices 

1. Deflation can also be caused by an increase in SRAS 

2. In the case of Singapore, we lack natural resources and thus depend on imports for raw materials & inputs such as oil 

3. In periods where there are fall in global commodity prices and oil prices like that of 2014 to 2016, prices of imported oil & commodities fall → reducing prices of factor inputs for firms → fall in COP → increase in SRAS → reflected by rightward shift in AS from AS0 to AS1 → fall in general price levels → causing deflation 

(b) Discuss whether deflation or inflation is more damaging for an economy. [15]

Why inflation is damaging 

1. Inflation erodes away the purchasing power of consumers → reducing the ability of consumers to consume → fall in material standard of living 

2. As exports become more expensive → fall in demand for exports → (X-M) fall → fall in AD → fall in real NY → lower economic growth 

3. 3Inflation increases uncertainty of businesses as cost margins become harder to estimate & this can discourage investments → fall in AD → fall in real NY → lower economic growth 

4. This is what is happening in countries like U.S., Singapore because of supply chain disruptions caused by the COVID-19 pandemic & the Ukraine war. 

5. A wage-price-spiral may also occur, as workers demand for higher wages given high inflation rates, and firms pass on the higher costs back to consumers in the form of higher prices, creating an endless cycle of higher prices & higher wages. 

Why deflation is damaging 

1. Deflation can be damaging when persistent 

2. A constant expectations of deflation can result in consumers holding back on purchases → fall in Consumption → fall in AD → fall in real NY → lower economic growth 

3. This was what caused economic stagnation in Japan for years 

4. Deflation can be sign of an ailing economy - when people are not spending and there is minimal economic activity which is causing AD to fall → causing deflation 

Is inflation or deflation more damaging? 

1. Whether inflation or deflation is more damaging depends on the extent and nature of the inflation / deflation. 

2. Firstly - the extent of inflation / deflation ; a slight rate of inflation at 2% is considered signs of a healthy and growing economy and a slight deflation may also be welcomed as consumers see an increase in purchasing power 

3. Secondly - the causes of inflation & deflation and whether the reasons are persistent. If inflation is caused by an increase in AD as economy is approaching full employment level, some level of higher inflation can be acceptable as a tradeoff for higher economic growth, whereas inflation caused by cost-push reasons may be less welcomed. When causes of inflation / deflation are transient, there’s usually not much cause for concern. Yet, when causes of deflation are persistent, there are usually more deeper underlying causes such as a lack of demand in the economy - which can be more damaging as there can be economic stagnation accompanying deflation. 

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