JC Econs Essay AD & AS Management Policies and Inflationary Pressure Model Answers
One of the main concerns for the Singapore government is to achieve low inflation, along with a high and sustained growth rate. As clearly stated in the mission statement of Singapore’s de-facto central bank, Monetary Authority of Singapore (MAS)’s mission is “to promote sustained and non-inflationary economic growth…’.
What is aggregate demand policy?
Aggregate demand (AD) is a macro economic concept representing the total demand for goods and services in an economy, including household expenditure (C), investment expenditure (I), government expenditure (G) and net exports (X-M).
AD = C + I + G + (X-M)
Fiscal policy affects aggregate demand through changes in government spending and taxation.
Question
Critically analyse why when experiencing high inflation, the government of an economy might prefer the adoption of aggregate supply side management policies over the use of aggregate demand side management policies. [25]
JC Economics – Demand Side Management Policies
Introduction:
Both the use of aggregate supply (AS) and the use of AD management policies can dampen inflationary pressures. Both have their own benefits and limitations hence their effectiveness is likely to depend on different contexts in different countries. Generally, a government might prefer the use of AS management policies if the cause of the high inflation is largely cost-push in nature while a government might prefer the use of AD management policies if the cause of the high inflation is largely demand-pull in nature. Nonetheless, it is always advisable for a government to use a complementary mix of AD and AS management policies concurrently to dampen inflationary pressure so as to increase overall effectiveness in dampening inflationary pressure.
Body:
Explain the causes of high inflation: an inordinate increase in general price level (GPL) is likely to occur due to high demand-pull inflation , given significant increases in AD when the economy is at full employment, and/or due to high cost-push inflation as a result of significant increases in costs of production. Significant increases in AD is likely to occur due to significant increases in C, 1, G and/or (X-M). For example, when foreign countries that buy the domestic country’s exports enjoy an increase in real national income, the demand for the domestic country’s exports is likely to increase significantly assuming the exports are normal goods with high positive income elasticity of demand. When the domestic economy is at full employment, resources are very scarce meaning that firms cannot increase production to meet the increase in demand for goods and services. Prices are likely to be bidded upward significantly resulting in high demand-pull inflation.
Significant increases in costs of production are likely to occur, for example, via higher prices in imported raw materials especially for countries like Singapore that lack domestic resources and hence would have to depend on imported resources for production i.e. domestically produced goods have high imported contents. Therefore, when there is a significant fall in supply of these resources in foreign countries that the domestic country imports raw material from, perhaps due to natural disasters that destroy factors of production in the foreign countries, and given that the demand for these resources is price inelastic, the domestic country is likely to pay significantly higher prices to import these resources assuming exchange rates remain unchanged. Domestic firms’ costs of production are likely to increase significantly and hence the significantly higher costs are likely to be passed on to consumers in terms of significantly higher prices leading to high cost-push inflation.
Reasons why the government of a country might prefer the use of AS management policies to dampen inflationary pressure.
A government can, for example, use market-oriented pro-competition AS management policy via deregulation to lower barriers to entry to create more contestable markets. An increase in contestability would suggest more firms entering the markets thus more firms selling differentiated goods resulting in more close substitutes available making the demand for the goods relatively more price elastic. Since decreases in prices are likely to result in more than proportionate increases in quantity demanded for the goods, firms are likely to increase production to lower prices. This can be illustrated by the shift of short run aggregate supply (SRAS) curve from SRASO to SRAS1 in Diagram 1.
(Sketch diagram on your own, as an exercise.)
In the case of Singapore, the deregulation of its telecommunication industry moved the industry from a traditionally monopolistic market structure to a more competitive market structure (e.g. besides Singtel, M1 and StarHub joined the industry) with formulated policy guidelines for the establishment of fair interconnection charging principles to ensure competitive rates.
A government can also use, for example, interventionist AS management policy via regulation to increase the productive capacity of its economy. In Singapore’s case, the Retirement and Re-employment Act aims to loosen Singapore’s tight labour market by increasing its quantity of labour resources via requirements for firms to offer re employment to eligible employers who turn 62 (retirement age) up to the age of 65. Increases in the quantity of labour are likely to increase the maximum output the economy can produce leading to a higher full employment level of output illustrated from YFO to YF1 in Diagram 1 i.e. the economy’s productive capacity and its long run aggregate supply increases illustrated from LRASO to LRAS1. At the same time, the increased supply of labour helps to reduce labour costs, thereby increasing SRAS as well.
Overall increases in AS are likely to result in a downward pressure on general price level illustrated from PO to P1 hence inflationary pressure is likely to dampen. Unlike the use of contractionary AD management policies, the use of AS management policies to dampen inflation is more likely to promote economic growth via an increase in potential growth (i.e. YFO to YF1) and actual growth (i.e. YFO to Y1) with higher employment due to higher production as the demand for labour is a derived demand. Current and future material living standards are therefore also likely to be higher. Moreover, the use of AS management policies would be more appropriate for cost-push inflation as the policies would tackle the root cause directly and would thus be more effective compared to AD-management policies.
Explain why the government of a country might not prefer the use of AS management policies to dampen inflationary pressure.
However, the use of AS management policies in dampening inflation faces limitations thus the government may not prefer the use of AS management policies to dampen inflationary pressure. If the high inflation is caused by demand-pull inflation illustrated from AD2 to AD3 resulting in a purely inflationary effect illustrated from P2 to P3 as a result of the economy operating at full employment illustrated at YF2, the use of short run AS management policies to decrease costs of production illustrated from SRAS2 to SRAS3 are not likely to dampen the inflationary pressure in the short run i.e. general price level remains high at P3.
(Diagram 2)
Also, the effects of increasing productive capacity arising from the use of AS policies are likely to happen only in the long run due to time lags. For example, it takes time for workers of retirement age to change their thinking regarding work continuation after retirement age and it also takes time for employers to make necessary adjustments to workplaces to better suit the re-employment of older workers. Even if the demand-pull inflation is dampened in the long run due to an increase in LRAS, structural unemployment is likely to arise if the AS policies used to increase the economy’s productive capacity result in changes in the structure of the economy. For example, if the government provides subsidies to incentivise firms to adopt advanced technologies to improve productivity, lower skilled labours are likely to get retrenched and due to mismatch of skills and job requirements, they are not likely to gain employment in the new and growing industries despite actively looking for work.
In addition, whether the quantity of Singapore’s labour resources can be increased successfully via the Re-employment Act would depend on whether eligible workers of retirement age are willing to continue to work. Plus, with more contestable markets, each firm is likely to earn a lower profit thus restricting their ability to engage in R&D to enjoy dynamic efficiency and/or to introduce better quality products. The economy is likely to lose opportunities to gain export quality. competitiveness and thus lose opportunities to earn higher export. revenue and to improve its balance of trade and balance of payments.
Explain why the government of a country might prefer the use of AD management policies to dampen inflationary pressure.
If the high general price level is as a result of demand-pull inflation, the government might prefer the use of contractionary AD management policies to dampen the inflationary pressure because of the ineffectiveness and possible. trade-offs arising from the use of AS management policies in dampening demand-pull inflation. A government can use contractionary exchange rate, monetary and contractionary fiscal policies to reduce AD via reduction in C, 1, G and/or (X-M) illustrated from AD2 to AD4 in Diagram 2 to dampen demand-pull inflationary pressure illustrated from P2 to P4 given SRAS2.
At the initial general price level P2, AS is in excess of AD resulting in surpluses in the markets and hence an unplanned fall in stock. Firms are likely to reduce production illustrated by the fall in real output from YF2 to Y4 and general price level is likely to decrease given that firms are likely to reduce prices to clear their excess stock. Moreover, the strengthening of the country’s domestic currency as a contractionary AD management policy is likely to have supply side effects via reducing firms cost of production illustrated from SRAS2 to SRAS3 by making the imports of raw materials for the domestic economy cheaper in terms of the stronger domestic currency.
Note that firms are likely to pass the lower costs in terms of lower prices to consumers. Overall, general price level is therefore likely to fall illustrated from P2 to PS and hence, inflationary pressure is likely to be further dampened. For a country that is heavily dependent on imports of raw material for production (i.e. cost of imported raw materials takes up a large proportion of production costs) due the lack of domestic resource substitutes (e.g. Singapore), the decrease in costs of production is likely to be significant resulting in significant increases in SRAS if the increase in SRAS is larger than the fall in AD due to the strengthening of the domestic currency, the country is likely to have no or a small decrease in real output but a significant fall in general price level. This might explain why countries with such import dependent economies might prefer the use of AD management policies via gradual appreciation of their domestic currencies especially when faced with threats of high inflationary pressure due to demand-pull and/or imported cost-push inflation.
Explain why the government of a country might not prefer the use of AD management policies to dampen inflationary pressure.
However, for economies that are largely resource self sufficient, the increase in AS is likely to be insignificant and hence is likely to be smaller than the fall in AD resulting in a likely fall in real output and hence a lower level of actual growth which is likely to lower availability of goods for consumption. Therefore, the use of AD policies to dampen demand-pull inflationary pressure is likely to result in lower material living standards. Moreover, with the fall in derived demand for factors of production due to the fall in production, the economies are likely to face increases in demand-deficient unemployment and thus are likely to lead to higher social stress level resulting in lower non-material living standards. Also, since the fall in AD is likely to decrease real output more than proportionately via the reverse damped multiplier effect, where falls in expenditures would generate falls in incomes and the falls in incomes would generate further falls in expenditures, countries with large multiplier sizes are likely to suffer larger trade-offs in terms of actual growth, employment and material living standards, and hence might not prefer the use of contractionary AD management policies to dampen demand-pull inflationary pressure.
In addition, the government of a country might not prefer the use of contractionary AD management policies to dampen inflationary pressure especially if the inflationary pressure is due to cost-push inflation e.g. due to structural rigidities such as strong trade union forcing firms to pay higher than market clearing wages resulting in significantly higher costs of production especially labour intensive industries. The use of contractionary AD management policies in such an economy is likely to lower the already falling level of actual growth, employment and material living standards. Even the domestic currency is strengthened to tackle inflationary pressure due to imported inflation. the strengthening of the domestic currency is likely to face trade-offs in terms of the effects of falling AD thus contractionary AD management policies although necessary might not be sufficient on its own to deal with high inflation.
Explain why the government of a country might not prefer the use of contractionary exchange rate policy to dampen inflationary press pressure.
A government might not prefer the use of contractionary exchange rate policy via allowing for the domestic currency to appreciate or via a revaluation of the domestic currency to reduce general price level because doing so is likely to cause external instability especially for countries like Singapore that are dependent on export for growth, dependent on imports for raw materials for production and with foreign direct investments (FDI) taking a large proportion of their total investment. With an increase in the external value of the domestic currency, exports are relatively dearer in terms of foreign currencies and imports are relatively cheaper in terms of domestic currency as a dollar of domestic currency can now be exchanged for a larger amount of foreign currencies.
Therefore, the demand for export is likely to fall while the quantity demanded for import is likely to less more than proportionately given the demand for imports is price inelastic perhaps due to the lack of domestic resource substitutes resulting from a lack of natural resources. Both export revenue (X) and import expenditure (M) are likely to decrease but if PEDx > 1 due to the large availability of close substitutes, Marshal-Lerner Condition (or aka MLC) given by PEDx + PED| >1 holds resulting in a worsening of the country’s balance of trade (or net export revenue) and thus worsening its current account. In addition, there might be lesser inflow of FDI because of higher costs of investment as a dollar of foreign currencies can now be exchanged for a lesser amount of domestic currency thus increasing the costs of FDI denoted in the domestic currency. The worsening of the capital-financial account coupled with the worsening of the current account would suggest the worsening of the BOP resulting in external instability.
Explain why the government of a country might not prefer the use of contractionary monetary and fiscal policies to dampen inflationary pressure.
A government might not prefer the use of contractionary monetary policy via reducing money supply to increase interest rates and/or to reduce liquidity, and might not prefer the use of contractionary fiscal policy via increasing taxes and/or reducing government spending (G) to reduce general price level because doing so is likely to cause external instability, lower living standards and in the worst case scenario, the economy may enter a state of stagflation. Increasing interest rates are also likely to increase firms’ cost of borrowing, and increasing corporate income taxes and/or decreasing subsidies to firms are likely to reduce firms’ post-tax profitability. As profit maximisers, domestic firms are likely to decrease domestic investment and foreign firms are likely to reduce FDI, for example, by cutting down funding for R&D and reducing productive assets accumulation. Overall, investment expenditure (1) is likely to fall and the economy’s capital-financial account is likely to worsen due to the fall in FDI.
Over time, the fall in domestic investment and FDI are likely to reduce. the economy’s productivity meaning that the same amount of inputs can now produce relatively lesser amount of output. Therefore, the maximum output the economy can produce is likely to fall leading to at lower full employment level of output illustrated from YFO to YF1 in Diagram 1(self sketched) i.e. the economy’s productive capacity and thus its long run aggregate supply falls illustrated from LRASO to LRAS1. The government of a country might not prefer the use of contractionary monetary policies to dampen inflationary pressure especially if the country has an interest inelastic marginal efficiency of investment (MEI). This is because an increase in the interest rates is likely to result in a less than proportionate decrease in investment and hence an insignificant fall in AD especially if investment expenditure takes up a relatively insignificant proportion of the country’s national income. Therefore, the effect on dampening inflation would not be significant.
The government of a country might also not prefer the use of contractionary monetary policies to dampen inflationary pressure especially if FDI takes up a large proportion of its BOP because a lesser inflow of FDI or an outflow out FDI would worsen the economy’s BOP significantly. Also, since a lower productivity also suggests that the costs of production are now spread across a relatively smaller output level, firms’ costs of production are likely to increase resulting in a fall in the economy’s short run aggregate supply illustrated from SRAS1 to SRASO and thus leading to a lower production illustrated from Y1 to YO (i.e. future material living standards are likely to fall). Given the decrease in the economy’s aggregate supply and assuming that the fall in AS is larger than the fall in AD, supply bottlenecks are likely to re-appear leading to an increase in general price level illustrated from P1 to PO. Coupled with the fall in production mentioned earlier, the economy is likely to enter a stagflation.
In addition, if the government’s fiscal policy focuses on the reduction in government expenditure, for example, by reducing spending on healthcare, education and infrastructure development, future non material living standards are also likely to decrease, for example, due to a less conducive living environment as the government cuts spending on renovating common facilities. The government of a country might not prefer the use of contractionary fiscal policies to dampen inflationary pressure especially the country is facing high level of unequal income distribution and low living standards. The use of contractionary fiscal policy in such cases is likely to involve high political costs.
In conclusion, both the use of AD and AS management policies to dampen inflationary pressure are likely to result in trade-offs and are subjected to limitations that limit their effectiveness in dampening inflationary pressure given the different contexts of different economies. Generally, it can be argued that the trade-offs and limitations when using AS management policies to dampen cost-push inflation would be less extensive and are less severe in magnitude at least in the long run as compared to using AD management policies. Thus, AS management policies are likely to be more appropriate when dampening cost-push inflation. Similarly, the trade-offs and limitations when using AD management policies to dampen demand-pull inflation would be less extensive and are less severe in magnitude as compared to using AS management policies. Thus, AD management policies are likely to be more appropriate when dampening demand-pull inflation.
Nonetheless, it is always advisable for a government to use a complementary mix of AD and AS management policies concurrently to achieve its macroeconomic objectives given that each policy has its own limitations and possible trade-offs.
Mark Scheme:
L3: For an answer that shows: Excellent depth in analysis; accurate and precise use of economic concepts and analysis in all explanations. Excellent breadth in analysis, briefly explain the causes of inflation
2-sided explanations. Explain why a government might and/or might not prefer the use of AD management policies to dampen inflationary pressure. AD policy as a whole is considered with excellent depth in analysis. At least 2 of the 3 AD policies, namely exchange rate and/or monetary and/or fiscal policies are considered with excellent depth in analysis.
Explain why a government might and might not prefer the use AS management policies to dampen inflationary: pressure with excellent depth in analysis. Market oriented and/or interventionist policies are considered with excellent depth in analysis.
L2: For an answer that shows: Good depth in analysis, accurate use of economic concepts and analysis in most explanations. Use of economic concepts and analysis may not be precise. Good breadth in analysis. Briefly explain the causes of inflation.
2-sided explanations. Explain why a government might and/or might not prefer the use of AD management policies to dampen inflationary pressure. AD policy as a whole is considered with good depth in analysis. At least 1 of the 3 AD policies, namely exchange rate or monetary or fiscal policies is considered with good depth in analysis.
L1: For an answer that Is largely irrelevant e.g. explanation of the use of AD and/or AS management policies to achieve other macroeconomic goals (i.e. economic growth, healthy balance of payments and low unemployment, etc) but did not tackle the problem of high inflation. Contains fundamental conceptual errors in analysis.
E2: For a well-reasoned criteria-based judgement that answers the question why AS management policies might or might not be preferred to AD management policies to dampen inflationary pressure.
E1:
For an unexplained criteria-based judgement that answers the question why AS management policies might or might not be preferred to AD management policies to dampen inflationary pressure.
Econs Tuition teacher’s Remarks:
1. Most students should expect at least 19 out of 25m for this simple essay question. More on this in our Econs revision lessons.)
2. Instead of comparing the use of AD and AS policies in decreasing general price level using the some basis of comparison, a significantly large majority of candidates simply explained how AD and AS work and their limitations. As a result, even if their answers attempt to compare between AD & AS policies, the comparisons are largely invalid and/or weak due to the use of different basis of comparison. Out of those who successfully compared the use of AD and AS policies in decreasing general price level, only a few candidates offered accurate and precise explanations as to why AD policies might be preferred over AS policies. The remaining candidates were satisfied with just offering explanations of why AS policies might be preferred over AD policies.
3. A significant majority suggested that AD policies would be preferred when the inflation was demand pull in nature and AS policies would be preferred when the inflation was cost push in nature. However, they went on to explain the working and limitations of AD policies in reducing demand pull inflation and those of AS policies in reducing cost push inflation without offering any explanation as to why AD policies might be preferred when faced with demand pull inflation and/or why AS policies might be preferred when faced with cost push inflation. A mistake made by a handful of candidates was to compare between expansionary AD and AS policies to arrive at the conclusion that AS policies would be preferred because the use of AS policies would decrease general price level while the use of expansionary AD policies would increase general price level. To reduce inflationary pressure, a government would adopt contractionary instead of expansionary AD policies. These candidates and a handful of other candidates also arrived at invalid explanations, for example, AS policies might be preferred over fiscal policies if the governments were running budget deficits thus were unable to fund the policies or that crowding out of private investments might occur when governments turn to borrow funds from the private sectors etc. Contractionary fiscal policies via increasing taxes and government expenditure would improve rather than worsen government fiscal budget positions. There were also a large handful of candidates who compared among different AD policies instead of comparing between AD and AS policies.
4. Many candidates wrongly suggested that AD policies cannot be used to reduce cost push inflation thus AS policies are preferred over AD policies when inflation is cost push in nature, and AS policies cannot be used to reduce demand pull inflation thus AD policies are preferred over AS policies when inflation is demand pull in nature. Candidates are to note that appreciation of exchange rate can be used by import reliant countries to reduce imported cost push inflation and the use of AS policies to increase economies’ productive capacities can reduce supply bottlenecks. and thus can be used to dampen demand pull the inflation.
5. Many H2 Econs students offered no explanations as to how a decrease in AD and/or on increase in AS would lead to a fall in general price level. These candidates were satisfied by simply using graphical illustrations to replace the required economic analysis e.g. by simply stating that the leftward shift in AD and the rightward shift in AS would lead to a fall in general price level as shown in their diagrams. Similarly, a significant majority of candidates who suggested that a fall in AD within the Keynesian range of the AS curve would not result in a reduction in general price level (i.e. a purely graphical approach) did not offer any economic explanations as to why there might be high inflation when an economy is in the Keynesian range. Surprisingly, a significant majority of candidates did not suggest or provide explanations of the causes of inflation. Also, a handful of candidates went into explaining the effects of high inflation as reasons to why governments might want to use AD and/or AS policies to reduce general price level. The latter was not required by the question.
6. Many adopted descriptive approaches toward the explanations of AS policies e.g. provided descriptions of AS policies followed by simply stating that AS would increase without offering any economic explanations as to how the policies would cause AS to increase. For those who did, a small minority adopted purely theoretical analysis, forgoing opportunities to exemplify with real world examples. Most completed their explanations of AS policies before proceeding to provide explanations of AD policies. The minority of candidates who attempted to complete their explanations of AD policies before proceeding to provide explanations of AS policies found themselves unable to finish writing their answers due to the attempts to explain all examples of AD policies and their limitations e.g. different examples of monetary policy, fiscal policy and exchange rate policy. As a result, their answers were usually one sided or looped sided.
8. Many stated that AD policies were preferred because the effects were immediate and that AS policies were not preferred because of time lags problem. Candidates are to note that no policies would have immediate effects as all policies would face time lags issue. Even if a relative approach was to compare the severity of time lags between AD and AS policies, the comparison is weak as both AD and AS policies faced similar time lags problem. Similarly, comparison based on willingness of economic agents to react to the policies was at best considered as an attempt at comparison if it was accurately and sufficiently explained.
9. If instead of NOT explain causes of inflation in front, what else can you explain? (Actually, causes not the best content explanation)