2026 ACJC H2 Econs Paper 2 Q5 Prelim ANS

5 (a) Explain how high inflation can benefit some but has adverse effects on others. [10] (b) Discuss whether exchange rate policy is the best policy for Singapore to reduce the effects of high inflation on households and firms. [15] Introduction Inflation refers to a sustained increase in the general price level (GPL) of goods and services in an economy. While a low and stable rate of inflation is generally considered desirable, high inflation — such as galloping inflation above 10% or hyperinflation — can have vastly different consequences depending on the economic position of the agent in question. Whether an individual or firm benefits or suffers from high inflation depends on factors such as the nature of their income, their debt position, and the price elasticity of demand for the goods they consumed. Requirement 1: How High Inflation Can Benefit Some ● Debtors benefit from high inflation as the real value of their debt falls. High inflation erodes the real value of money over time. For households or firms that have borrowed money (i.e., debtors), the nominal value of their debt remains fixed, but the real value of what they owe falls as the general price level rises. For example, a household with a fixed-rate mortgage of $500,000 will find that the real burden of repaying this debt is reduced when inflation is high, as the purchasing power of $500,000 has fallen. In other words, they are repaying their debt with money that is worth less in real terms. This effectively constitutes a transfer of wealth from creditors to debtors, benefiting the latter. ● Variable income earners and asset holders may benefit from high inflation. Households whose incomes are variable and tend to rise with the price level — such as those earning rental income from property or profits from businesses — may see their nominal incomes increase in line with or even faster than inflation. For instance, landlords can raise rents as the cost of living rises, preserving or even increasing their real income. Similarly, holders of real assets such as properties and commodities may see the nominal value of their assets appreciate significantly during periods of high inflation, increasing their nominal wealth. ● Dominant firms with price-setting ability or market power may benefit in the short run. Firms that sell goods with relatively price-inelastic demand — such as producers of necessities or firms with strong brand loyalty — may pass on rising costs to consumers in the form of higher prices with less than proportionate fall in quantity demanded. This allows them to enjoy an increase in revenue, effectively maintaining or even expanding their profit margins in the short run, particularly if their input costs rise more slowly than the prices they charge. Requirement 2: How High Inflation Has Adverse Effects on Others ● Fixed income earners suffer a fall in real income and material standard of living.

Households on fixed nominal incomes — such as pensioners receiving a fixed private pension, workers on fixed-wage contracts, or recipients of fixed government transfers — are particularly vulnerable to high inflation. Although their nominal income remains unchanged, the purchasing power of that income falls as the GPL rises . For example, if inflation is 15% but a pensioner's income remains fixed, their real income falls by approximately 15%, meaning they can afford fewer goods and services. This leads to a direct fall in their material standard of living. ● Savers are adversely affected as the real interest rate falls. The real interest rate equals the nominal interest rate minus the inflation rate. When inflation is high and nominal interest rates do not adjust upward sufficiently, the real interest rate falls — and may even become negative. This means that the real value of savings deposited in bank accounts is eroded over time. For example, if a saver earns a nominal interest rate of 2% but inflation is 10%, the real return on savings is −8%, meaning the purchasing power of their savings is declining. This discourages saving and penalises those who rely on interest income. ● Creditors lose out as the real value of debt repayments falls. As noted above, while debtors benefit, creditors — such as banks and individuals who have lent money — are adversely affected. The money they receive in repayment is worth less in real terms than when it was originally lent. This represents a redistribution of wealth away from creditors, reducing their real returns and potentially discouraging lending in the future. ● Firms with price-elastic demand face squeezed profit margins. Firms that face relatively price-elastic demand for their products — such as those in highly competitive markets — will find it difficult to pass on rising input costs to consumers without suffering a significant fall in quantity demanded. As a result, their profit margins are squeezed. High and unanticipated inflation also introduces uncertainty into business planning, making it harder for firms to accurately forecast costs and revenues. This may lead to a reduction in investment, restricting future productive capacity and long-run growth. ● External competitiveness is eroded, harming export-oriented firms and the economy. When domestic inflation is higher than that of trading partners, domestically produced goods become relatively more expensive in foreign markets. This erodes export competitiveness , leading to a fall in export revenue and a worsening of the balance of trade. Import-competing firms also face greater pressure as foreign goods become relatively cheaper. For small, open economies that are heavily trade-dependent, this can have a significant adverse impact on balance of trade and consequently, economic growth and employment. Conclusion In summary, high inflation redistributes income and wealth across different groups. Debtors, variable income earners, and asset holders may benefit, while fixed income earners, savers, creditors, and firms with limited pricing power suffer adverse consequences.