MI Prelims H2 2013


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MI Prelims H2 2013

Introduction

One of the macroeconomic aims of the Singapore government is to maintain price stability (low inflation levels) so as to create a conducive environment for investment, maintain export competitiveness to sustain non – inflationary economic growth. There are two main types of inflation – demand-pull and cost-push. An increase in the inflation levels will lead to problems for both the domestic and the external sector.

 

Thesis: Increase in inflation levels may cause more problems for the domestic sector

An increase in inflation levels will lead to greater uncertainty in the economy and firms will face difficulty predicting future costs, revenue and profits. This will reduce business confidence and the expected rate of returns from investment will fall. Firms will thus reduce their investment expenditure.

Part of these investment expenditure could have been channeled into useful investment projects like Research and Development (R&D) to search for cheaper and more efficient methods of production, which will serve to increase the productive capacity in the economy. However, since firms are deterred from taking up investment projects in view of the higher inflation levels, potential economic growth is hindered.

Furthermore, if the increase in inflation levels is due to cost-push inflation, where there is persistent increases in cost of production, it may lead to an increase in unemployment in the country. This is because with higher costs of production, existing firms may be encouraged to relocate part of their operation and production processes to other countries with lower cost of production. These firms will bring out with them job opportunities, which will then lead to increase in unemployment in the country.

On the overall, the high inflation rates will negatively affect the economic growth and employment levels in the economy. This illustrates how increase in inflation levels can cause severe problems for the domestic sector, adversely affecting the macroeconomic aims of the economy.

 

Anti-Thesis: Increase in inflation levels may cause more problems for the external sector

1) Worsening of current account

An increase in the inflation levels is likely to worsen the current account of the Balance of Payment.

When the domestic inflation rate is relatively higher than that of trading partners, exports from the domestic country will become more expensive in the foreign market (less price competitive). The price demand elasticity of Singapore’s exports is expected to be more than 1 (PEDx > 1), given the wide availability of substitutes in the global market, the increase in the price of exports will lead to a more than proportionate fall in the quantity demanded of exports. Overall export revenue falls.

At the same time, imports will become relatively cheaper in the domestic market, i.e more price competitive when compared to the more expensive domestically produced goods. As consumers are inclined to switch to buying the relatively cheaper imports, demand for imports increases and total expenditure on imports increases.

The value of net exports (X-M) will hence fall, worsening the current account and the Balance of Payment of the country.

 

2) Exchange Rate

The fall in the quantity demanded for the country’s exports will lead to a fall in foreigners’ demand for the country’s currency (e.g DDSGD falls). At the same time, the rise in the demand for imports will increase the supply of the country’s currency in the foreign exchange market (e.g SSSGD increases).

As a result, there will be a depreciation in the country’s currency. For countries that are heavily dependent on imports (e.g Singapore), a depreciation in the currency may eventually lead to / worsen cost-push inflation as imported factor inputs become relatively more expensive.

 

3) Worsening of Capital and Financial account

Cost-push inflation means higher production cost. Foreign investors may hence be less willing to invest in the domestic country, leading to a fall in inflow of new Foreign Direct Investments (FDIs) into the country. At the same time, existing foreign firms may also choose to relocate their production to other countries with lower cost of production, leading to an increase in outflow of FDIs.

Furthermore, an increase in inflation levels will also lead to capital flight as people prefer to put their money in countries where the monetary situation is more stable, resulting in short–term capital outflow. This will worsen the Capital and Financial Account (CFA) and hence the Balance of Payment of the country.

 

Evaluation (Making a Judgement)

Singapore is endowed with little natural resources of her own and with a small domestic market. Thus she is very highly dependent on imported factor inputs (e.g raw materials) for her domestic production processes. At the same time, she is also highly reliant on foreign markets as key destinations for her exports of finished products. In addition, Singapore is also very reliant on capital flows and FDIs. Since Singapore is such an open economy with high dependency on trade and FDIs, an increase in inflation levels is expected to cause more problems for her external sector than her domestic sector.

However, problems from the external sector will have spillover effects on the domestic sector as well. E.g. an increase in inflation levels will reduce the price competitiveness of Singapore’s exports, leading to a fall in the quantity demanded for exports. Since Singapore is an export–reliant country, a fall in the quantity demanded for exports will severely affect her AD. The fall in AD will lead to a fall in real national output by multiplied times, through the multiplier effect. This would trigger a fall in domestic production, employment and economic growth.

In general, an inflation rate of 2 – 3% on average would not cause much of a problem for the domestic or external sectors of the economy. In fact, mild demand–pull inflation may be favourable to economic growth since the excess demand and the prospects of higher returns may serve to stimulate investment and production in the economy.

Nonetheless, inflation is of great concern to Singapore and therefore the government has to be vigilant in keeping inflation rates in check.