EJC H2 ECONS Essay4 Suggested ans and mark scheme

1 JC2 Preliminary Examinations 2018 H2 Economics Paper 2 – Essay Part (a): Explain possible causes of rising price pressures of goods and services in an open economy. [10] Question Dissection Command Word Explain Question Type Explanation Concept(s) • Meaning of an open economy • Causes of inflation in an open economy o Cost-push inflation o Demand-pull inflation End Point To explain at least 2 causes of inflation specifically in the context of an open economy. Context Any country, though reference can be made to Singapore’s context Suggested Answers (I) Introduction An open economy refers to an economy that interacts freely with other economies around the world. Economic openness can be measured as openness and reliance of an economy to trade, foreign investment, labour and capital flows. Singapore is one such open economy where its external demand constitutes a large percentage (about 300%) of its GDP and FDI is about 70 % of its total investments. Due to the constraints of a small population size with a lack of natural resources, the Singapore economy has to be open which means that it is heavily reliant on exports and FDI to drive its economic growth. When an economy is faced with rising price pressures on good and services, it suggests that the economy is facing an Inflationary situation. Inflation is defined as a sustained rise in the general price level of a given basket of goods and services in an economy over time, usually a year. Hence rising price pressures (or inflation) can be caused by a persistent rise in aggregate demand (AD) or due to a persistent fall in aggregate supply (AS). Being open means that the main types of rising price pressures of goods and services is often that of import-price-push inflation and external demand-led demand pull inflation. 4 Many economists argue that managing rising price pressures is the single most important macroeconomic objective for governments. (a) Explain possible causes of rising price pressures of goods and services in an open economy. [10] (b) Discuss the extent to which a government’s policy decisions to manage rising price pressures are affected by the degree in which its economy is open. [15]

2 (II) Body (1) Cost-push Inflation Being open makes an economy most vulnerable to external supply shocks such as increase in the price of imported oil and other raw materials caused by strong demand from China and other emerging economies , higher prices of imported food due to bad weather, and higher foreign inflation. Singapore’s lack of natural resources implies a heavy reliance on imported raw materials and necessities for both the production of goods and services, as well as for consumption respectively. As such open ec onomies such as Singapore are extremely susceptible to rising prices pf imported good s and services. An example is how Singapore’s inflation rate rose to 6.6% in 2008, three times the inflation rate in 2007. This was because of rising food prices in our neighbouring countries, coupled with sharp increases in global oil prices that year. Figure 1: Cost-push inflation (from imported inflation) As a result of higher cost of production due to higher import prices, ceteris paribus, profits fall and producers cut back on production, causing the the SRAS 1 curve to shift upwards (i.e. to the left) to SRAS2. , This results in shortages and causes an upward pressure on prices thereby resulting in a higher general price level, P 2 and a lower equilibrium national output at Y 2. If there are further increases in costs of production, and firms pass on the higher costs to consumers in the form of higher prices, SRAS will then fall further from SRAS 2 to SRAS 3, causing the general price level to rise to P3 and the level of national output to fall to Y3. Hence, with higher prices of imported final products as well as through higher cost of imported inputs which raise cost of production, this will cause rising domestic price pressures of goods and services in an open economy such as Singapore. (2) Demand-pull Inflation Being open, an economy is also very prone to demand pull inflation, especially when there is strong growth of its trading partners. For an open economy like Singapore, strong growth of its trading partners such as China means there is a rise in real national income of such countries. This rise in foreign purchasing power from these countries will cause a more than proportionate increase in the demand for Singapore’s exports, since Singapore exports mainly goods whose demand is income elastic for instance electronics and high-end pharmaceutical products. This

3 leads to a rise in Singapore’s total export revenue. Assuming total expenditure on imports remaining constant, there is a rise in (X-M). Strong growth of its trading partners also boost both firms’ profitability as well as business confidence. Assuming that these foreign firms are equally confident in an open economy such as Singapore, a rise in their expected profitability will increase their Marginal Efficiency of Investment (MEI), thereby making them invest in Singapore. In other words, foreign direct investment (FDI) in Singapore rises. Figure 2: Demand-Pull Inflation Ceteris paribus, AD increases sharply due to an increase in FDI and net exports which is a large component of AD. This is shown by a rightward shift of AD curve from AD 0 to AD 1. Assuming the country is operating near full employment, there will be a shortage of final goods and services which exerts upward pressure on GPL. GPL continues to rise until shortage is eliminated. The persistent increase in the general price level services from P 0 to P 1 depicts demand-pull inflation. Hence, in an open economy, external factors such as strong growth and thus rising affluence of its trading partners would be one of the main causes of demand-pull inflation, hence accounting for the significant impact on rising price pressures of goods and services. (III) Conclusion A very open economy like Singapore which is resource-scarce and import-reliant given her small domestic market, external factors such as imported inflation (cost-push inflation) and rising affluence of its trading partner (demand-pull inflation) would be the main causes of inflation in the domestic economy. Moreover, both demand-pull and cost-push inflation can reinforce each other to bring about a greater rise in price pressures of goods and services in an open economy. AD1 Real national output General price level P1 Yf AS E1 0 AD0 Y0 P0 E0

4 Level Knowledge, Application / Understanding and Analysis Marks L 3 For an answer that gives a detailed and analytic explanation using AD-AS model on the causes of rising price pressures of goods and services in an open economy Well-elaborated analysis would include the use of AD-AS model to explain the demand-pull and cost-push inflation and relevant examples of an open economy. is required, with clear reference made to the diagrams. 8 – 10 L 2 For an answer that gives a descriptive explanation on the causes of rising price pressures of goods and services in an open economy Some gaps are evident in some of the analysis and explanation may only focus on one cause of inflation (max 5 marks) 5 – 7 L 1 For an answer that shows some basic knowledge of the possible causes of rising price pressures of goods and services in an open economy Limited application of economic analysis 1 – 4 Part (b): Discuss the extent to which a government’s policy decisions to manage rising price pressures are affected by the degree in which its economy is open. [15] Question Dissection Command Word Discuss Question Type Explain, e