RI 2026 Macroeconomic Aims and Issues Student T2W5 Class Test 3 Mark Scheme

T2W5 Class Test 3 Macroeconomic Aims and Issues – Mark Scheme © Raffles Institution 1 T2W5 Class Test 3 Macroeconomic Aims and Issues Mark Scheme Singapore had experienced annual deflation in a number of years; 2020: - 0.5%, 2015: -0.5%, 2002: -0.4%, and 1998: -0.3%. With the exception of 2015, deflation in 2020, 2002, and 1998 were during economic recession period. (a) Explain one possible demand-side cause and one possible supply-side cause of deflation in Singapore. [10] (b) Discuss whether deflation or inflation is more damaging for Singapore’s economy. [15] Suggested answers for (a) Introduction • Deflation is defined as negative inflation or a sustained fall in general price levels (GPL). • The two main causes of deflation in Singapore stems from a fall in aggregate demand (AD) and a rise in aggregate supply (AS), particularly due to a fall in cost of production (COP). Body R1: Fall in AD causing deflation • In 2019, before the COVID -19 pandemic (2020), Singapore’s economy was experiencing positive growth, and its AD could be operating on the intermediate range of its AS curve with limited spare capacity. • As a small and open economy, Singapore’s (SG) economy is trade- oriented and depends heavily on trade for its economic growth. In 2020, w hen the global economy got weaker due to the onset of the COVID -19 pandemic where many of SG’s trading partners went into recessions, the real national income of SG’s trading partners falls such as in the US. This causes the average income of Americans to fall (assuming constant population size), making them less willing and able to purchase and consume goods and services, including SG’s exports to the US. • Assuming SG exports are normal goods with YED>0, the demand for SG’s exports falls, ceteris paribus, reducing the quantity of her exports, causing a fall in X component of SG’s AD. Alternatively, the following analysis also works: • Due to the weak global economic conditions in 2020 during the pandemic, households and firms became pessimistic and experienced lower confidence in the economy. • Households predict that their future income may decrease and increase their precautionary savings, causing a fall in consumption spending (C) in AD. In addition, firms expect future demand to be weak, thus reducing their expected returns on investment proj ects, causing MEI to fall and overall reducing investment spending (I) in AD. Price Adjustment Mechanism • Since AD = C+I+G+(X-M), the fall in X and/or C and I will result in a fall in AD from AD0 to AD1. The fall in AD will start to create s urpluses in the economy because current spending is below current production levels at the initial general price level P0. • The unplanned buildup of surplus inventories of goods and services will create downwards pressure on prices as firms are more willing to reduce prices to clear excess inventories. • The reduction in production, coupled with the fall in demand for raw materials and labour put downward pressure on cost of production, allowing the firm to reduce price. This c ause the fall in GPL from P0 to P1.

T2W5 Class Test 3 Macroeconomic Aims and Issues – Mark Scheme © Raffles Institution 2 Explain how the fall in GPL is sustained Either • When AD falls from AD0 to AD1, firms will reduce output by hiring less labour. With lower income, households will spend less on induced consumption. • This will trigger a multiplied decrease in AD from AD0 to AD2 via the reverse multiplier process where one person’s cut in spending is another’s reduction in income. • This multiplied fall in AD from AD0 to AD2 will result in a sustained fall in GPL from P0 to P1 followed by P2, showing deflation. Or • When the GPL falls from P 0 to P1, households may develop expectations that prices will continue to fall in the future, thus withholding their purchases now and causing C to fall further. • Moreover, as firms expect future returns to decrease due to weaker demand, I also fall. • Combined, this leads to AD falling further from AD1 to AD2. Through the same adjustment process as before, surplus occurs and there is a further fall in GPL from P1 to P2, showing deflation. Figure 1: Deflation caused by fall in AD R2: Rise in AS causing deflation • The SG government has proactively increased spending on expanding our burgeoning Artificial Intelligence (AI) sector to increase the productivity levels for both private and public firms. For example, through the National Artificial Intelligence Strategy ( NAIS) 2.0, the government has committed to spend on high-performance computing resources to support AI industry’s growth. • The above helps to increase the productivity of SG’s economy. The workers working with more efficient AI tools will see an increase in output per unit labour hour. Assuming productivity growth outpaces wages growth, this leads to a fall in unit cost of production. • As the costs fall, firms become more willing and able to produce more outputs at each GPL level due to rising profitability, causing AS to rise and shift downwards from AS1 to AS2. • At the initial GPL, P1, aggregate supply (output) exceeds the level of aggregate demand (spending). This will lead to an accumulation of stocks and inventories and will cause firms to lower prices to sell off the excess inventories. The firms are also more willing and able to pass some cost savings on to other economic agents such as the consumers in the form of lower prices. As GPL falls, consumers are incentivised to consume more goods and services. This is represented by a downward movement along the AD curve. This continues until the GPL falls to P2.

T2W5 Class Test 3 Macroeconomic Aims and Issues – Mark Scheme © Raffles Institution 3 Figure 2: Deflation caused by rise in AS (fall in COP) Alternatively, you can explain with both a fall in COP and a rise in productive capacity. (However, students should focus on the fall in COP to explain falling prices.) • Moreover, with the rise in quantity of capital goods acquired and with greater output per unit input from better capital -labour ratio, this increases the AS and the productive capacity, shifting AS rightwards. • Overall, AS shift outwards from AS 0 to AS1. As the costs of production falls for the firms, they are more willing and able to pass some cost savings onto other economic agents (such as to consumers) as lower prices, decreasing the GPL from P0 to P1 and leading to deflation. Figure 3: Deflation caused by rise in AS (fall in COP and rise in Yf) Conclusion • Deflation caused by fall in AD tends to be from external factors for SG whereas deflation caused by rise in AS can be from both internal and external factors. Mark Scheme: Knowledge, Application, Understanding, Analysis L1  Lack application of relevant economic framework and context  Critical errors in analysis  Significant conceptual gaps in explanation 1 - 4 L2  Some economic analysis for both requirements (R1 and R2) but with gaps or lapses in explanations  Some application of context and use of examples  Lacking in full scope of analysis 5 - 7 L3 A well-developed answer that demonstrates:  Rigorous analysis for BOTH requirements  Good scope of coverage  Good application of contextual examples 8 - 10

T2W5 Class Test 3 Macroeconomic Aims and Issues – Mark Scheme © Raffles Institution 4 (b) Discuss whether deflation or inflation is more damaging for Singapore’s economy. Introduction • Clarify that inflation/deflation is damaging because it either (i ) harms SOL or (ii) hinders the attainment of other economic aims Requirement #1: Inflation is damaging for an economy (2 well developed arguments is sufficient) 1. Reduces investment which hinders actual and potential economic growth • High and especially unstable inflation cripples long term business planning because it creat