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 inflatio n on an economy depends on the cause, extent and duratio n. If the negative inflation is due to a fall in aggregate demand and a deflation results as seen in the euro zone and Japan, the economies are likely to be in recession and is undesirable. GPL AS 0 Real GDP AD P1 Y1 Y0 P0 AS 1

Pioneer Junior College (Economics Department) 3 Question: 4 Singapore’s inflation moderated to −0.5% in 2015, f rom 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 (b) Discuss whether exchange rate policy should rem ain the most important policy in maintaining price stability in Singapore. [15] Singapore uses exchange rate policy to manage infla tion. Being a small and open economy largely reliant on FDI & trade for its growth. Singapore al so lacks resources and hence very reliant on imports. Whether the use of exchange rate policy is the most important policy for an economy such as Singapore depends on the context of the economy, cause of inflation and the time period. Gradual appreciation of the Singapore Dollar is the most important policy in maintaining low inflation in Singapore. As the Singapore economy which lacks nat ural resources, Singapore has to rely on imports for almost everything. Hence a gradual appr eciation of the Singapore dollar can reduce the effects of imported inflation. As Singapore dollar appreciates, imports become cheaper in terms of domestic currency, reducing imported cost of produc tion. Assuming firms pass on cost savings to consumers by reducing prices, the AS curve shifts d ownwards to alleviate cost push inflation as seen in Fig 1 where a downward shift of AS from AS 2 to AS 1 will reduce general price levels from P 2 to P 1. Figure 1 Figure 2 Currency appreciation can also help dampen the rise in AD to control demand pull inflation as an appreciation of currency causes exports to be more expensive in foreign currencies, causing quantity demanded for exports to fall and imports to be chea per in domestic currencies, causing quantity demanded for imports to rise. If Marshall-Lerner co ndition holds where |PED x + PED M|>1, the appreciation of currency will cause net exports (X- M) to fall, resulting in a fall in AD, controlling the overheating effects in our economy. In Fig 2 above, a fall in AD from AD 4 to AD 3 can reduce the general price levels from P 4 to P 3. Therefore, given Singapore’s open economy, a gradua l appreciation of our currency is an effective and important tool to manage inflation in our econo my. This is further supported in the preamble where 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. Despite the importance of Exchange rate, it does n ot tackle demand-pull or cost push inflation attributed to domestic reasons (high demand for hou sing, high labour cost etc), which has been a source of inflation in recent years. Hence it alone might not be enough to maintain price stability. The Singapore government also make use many cooling measures to tackle high inflation brought about by domestic cost pressures. For example, a hi gher additional stamp duty was imposed on citizens who are purchasing their second property a nd this will reduce excessive demand for housing GPL Real GDP AD 1 Y1 AS 1 Y2 P1 P2 AS 2 GPL Real GDP AD 3 AS 0 Y3 P3 AD 4 P4 Yf

Pioneer Junior College (Economics Department) 4 which subsequently reduces investments. The ease of obtaining a housing loan has also been tightened, tackling the problem of rising housing p rices caused by rising demand. Also, measures to restructure the auto vehicle loan limits and additi onal registration fees system were also targeted at cooling the rising COE prices. The usage of targeted cooling measures serves to ta ckle the problems of rising prices caused by domestic cost pressures efficiently. However, somet imes cooling measures may not bring about the intended effects and this requires additional polic ies. For instance, the housing cooling measures was the seventh cooling measures thus far. On top of th at, the effectiveness of such cooling measures depends on the abilities of the authorities to chec k market trends and to identify appropriate measures. Supply-side policies like education, training, subs idies and tax incentives to encourage Research & Development allow the economy to shift the AS curve to the right by increasing the quantity and quality of res ources. With an increase in AS, Singap