Q.57 inflation-unemployment-and-singapore

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Q.57 inflation-unemployment-and-singapore

  1. 1. (a) What are the causes of inflation in Singapore? [10] (b) Discuss whether low inflation is a more important macroeconomic objective than low unemployment in Singapore. [15] (a) Inflation is a rise in the general price level over a period of time. Monetary economists, however, define inflation as a sustained rise in the general price level and refer to a one-off rise as a price shock. Inflation in Singapore can be classified into demand-pull inflation and cost-push inflation. Demand-pull inflation occurs when the general price level rises due to an increase in aggregate demand. Given any increase in aggregate demand, the closer the economy to the full-employment equilibrium, the larger the rise in the general price level. 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. 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. Demand-pull inflation in Singapore is mainly caused by external factors. Due to the larger external sector of the Singapore economy, the aggregate demand usually increases when the exports increase due to an increase in the national income of its trading partners. The aggregate demand in Singapore also increases when the consumption expenditure and investment expenditure increase due to stronger consumer and business sentiment but this happens to a smaller extent as they are small components relative to the exports. Further, consumption expenditure does not increase substantially in Singapore due to the culture of thrift. The aggregate demand in Singapore sometimes increases due to an increase in the © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  2. 2. government expenditure but this happens to an even smaller extent as it is the smallest component and the government has adopted a prudent fiscal policy. Cost-push inflation occurs when the general price level rises due to a rise in the cost of production in the economy, independent of demand. 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 reduce output at the same prices which will lead to a decrease in aggregate supply. Aggregate supply is the total supply of goods and services in the economy over a period of time. In the above diagram, a decrease in aggregate supply (AS) from AS 0 to AS1 leads to a rise in the general price level (P) from P0 to P1. Cost-push inflation in Singapore is mainly caused by external factors. Due to lack of factor endowments, the cost of production in Singapore usually rises when the prices of imported intermediate goods rise due to inflation in other economies or a rise in commodity prices. The cost of production in Singapore also rises when workers bargain for higher wages due to expectations of price increases or a tight labour market but this happens to a smaller extent. The cost of production in Singapore sometimes rises due to an increase in the goods and services tax but this happens only once in every five to ten years. In conclusion, due to the characteristics of the Singapore economy, both demandpull inflation and cost-push inflation in Singapore are mainly caused by external factors. Therefore, the MAS holds the view that the exchange rate is the most effective policy instrument for achieving low inflation in Singapore. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  3. 3. (b) Unemployment is the state of the economy in which some workers are not employed in the production of goods and services. The question on whether low inflation is a more important macroeconomic objective than low unemployment in Singapore can be discussed with reference to the short-run conflict between the two macroeconomic objectives and the state of the economy. Low inflation helps the economy avoid the adverse effects of high inflation. When inflation is high, nominal interest rates will not fully compensate for the rise in the general price level which will reduce the amount of goods and services that can be purchased with any given amount of savings. When inflation is high, domestic goods and services may become relatively more expensive than foreign goods and services. If this happens, net exports will fall. Since high inflation tends to be less stable, firms will find it harder to estimate the costs and revenues of investments when inflation is high which will lead to a decrease in investment expenditure. High inflation will lead to a high menu cost and a high shoe-leather cost of inflation. Low unemployment helps the economy avoid the adverse effects of high unemployment. High unemployment will cause the economy to lose a large amount of output. It will cause a large number of people to lose their income. Further, if the unemployed remain unemployed for a long period of time, they may lose their skills and knowledge. When unemployment is high, the employed will lose some of their income in the form of a pay cut. High unemployment will cause firms to lose a large amount of profit. When unemployment is high, the government will lose a large amount of tax revenue. High unemployment will lead to a high crime rate, high divorce rate, high suicide rate and social unrest. Although low inflation and low unemployment are desirable for the Singapore economy, they cannot be achieved simultaneously in the short run. If the Singapore government increases aggregate demand to reduce unemployment, inflation will rise, and vice versa. The short-run trade-off between inflation and unemployment can be shown by the short-run Phillips curve. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  4. 4. In the above diagram, when the unemployment rate () falls from 0 to 1, the inflation rate () rises from 0 to 1. Owing to the conflict between low inflation and low unemployment, whether the former or the latter is a more important macroeconomic objective in Singapore will depend on the state of the economy. For instance, in the first half of 2008, inflationary pressures in Singapore were rather high due to a rapid rise in food and oil prices. Therefore, fighting inflation was the more important macroeconomic objective of the Singapore government. In September 2009, unemployment in Singapore reached an all-time high of 5 per cent. Therefore, reducing unemployment was more important than reducing inflation. In the event that both inflation and unemployment are high in Singapore, such as the oil crisis of the early 1970s, low inflation will be a more important macroeconomic objective than low unemployment. First, the savings rate in Singapore is close to 50 per cent which is very high due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. Therefore, achieving low inflation is important in Singapore as it helps preserve the real value of the high savings. Second, high inflation will affect retirees badly as these people live on their savings and they are unlikely to be able to rebuild the real value of their savings in the face of high inflation as they have stopped working. Therefore, achieving low inflation is important in Singapore as the population is aging rapidly. One-fifth of the population in Singapore will be 65 years of age and above by 2030. Third, the Singapore economy is rather exportdependent due to the small domestic sector. The exports of Singapore are over 200 per cent of the national income. Therefore, achieving low inflation is important in Singapore as it helps increase the export competitiveness. When the exports of Singapore rise, the aggregate demand will rise which will lead to an increase in the national income and hence a fall in unemployment. In the final analysis, since low inflation is generally more important than low unemployment in Singapore, it is important for the government to use the appropriate policies to achieve price stability. Given the large total trade of Singapore relatively to the national income, the use of exchange rate policy through a modest and gradual appreciation of the Singapore dollar can curb imported inflation, cost-push inflation and demand-pull inflation. Further, the Singapore government can use supply-side policies to achieve price stability in the long run. However, in a recession, the Singapore government should devalue the Singapore dollar to boost exports. The use this policy, coupled with the use of expansionary fiscal policy and short-term supply-side measures, will cushion the negative impact of the recession on unemployment in Singapore. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek

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