Q6

(a) (b)

Explain what causes inflation [10] Discuss whether a low rate of inflation should be the economic priority of a government [15] GCE A Level Nov 01

Part (a) Introduction Define inflation State that inflation may be caused by increase in AD (DD-pull) or fall in AS (cost-push). Body 1. Explain DD-pull inflation Explain factors that may cause an increase in AD o Explain factors that may cause autonomous increase in C, I, G or (X-M) (at least 2 components) Eg. increase in C due to positive expectations (households expecting rise in income and wealth), increase in I due to fall in interest rate or business optimism. o Provide real-world example eg. positive outlook in China people getting more materialistic increase in C increase inflation rate Illustrate rightward shift of AD using AD/AS model. Explain why increase in AD leads to rise in general price level o When economy is in intermediate or classical range lack of spare capacity as resources are near or at full employment input prices and production costs rise due to higher demand and lack of capacity output cannot increase sufficiently to meet rise in demand hence price level increases 2. Explain Cost-push inflation Explain factors that may cause a fall in SRAS o Increase in costs of production (not caused by rise in demand) eg. oil price hike, trade unions demanding higher wages (in excess of productivity growth) o Supply shocks o Increase in structural rigidities eg. increase in minimum wage or price floor, increase in monopoly power of firms supplying key inputs eg. power supply, transport costs, rentals, etc. o Provide real-world example eg. restriction of foreign labour in Singapore leads to rise in wages increase in labour costs passed down to consumers increase in price level Illustrate upward shift of SRAS in AD/AS model Explain that the upward and leftward shift of SRAS leads to increase in price level and fall in real output Conclusion Inflation may be caused by demand-pull or cost-push factors. In the real world, these two types of factors may sometimes reinforce each other. Eg. demand pull inflation may cause trade unions to demand higher wages due to the higher cost of living. The wage increases may outstrip productivity growth, causing a rise in unit cost of production. This causes an upward shift of SRAS leading to cost-push inflation, and sometimes resulting

in a wage-price spiral. It is important to understand the causes of inflation as this would determine the type of policies that should be adopted to control the inflation. Part (b) Cambridge Examiners comment: many concentrated purely on the benefits of a low rate of inflation. In consequence, these answers did not address the point of the question, which is whether control of inflation (or some other macroeconomic policy objective) should be the government's main priority. It was thus intended that candidates should give a balanced and evaluative discussion about the major macroeconomic goals of a government. These were to be weighed against pursuing the control of inflation as the main priority. Introduction Explain that price stability is one of the macroeconomic aims of the government Low inflation means that prices are relatively stable and hence may stimulate investments and has a positive effect on the economy However, low inflation is not the only macroeconomic aim and has to be balanced with other macroeconomic objectives of the government Body 1. Thesis: Low inflation should be the economic priority Stable prices help businesses in planning and forecasting sales and output and indicate that the economy is growing at a healthy rate as cost increases are more stable, businesses may be more optimistic about future profitability stimulate investments Maintains purchasing power of households and hence standard of living welfare of low income earners and pensioners is preserved Encourages savings since real value of savings is preserved. Increased savings can be channeled into productive investments Low inflation helps a country maintain export competitiveness if a countrys inflation rate is lower than other countries, exports become relatively cheaper and imports more expensive than domestically produced goods (X-M) improves growth and employment Moreover, low inflation avoids the undesirable effects of high inflation: o Erosion of purchasing power causing people to work harder and experience greater stress o Uncertainties of cost increases and future profitability causing fall in investments o Distortion of price signals causing allocative inefficiency o Redistributive effects which worsen income and wealth disparities o Menu costs reduces wastage of resources due to constant changing of menu prices, price tags, etc. o Shoe leather costs reduces wastage of time and effort and other costs (eg. transport) due to more frequent transactions such as going to the bank, shops etc.

Hence it is necessary to maintain a low rate of inflation

2.

Anti-thesis: Low rate of inflation is not the only aim. Other macroeconomic objectives may be the priority: Explain importance of the other macro aims: (Refer to Chap 6) Low unemployment Unemployment represents inefficient use of the countrys scarce resources potential output is not achieved (producing at a point inside the PPF) welfare of the society is not maximized. Low unemployment therefore ensures that resources are fully utilised and social welfare is maximised Low unemployment is important in maintaining material and non-material standard of living. Unemployment means that some people are deprived of a job and means of earning an income can also cause emotional distress and lack of self-esteem hence reduces both material as well as non-material aspects of standard of living Low unemployment helps to promote social stability. Unemployment may cause social problems such as higher incidence of crime or social unrest Low unemployment helps to reduce strain on the government budget. High unemployment leads to higher spending on unemployment benefits, training and job matching services, etc. Also, loss of potential income tax revenue Hence the government also needs to ensure low unemployment as a priority Sustainable economic growth Sustainable economic growth is important to ensure improvement in standard of living As a countrys population grows, economic growth is essential to ensure that the standard of living of people is maintained or improved. Without economic growth, the national income per capita will fall as population increases, leading to a fall in standard of living Excessive growth beyond the countrys productive capacity is also undesirable as it leads to inflationary pressure. Hence, economic growth should be sustained at the long term growth rate of the countrys productive capacity so that the peoples welfare will continue to improve and not deteriorate. Hence the government also needs to adopt strategies to promote sustainable economic growth Healthy balance of payments A healthy balance of payments is important to ensure that the country is financially stable and not running into serious debt A persistent balance of payments deficit means that the country is drawing down its reserves (hence losing its wealth) or relying on international borrowing to finance its deficit, which could give rise to a severe foreign debt problem. A persistently high balance of payments surplus could lead to excessive growth in aggregate demand (eg. due to increase in X or inflow of foreign investments) which may result in inflationary pressure. Hence the government needs to look into maintaining a healthy balance of payments

3.

Discuss possible conflicts of priorities:

Inflation vs unemployment / economic growth eg. To reduce demand inflation, the government may need to pursue contractionary AD policies such as increasing taxes or raising interest rate. Such contractionary policies may have an excessive impact on the economy and lead to higher unemployment and lower economic growth Inflation vs balance of payments eg. To control imported inflation, the government may use exchange rate appreciation to reduce import prices. However, this would also make exports less competitive and worsen the trade balance Inflation vs potential growth eg. To control inflation, increasing interest rate to reduce Investment would help to reduce AD and lower price level, but this would impact long term growth, as fall in Investment could result in slower future growth Whether inflation should be the economic priority depends on the prevailing conditions in the economy. If the country is experiencing high demand-pull inflation at full employment level, then lowering the inflation rate could be a key priority as there is little conflict with unemployment and economic growth. However, if the inflation is cost-push in nature, attempts to control inflation by reducing AD would cause further decline in real output and employment, thereby causing or worsening a recession. If the country is experiencing a severe recession with high unemployment, maintaining low inflation could become less important (priority should be given to economic growth and reducing unemployment). (Eg. in the recent global economic crisis, many governments resorted to loosely increasing money supply through quantitative easing despite the potential risk of inflation arising from excessive growth in money supply.) Prolonged high unemployment may be seen to have more serious impact on peoples well-being, as it could lead to social problems such as higher incidence of crime, suicides, depression, riots, etc. and having a job may be considered a basic need for an adult in society.

4.

Conclusion and Evaluation: Low inflation rate is important in stimulating investments and maintaining healthy growth in the economy, as well as avoiding the undesirable effects of high inflation. However, other economic objectives need to be considered as well. The government will need to balance the different macroeconomic objectives taking into account the prevailing conditions in the economy. Moreover, policies taken to address one economic objective such as inflation may sometimes conflict with other macroeconomic aims such as unemployment. Hence, the government should take into consideration the impact on various macroeconomic objectives in the light of the existing economic situation when deciding on policies to address any economic priority.