a) Explain the causes of inflation [10]

Introduction

  • Inflation is a sustained increase in the cost of living or the average / general price level leading to a fall in the purchasing power of money.
  • The opposite of inflation is deflation which is a decrease in the cost of living or average price level.
  • The rate of inflation is measured by the annual percentage change in consumer prices.
  • Inflation can come from both the demand and the supply-side of an economy
  • Inflation can arise from internal and external events

Body

Some inflationary pressures direct from the domestic economy, for example the decisions of utility businesses providing electricity or gas or water on their tariffs for the year ahead, or the pricing strategies of the food retailers based on the strength of demand and competitive pressure in their markets.

A rise in the rate of GST would also be a cause of increased domestic inflation in the short term because it increases a firm’s production costs.

Inflation can also come from external sources, for example a sustained rise in the price of crude oil or other imported commodities, foodstuffs and beverages.

Fluctuations in the exchange rate can also affect inflation – for example a fall in the value of the pound against other currencies might cause higher import prices for items such as foodstuffs from Western Europe or technology supplies from the United States – which feeds through directly or indirectly into the consumer price index.

Demand-Pull Inflation

Demand-Pull Inflation

  • Demand pull inflation occurs when aggregate demand is growing at an unsustainable rate leading to increased pressure on scarce resources and a positive output gap
  • When there is excess demand, producers are able to raise their prices and achieve bigger profit margins because demand is running ahead of supply
  • Demand-pull inflation becomes a threat when an economy has experienced a boom with GDP rising faster than the long-run trend growth of potential GDP
  • Demand-pull inflation is likely when there is full employment of resources and SRAS is inelastic

Main Causes of Demand-Pull Inflation

  • depreciation of the exchange rate increases the price of imports and reduces the foreign price of a country’s exports.  If consumers buy fewer imports, while exports grow, AD in will rise – and there may be a multiplier effect on the level of demand and output
  • Higher demand from a fiscal stimulus e.g. lower direct or indirect taxes or higher government spending.  If direct taxes are reduced, consumers have more disposable income causing demand to rise. Higher government spending and increased borrowing creates extra demand in the circular flow
  • Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand – for example in raising demand for loans or in leading to house price inflation. Monetarist economists believe that inflation is caused by “too much money chasing too few goods” and that governments can lose control of inflation if they allow the financial system to expand the money supply too quickly.
  • Fast growth in other countries – providing a boost to Singapore exports overseas. Export sales provide an extra flow of income and spending into the Singapore circular flow – so what is happening to the economic cycles of other countries definitely affects Singapore.

Cost-Push Inflation

Cost-push inflation occurs when firms respond to rising costs, by increasing prices to protect their profit margins.

There are many reasons why costs might rise:

  • Component costs: e.g. an increase in the prices of raw materials and other components. This might be because of a rise in commodity prices such as oil, copper and agricultural products used in food processing. A recent example has been a surge in the world price of wheat.
  • Rising labour costs – caused by wage increases, which are greater than improvements in productivity. Wage costs often rise when unemployment is low because skilled workers become scarce and this can drive pay levels higher. Wages might increase when people expect higher inflation so they ask for more pay in order to protect their real incomes. Trade unions may use their bargaining power to bid for and achieve increasing wages, this could be a cause of cost-push inflation
  • Expectations of inflation are important in shaping what actually happens to inflation. When people see prices are rising for everyday items they get concerned about the effects of inflation on their real standard of living. One of the dangers of a pick-up in inflation is what the Bank of Englandcalls “second-round effects” i.e. an initial rise in prices triggers a burst of higher pay claims as workers look to protect their way of life. This is also known as a “wage-price effect”
  • Higher indirect taxes – for example a rise in the duty on alcohol, fuels and cigarettes, or a rise in Value Added Tax. Depending on the price elasticity of demand and supply for their products, suppliers may choose to pass on the burden of the tax onto consumers.
  • A fall in the exchange rate – this can cause cost push inflation because it leads to an increase in the prices of imported products such as essential raw materials, components and finished products
  • Monopoly employers/profit-push inflation – where dominants firms in a market use their market power (at whatever level of demand) to increase prices well above costs

Cost-push inflation such as that caused by a large and persistent rise in the world price of crude oil can be shown in a diagram by an inward shift of the short run aggregate supply curve. The fall in SRAS leads to a contraction of national output together with a rise in the level of prices.  This is shown in the next diagram.

b) Consumer prices in Singapore are set to rise 2.5% to 3% in 2013, as the economy continues to grow and business pass on more of their rising cost to customers. Domestic costs would rise as firms grapple with higher wages, rents and vehicle costs while imported inflation will stay muted.

Discuss the view that inflation has more harmful effects on the domestic or external sector of the Singapore’s economy. [15]

The inflation rate in Singapore was recorded at 0.40 percent in February of 2014. Inflation Rate in Singapore averaged 2.81 Percent from 1962 until 2014, reaching an all time high of 34 Percent in March of 1974 and a record low of -3.10 Percent in September of 1976. In Singapore, the most important categories in the consumer price index are housing (25 percent of total weight) and food (22 percent). The index also includes: transport (16 percent), education (7 percent), health (6 percent), communication (5 percent) and clothing and footwear (3 percent). Recreation, alcoholic beverages, tobacco and others account for the remaining 16 percent of total weight. A rise in consumer prices as mentioned in the preamble would therefore mean an increase in the above components of the CPI in the year 2013.

Many governments have a target for a low but positive rate of inflation as they believe that persistently high inflation can have damaging consequences to both the domestic and external sector of an economy.

Domestic sector refers to the combination of the households, businesses, and governments of a particular nation that undertake consumption and production activity within the political boundaries of that nation. The external sector of the economy refers to the international transactions that all residents of the country (private and public sector) conduct with the rest of the world. BOP and exchange rate is typically used as a measure on the performance of the external sector of the economy.

In this essay we will discuss the view that inflation has more harmful effects on domestic or external sector of the Singapore’s economy.

Harmful Effects on domestic sector includes:

  • Income redistribution: One risk of higher inflation is that it has a regressive effect on lower-income families and older people in society. This happen when prices for food and domestic utilities such as water and heating rises at a rapid rate.
  • Falling real incomes: With millions of people facing a cut in their wages or at best a pay freeze, rising inflation leads to a fall in real incomes.
  • Negative real interest rates: If interest rates on savings accounts are lower than inflation, people who rely on interest from their savings will be poorer. Real interest rates for millions of savers have been negative for at least the past four years
  • Cost of borrowing: High inflation may also lead to higher interest rates for businesses and people needing loans and mortgages as financial markets protect themselves against rising prices and increase the cost of borrowing on short and longer-term debt. There is also pressure on the government to increase the value of the state pension and unemployment benefits and other welfare payments as the cost of living climbs higher.
  • Risks of wage inflation: High inflation can lead to an increase in pay claims as people look to protect their real incomes. This can lead to a rise in unit labour costs and lower profits for businesses
  • Business competitiveness: If one country has a much higher rate of inflation than others for a considerable period of time, this will make its exports less price competitive in world markets. Eventually this may show through in reduced export orders, lower profits and fewer jobs, and also in a worsening of a country’s trade balance. A fall in exports can trigger negative multiplier and accelerator effects on national income and employment.
  • Business uncertainty: High and volatile inflation is not good for business confidence partly because they cannot be sure of what their costs and prices are likely to be. This uncertainty might lead to a lower level of capital investment spending.
External sector
BOP
Inflation hurts the external sector as well because it hurts export competitiveness and hence worsens the balance of payments. In addition, we can expect the Sing dollar to depreciate, which hurts Singaporeans even more because most of inputs are imported from overseas. First, why would the current account worsen? This is because when there is inflation in Singapore, goods and services become more expensive relative to other countries’ goods and services, decreasing export competitiveness. This causes other countries to demand less of Singapore goods and hence the current account worsens, since it is (X – M), where X is falling. One can also argue that the capital account worsens, since due to worsening economic conditions, capital flight might occur and foreigners might pull capital out of Singapore. Therefore, the balance of payments worsens when inflation occurs.
Exchange Rate
Secondly, when other countries demand less of Singapore’s goods, this lowers the demand for the Singapore dollar and hence the Singapore dollar depreciates vis-à-vis other currencies. Even though the government uses a managed floating exchange rate system, the lack of demand for the Singapore currency will still lead to depreciation and a rise in the inputs that are imported. When inputs that are imported are more expensive, export competitiveness is once again further worsened in some kind of a spiraling effect and that makes the current account worsen even further. Thus, depreciation due to inflation is not a positive impact.

 

Positive Consequences of inflation

On the flip side, inflation have positive consequences as well. Some of the potential advantages of benign inflation to either the domestic or external sectors are as follows:

  1. Higher revenues and profits: A low stable rate of inflation of say between 1% and 3% allows businesses to raise their prices, revenues and profits, whilst at the same time workers can expect to see an increase in their pay. This can give psychological boost and might lead to rising investment and productivity.
  2. Tax revenues: The government gains from inflation through what is called ‘fiscal drag effects’. For example many indirect taxes are ad valorem in nature, e.g. GST at 7% – so as prices rise, so does the amount of tax revenue flowing into the Treasury.
  3. Cutting the real value of debt: Low stable inflation is also a way of helping to reduce the real value of outstanding debts – there are many home owners with huge mortgages who might benefit from a period of inflation to bring down the real burden of their mortgage loans. The government too might welcome a period of higher inflation given the huge level of public sector debt.
  4. Avoiding deflation: Perhaps one of the key benefits of positive inflation is that an economy can manage to avoid some of the dangers of a deflationary recession.

Conclusion

In conclusion, to a large extent, the external sector of the Singapore economy will be worse hit, as Singapore is a small and open economy and therefore reliant on imports and exports. The local domestic sector is also hit, but nonetheless the external sector is linked with the domestic sector, and problems with BOP and depreciation will also lead to unemployment and cost push inflation as well as lack of economic growth. Therefore, in the final analysis, the external sector is always worse hit than the domestic sector in Singapore as a general rule, but the two are actually closely and intimately allied, and eventually their impacts are almost always intertwined and interacting.