PJC_H2_ECONS_P2_Q4

Pioneer Junior College (Economics Department) 1 PJC 2017 H2 Prelim Exam Paper 2 Question: 4 Singapore’s inflation moderated to −0.5% in 2015, from 1.0% in the preceding year. In October 2015, MAS eased policy further by reducing the rate of appreciation of the policy band slightly, in view of reduced price pressures alongside a weaker growth outlook. Source MAS Annual Report 2015/16 (a) Explain the possible causes of deflation in a c ountry. [10 ] (b) Discuss whether exchange rate policy should rem ain the most important policy in maintaining price stability in Singapore. [15] Deflation is defined as a sustained decreased in th e general price level of an economy. It can be caused by either a fall in aggregate demand or a rise in aggregate supply or both. Deflation can be caused by a fall in aggregate demand. For example, falling C and I due to due to consumer and business pessimism about the future state of the economy as that witnessed in Japan or debt p roblem in the euro zone and austerity measures implemented which reduces government spending. All this cause a leftward shift of the aggregate demand (AD) curve from AD 1 to AD 2, leading to a fall in the general price level from OP 1 to OP 2. Thus, one of the causes of falling GPL is falling AD. Another cause of deflation is due to rising AS due to improvement in technology. An improvement in technology improves the efficiency of capital, redu ces the average cost of production and raises the productive capacity in the economy. The lower cost of production allows firms to lower prices, and this will lead to a downward shift of the aggregate supply (AS) curve. The increased productive capacity increases the full employment output of th e economy, hence there is also a rightward shift of AS. AS cu rve shifts from AS 1 to AS 2, the equilibrium general price level falls (P 1 to P 2) while the real output increases (Y 1 to Y 2). Hence another cause of deflation is due to improvem ent in technology. GPL AS Real GDP AD 2 P2 Y2 Y1 P1 AD 1

Pioneer Junior College (Economics Department) 2 The third cause of deflation is due to falling prices of factors of production. A reduction in the price crude oil for example, red uces the cost of production of most industries as crude oil is a main source of energy. This will inc rease the profit margin of firms and increase the aggregate supply in the short run. Given aggregate demand curve AD, the AS curve shifts downwards from AS 0 to AS 1 as shown in figure 1 below, leading to a fall in t he general price level from OP 0 to OP 1 . A fall in prices of factors of production is another possible cause of deflation Deflation is cause by either a fall in AD or / and a rise in AS. The desirability of negative