JC Economics Demand-Pull & Cost-Push Inflation Essay Model Answers
Here a few sample questions on the goals of inflation, including Demand-Pull & Cost-Push factors for selected economies, as well the appropriate macroeconomic policies.
JC Economics Essay Outline – Factors of Inflation in Singapore
Question
(a) Explain the main sources of Inflation in Singapore. [10]
Prior to the global financial recession, Singapore was experiencing inflation which peaked at 6.6% in 2008. (Singapore’s average inflation was below 2% prior to 2008) Singapore faced two types of inflationary pressure, namely demand pull and cost push.
Factors causing DD-pull inflation:
• Strong external demand resulted from healthy economic growth in USA, EU and Japan, as well as in Asia. Higher income and increasing demand for intermediate electronic products boosted Singapore’s export earnings, driving up AD and hence the general price level;
Positive economic outlook with high growth rates (average more than 8% in prior 2008), attracted greater inflows of FDIs as well as increasing domestic investment, driving up AD and hence general price level; • Strong growth in the domestic construction industry, building of IRs, commercial and residential projects as well as government’s spending on infrastructure projects (e.g. MRT lines) pushed up AD; . Strong domestic household consumption due to good performance in the stock markets, as well as higher household income;
As a result of persistent increased in AD and moving towards full employment output, Singapore’s economy experienced high demand pull inflation.
Factors leading to cost push inflation
• Imported cost push: Rising cost of food (23.4% of CPI basket) due to supply shocks as a result of poor weather conditions and diversion of global food supply towards biofuel production; Rising oil prices in the past few years results in rising energy cost and transportation cost;
Domestic cost push > Rising wages as economy growth increased demand for labour, Given the small domestic labour cost, firms had to offer higher wages to attract workers; Rose in GST from 5% to 7% pushed up the general price level; Rising property rentals due to strong demand
An Improved Essay Response:
Singapore is a small and open economy with limited amount of natural resources and relies heavily on trade as a source of sustained economic growth. Singapore mainly imports raw materials and primary products, as well as consumer durables, while exporting high-end manufactured goods e.g. microchips, wafers, oil rigs and increasingly services as well. External demand contributes a significant proportion of Singapore’s aggregate demand and total trade is approximately 4 times of Singapore’s GDP. Domestic consumption also contributed closed to 40% of the GDP.
Inflation can be classified as demand pull or cost push based on the causes of inflation. Demand pull is caused by high aggregate demand and the constraints of aggregate supply. Cost push inflation is caused by the rising costs, leading to a shift in AS.
An excessive increase in the aggregate demand (AD) can be caused by an increase in any of its components, namely consumption, investment, government expenditures and net export. An excessive and continuous increase in one or a combination of the components will lead to an excessive and continuous increase in aggregate demand, which causes demand-pull inflation.
Over the past few years, Singapore enjoyed strong external demand for our exports due to strong economic growth in both developed and emerging economies. Couple with strong domestic demand (consumption) as a result of strong economic performance and consumers’ confidence. Government’s expenditure on the infrastructure was high during that period of time as the Government developed world class transportation system. Demand pull inflation was triggered off by strong increased in the AD as shown in diagram below.
Besides rising AD, inflation in Singapore can also be caused by an increase in the cost of production. This gives rise to cost-push inflation. Imported cost push inflation occurs when the prices of imports rise as a result of inflation in their country of origin. If these imported goods are intermediate goods, this will increase the cost of production and the importing price of the goods. Imported final goods will also be more expensive, which contributes to the overall increase in price level. Countries like Singapore are very susceptible to such inflation, as we have little resources and depend on materials for production and importing final goods. Similarly, when oll prices rises significantly, there is also spills over effect on the entire economy. This causes the cost of production to increase significantly. Singapore faced increasing wage pressure during the period 2006-2008 as the economy expanded and higher demand for workers push up the wages. As shown in diagram, when costs of production rises, the aggregate supply curve shifts from AS to AS¹ resulting in higher general price level. With increasing AD and rising AS, the general price level has risen from P1 to P2.
Summary of Inflation Sources:
JC Economics Essay Outline – Factors of Inflation in Other Economies
(a) Explain the main sources of Inflation in China / India. [10]
Causes of Inflation in China
There are a few key factors that will continue to drive China’s pace of inflation. The more obvious culprit is the Chinese government’s strict currency control that had artificially depreciated the foreign exchange rate of the Yuan. The cheaper Chinese currency was one of the contributing factors to a strong manufacturing and export business activity. But it also has its downside by making any imported food and energy resources more expensive.
China’s unprecedented rate of development has contributed to a strong demand pull inflation. Rampant consumerism coupled with a large growing population will continue to drive the increase in consumer demand. This consumer led demand in turn cause a corresponding increase in business activities and ultimately production cost.
There is also the expectation of future economic development and potential appreciation of the Chinese Yuan (also known as Ren Min Bi, RMB). This has led to huge inflows of both hot money and legitimate long term investments into the China economy. The side effects are pockets of assets bubbles forming in the China property market especially in the first tier cities like Shanghai and Beijing.
The recent wage increase has also put pressure on the cost push inflation in China. The main reasons for the wage increased are due to the shortage of semi skill work force, especially in the urban cities, as well as the government’s intention to allow wages of labour to increase to reduce the impacts of rising cost of living and reducing income disparity.
Causes of Inflation in India
As India grows prosperous, inflation starts spiralling. With breakneck growth, an outsourcing industry that leads the world and hundreds of millions of consumers demanding more class and comfort, India has an economy most countries would envy. After three years of near double-digit growth, India’s economy is showing signs of setting off an inflationary spiral. Food prices are climbing for just about everything from lentils to onions, squeezing the poor. Apartment rents and prices are rising steeply, especially in large cities. Factories that make the ubiquitous Indian motorcycles are running at full tilt and still have fallen weeks behind in meeting orders from dealers.
Demand for nearly everything from housing to beer is outpacing supply in part because white-collar salaries are rising faster in India than anywhere else in Asia, climbing 13.7 percent on average over the past year
(Source: The New York Times)
Hence, a typical question can be (especially Case Study Question):
To what extend the case suggested that the inflation in India is cost push. [6]
Cost push inflation is usually caused by an increased in the cost of production in the economy and can either be domestic cost push like wages and imported cost push. It is evidenced from the extract that India faced both internal wage push inflation due to rising white-collar salaries which average over 13% increased. India is a net importer of food, thus higher imported food prices highlighted in the case caused imported cost push inflation.
However, there was also demand pull inflation pressure in India. Higher demand for their outsourcing services (X) and consumer demand (C) has caused AD to rise. As India was facing capacity constraint, increasing AD put tremendous inflationary pressure on the economy.
As India still enjoy positive real economic growth, demand pull inflation is the dominating inflation in the economy as shown in the following diagram. (DRAW AD/AS)
JC Economics Essay – Consequences of Inflation
Discuss the impacts of increasing Inflation rates on the Singapore economy. (15)
As discussed in part a, the main sources of inflation in Singapore are demand pull and cost push. An increasing rate of inflation will increase cost of living, thus impacts on the household as it reduces their real purchasing power. Although their real income may have increased on average, the lower income group will be affected more severely as their nominal income increased may lag behind the high rate of inflation.
In general, as general price level increased, especially due to higher cost of production, Singapore’s export will lose its competitiveness in the export sectors. Our export will be more expensive as compared to our competitors in the international markets, if our inflation rates are higher than theirs, cp. If demand for our exports are price elastic, the export earnings will fall. This will worsen the balance of trade. Investors will lose confidence in the economy with the increasing rates of inflation. Short term capital will also flow out, resulted in a worsening capital account.
Falling investment and export revenue will reduce AD, and with falling output, unemployment will increase and national income will fall. Other countries at the same time may suffer from higher rates of inflation compared to Singapore. WE can see that most regional countries experienced closed to or double digits inflation rate from 2007-2008. Thus, Singapore’s exports may not lose its price competitiveness after all.
On the other hand, if the Inflation is predominantly demand pull, real national income will increase and the economy will be moving towards short term full employment. This was the case for Singapore from 2006-2007 as the economy faced increasing Inflation rates, it stilled registered real GDP growth average 8% from 2006-2007. As shown in the following diagram, with increasing AD (demand pull) and upwards shift of AS (cost push), Singapore experience high rates of inflation. However, with AD increased more than AS, real national Income Increased. Nevertheless, the government has to be very careful in managing the situation before the economy suffers from overheating.
In conclusion, increasing rates of inflation will post certain threats to the Singapore’s economy. The final impacts will be minimized if the government can adopt appropriate policies to filter off the inflationary pressures.
JC Economics Essay – Policies to Combat Inflation
Discuss how effective interest rates alone might be in controlling Inflation if the rate of inflation were to become unacceptably high. [15]
An unacceptable high rate of inflation brings about undesirable effects on the internal and external sector of an economy. There is thus a need for the government to implement appropriate measures to control such high inflation. One of them is through the use of money supply to increase interest rates. According to Monetarist, money supply influence price level directly and thus monetary policy is effective in solving inflation.
Internally, a higher interest rate would imply that the of borrowing is increased and at the same expected rate of returns, previously profitable investment projects will now appear less profitable. Hence investment falls. In addition, the higher interest rates would discourage consumption as consumers find their returns from savings increased. The opportunity cost of current consumption has increased. Hence consumers would rather save than spent. Hence consumption falls. Together with a fall in C and I, AD fall. When the economy is at full employment, a fall in AD results in a fall in general price level.
Externally, higher interest rates will lead to greater capital inflow and less capital outflow. This will lead to an increase in the demand for domestic currency and fall in supply of domestic currency. The external value of the domestic currency will appreciate. As a result of the appreciation, price of imports will fall in domestic currency and this helps to reduce inflation, especially if the country imports extensively consumer and capital goods. The fall in price of imported capital goods also lower the cost of production and leads to lower cost push inflation. As the price of imported consumer goods fall, consumers will also not be pressured to demand for higher wages. This help to keep the wage cost low and thus further help in reducing cost push inflation.
In addition, the higher exchange rate will cause the price of exports to rise in foreign currency. This will lead to a fall in quantity demanded of exports. Assuming elastic demand for exports, the value of exports will fall and thus the aggregate demand will fall. This will help to reduce demand-pull inflation assuming elastic demand for imports and exports. If demand for imports and exports is inelastic, a rise in exchange rate will improve the balance of trade and increase the aggregate demand, thus worsening demand-pull inflation.
The extent interest rate alone is effective in reducing inflation depends on the interest elasticity of consumption and investment. If consumption and investment are interest inelastic (possibly due to optimism as consumer and investors will continue to borrow despite the high interest rate), then higher interest rates alone may not be enough in controlling demand-pull inflation. However, despite the possibly weak interest rate effect, many central banks still resort to MP to influence i/r and price level as i/r rates can be easily and quickly changed to influence aggregate expenditure, thus reducing the problem of time lag.
Furthermore, it depends on whether the Marshall-Lerner condition holds true. Theoretically, the condition holds true only in the long run. The nature of the economy also determines whether interest rates alone is enough to reduce inflation. For countries such as Singapore who has no control over interest rates, interest rate fails completely as a policy to control inflation.
Monetary policy which raises i/r may also be unpopular as it raises the debt burden of home owners who borrow to purchase their houses and government’s national debt burden. Also, frequent changes in i/r may not be desirable for producers in making long term investment decisions. Thus, investment may be reduced and this will affect the productivity and long term growth of the country. Whether interest rates alone is effective in reducing inflation also depends on the root cause of the inflation. If the higher expenditure is due to higher G or lower T, then fiscal policy of reducing G and increasing T may be a better policy in reducing inflation. On the other hand, if the higher expenditure is due to easy availability of credit (e.g. lower restrictions on hire purchase), then a better form of monetary policy will be to control the availability of credit (qualitative MP) and not interest rates.
If inflation is due to high cost of production, then interest rates failed completely. If the cost of production is raised due to an increase in wages faster than labour productivity, then an appropriate solution will be to increase the labour productivity and not increase interest rates.
In a nutshell, the impact of interest rates on the general price level depends on the nature of the economy and the causes of inflation. Hence it is difficult to pinpoint whether interest rates alone is sufficient to control inflation. Given the difficulty in identifying the root cause of inflation, countries generally have to use a mixture of measures to bring inflation down before it escalate out of control.