PJC_H2_ECONS_P2_Q4_Suggested_Ans

1 PJC 2018 H2 P2 Question 4: Singapore had experienced annual deflation in a number of years, particularly during economic recessions in 2002, 1998 and 1986. However, the lower prices in 2015 and 2016 are due mostly to lower global crude oil prices and cheaper housing and utilities as well as transport costs. Source: Adapted from Singapore Business Review 24 May 2016 a) Explain why deflation might be a concern to a government. [10] b) Assess alternative policies that the Singapor e government might adopt to manage the economy when faced with deflation. [15] (a) Deflation is the sustained fall in general price level. Government will be more concerned with deflation if the deflation is caused by a fall in aggregate demand during economic recessions. The lower prices seen in 2015 and 2016 due to lower global crude oil prices are probably seen to be less concerned. However, the government will also need to assess whether this lower oil prices is due to oversupply of oil or a fall in world demand for oil due to worldwide recession in order to determine the impact on the economy. For Singapore, a worldwide recession is likely to cause a fall in exports and hence a fall in in aggregate demand. This will result in a leftward shift in the AD causing the general price level to fall and also a fall in the real GDP. As demand for goods and services fall, firms will cut back on their production and this will lead to a fall in the demand for labour. Producers will start to retrench workers and this will lead to a rise in cyclical unemploy ment. To the producers, lower prices also cause uncertainties to the firms and firms will start hold back on investment resulting in a further fall in aggregate demand and higher unemployment. Consumers, on the other, will benefit from the lower pr ices in the short run. Lower prices will allow consumers to buy more goods and services. There will be redistribution of income caused by a fall in general price level. To the saver, their savings will also increase in real value. This will increase their material standard of living. Fixed income earners will now enjoy higher real income and hence higher purchasing power to consume. Borrowers, on the other hand, will lose out as they have to repay their loans that have an increasing real value. However, in the long run, if prices continue to fall, consumers will hold back their consumption in anticipation of further fall in prices. This will result in firms cutting back on production and hence a fall in AD which results in higher unemployment. With lower or no income, consumers will cut back on c onsumption and this will result in a deflationary spiral which worsens the country’s economic growth and rising unemployment, thus penalizing consumers. To the government, lower prices creates uncertainties and will affect consumers and investors’ confidence hence affecting the government’s ability to achieve macroeconomic objectiv