Price Instability (Macroeconomic Issues & Policies)

Question 1

What is Inflation?

Answer 1

Inflation is the sustained increase in the general price level (GPL), of an economy, over a period of time, usually a year.

Question 2

What is General Price Level (GPL)?

Answer 2

General Price Level (GPL) is defined as the average price of goods and services in an economy.

Question 3

What is Deflation?

Answer 3

Deflation is the sustained decrease in the general price level (GPL) of an economy, over
a period of time, usually a year.

Question 4

What are the causes of inflation?

Answer 4

• Demand-pull inflation
• Cost-push inflation

Question 5

What is Demand-pull Inflation?

Answer 5

Demand-pull inflation is caused by persistent increases in aggregate demand when the economy is operating near or at the full employment level of national output.

Question 6

What is Cost-push inflation?

Answer 6

Cost-push inflation is caused by a sustained increase in the cost of production and hence a persistent fall in aggregate supply and thus increase in GPL

Question 7

What is Wage-push inflation?

Answer 7

Rise in wages not matched by increases in labour productivity can lead to wage-push inflation

Question 8

What is Tax inflation?

Answer 8

Changes in tax policies may cause cost-push inflation . Rise in indirect taxes, i.e. tax on goods and services leading to tax-push inflation

Question 9

What is Imported inflation?

Answer 9

Rise in the prices of imported factor inputs leading to imported inflation. Countries dependent on imported factor inputs may experience an increase in import prices as a result of inflation in other countries or currency depreciation of the domestic country. This heightens cost of production and causes a fall in SRAS.

Question 10

What is Wage-price Spiral?

Answer 10

The wage-price spiral is a macroeconomic theory used to explain the cause-and-effect relationship between rising wages and rising prices, or inflation.

Question 11

What is Anticipated-Inflation?

Answer 11

Anticipated-Inflation means that individuals are prepared for it; hence they adjust and account for the inflation that occurs.

Question 12

What is Unanticipated-Inflation?

Answer 12

Unanticipated-Inflation means that individuals are unprepared or wrongly prepared for it.

Question 13

What is the formula for Real rate of interest?

Answer 13

Real rate of interest = money rate of interest - inflation rate

Question 14

What are the demand-side reasons for deflation?

Answer 14

a) Cyclical price changes
b) Loss of confidence among customers and investors
c) Fiscal austerity
d) Credit crunch
e) The Paradox of Thrift

Question 15

What are the supply-side reasons for deflation? (SRAS)

Answer 15

a) Strong exchange rate
b) A fall in wage rate
c) Globalisation

Question 16

What are the supply-side reasons for deflation? (LRAS)

Answer 16

a) Improved productivity
b) Technological advances

Question 17

What are the effects of prolonged deflation on consumers?

Answer 17

With falling GPL, consumers delay their purchases in anticipation of further price cuts, causing GPL to fall further. This leads to a downward spiral of prices for consumers. Weak consumer sentiments continue to cause consumers to delay their consumption

Question 18

NOTE: all effects of deflation is on pg 23

Question 19

What is a Deflationary Trap?

Answer 19

A deflationary trap is a state of persistent deflation that can spiral downwards in the face of zero percent interest (nominal)

Question 20

What are the demand-side factors of inflation in the context of Singapore?

Answer 20

a) Rise in World Demand for Exports
b) Foreign Direct Investment

Question 21

What are the Supply-Side factors of inflation in the context of Singapore?

Answer 21

a) Imported Inflation [Key source of Inflation in Singapore]
b) Domestic changes in Cost of Production

Question 22

Note: the more IMPORT price inelastic, the greater the risk of imported inflation occurring in the country due to lack of substitutes found locally.

Question 23

Note: Consumption and Investment largely depend on PERMANENT EXPECTATION of FUTURE INCOME. Increase in taxes temporarily will not have the desired effects on consumption and investment. People may base their consumption decision based on their PERMANENT INCOME, NOT current disposable income.

Question 24

Note: Contractionary Fiscal Policy would be inappropriate to use to reduce demand-pull inflation if consumers and producers have a POSITIVE OUTLOOK OF THE ECONOMY

Question 25

What are the AD/AS factors of Contractionary Fiscal Policy?

Answer 25

i) Reduced Government spending
ii) Increased direct taxes

Question 26

What are the AD/AS factors of Contractionary Monetary Policy? (internal effects)

Answer 26

It involves the central bank INCREASING THE RATE OF INTEREST or REDUCING THE SUPPLY OF LOANABLE FUNDS. Higher interest rate -> higher cost of borrowing -> less borrowed for consumption and investment expenditure (C&I)

Question 27

What are the AD/AS factors of Contractionary Monetary Policy? (external effects)

Answer 27

The rise in interest rate will lead to inflow of hot money in search for higher returns -> leading to increase in demand of the currency in the forex market -> appreciation of exchange rate occurs. With a stronger exchanger rate, exports are more expensive in foreign currency terms -> leading to a fall in demand of our exports. Imports would be cheaper in local currency terms -> leading to a rise in quantity demanded of the imports -> leading to a fall in X and a rise in M. (X-M) would then fall.

Question 28

What is the adjustment process?

Answer 28

This creates a surplus of goods at initial GPL (P1), thus creating a downward spiral on price. Firms decrease production, where factors of production are no longer scarce. Decreased production results in less competition for scarce resources, REDUCING FACTOR PRICES. Firms would therefore be willing to sell additional units at a lower price (shown by a movement along the AS curve). Thus the economy re-equilibrates at lower GPL,P2.

Question 29

What is irrational exuberance syndrome?

Answer 29

Its is when during an economic boom, businesses and consumers have high confidence. They are willing to go into debt to finance consumption despite higher interest rates.

Question 30

Note: the more open the economy, the harder it is for Central Bank to control credit creation by commercial banks, since commercial banks may have alternative (foreign) sources of credit.

Question 31

What is GRAMA?

Answer 31

Gradual and Modest Appreciation

Question 31

How does price fall when Exchange Rate policy is implemented? (Demand-pull inflation)

Answer 31

With revaluation, the price of exports in terms of foreign currency will be more expensive. This leads to a fall in demand for exports. X falls.

The price of imports in terms of local currency will fall, leading to an increase in quantity demanded of imports. M rises.

The revaluation will lead to a fall in (X-M).

Question 32

Note: the MAS generally maintains an appreciating exchange rate to reduce inflation and promote price stability because this will also encourage economic growth

Question 33

How does price fall when Exchange rate policy is implemented? (Cost-push inflation)

Answer 33

With the price of imports in terms of local currency falling, this directly lowers the cost of imported factor inputs/FOP

Question 34

What is the aim of Supply-Side policy?

Answer 34

Supply side policy aims to combat inflation in order to achieve price stability in the economy, through productive growth and expansion of productive capacity.

Question 34

What is Deregulation?

Answer 34

Reduce market dominance and lower prices. Such policies encourage firms to use cost efficient production methods and thus reduce the cost of production

Question 35

What is Labour Market Reform?

Answer 35

Reduce power of trade unions to prevent excessive wage demands so as not to raise wage cost.

Question 35

What are the Market-Oriented Policies?

Answer 35

i) Deregulation
ii) Labour Market Reform
iii) Reduce Taxes

Question 36

What are the Interventionists policies?

Answer 36

i) Improving labour mobility
ii) Increase Productivity

Question 37

Note: Government expenditures on productivity growth is thus considered FISCAL POLICY with supply-side effect

Question 38

What is Short-run Supply-side policies?

Answer 38

Short-run supply-side policies are policies that are reducing the GPL in the short-run using controls on prices and income/wages

Question 39

What are the two types of Income policy?

Answer 39

i) Statutory- This occurs when the government passes legislation to limit or to freeze wages
ii) Voluntary- This occurs when the government tries through argument and persuasion to impose a wages policy

Question 40

What is Income Policy?

Answer 40

This is where the government takes measures to restrict the increase in wages (incomes).It tries to ensure that wages and other incomes do not rise faster than the increase in productivity in the economy

Question 41

What is Price Control?

Answer 41

This means fixing maximum prices or fixing the range of permissible prices.

Question 42

What are the two Short-run supply side policy?

Answer 42

i) Income Policy
ii) Price Control

Question 43

How does improving Labour Mobility result in reduced costs?

Answer 43

Relevant agencies can provide education and training to equip workers with relevant skills, so that labour can move from declining industries to rising industries, reducing the strain in the labour supply and thus reducing wage rates in the rising industries, thereby reducing firms’ cost of production

Question 44

How does the government encourage productive growth?

Answer 44

The government can provide training, subsidies for investments in capital goods, grants for R&D projects and for firms to invest in up-to-date equipment.

When Productivity increases, faster than wages increase, cost of production falls. As labour productivity increases, quality of labour resource improves and quantity of resources increase as more goods and services can be produced with the same amount of labour

Question 45

What are the unintended consequences of Income Policies?

Answer 45

Income Policies are only effective when they are in operation. Once they are relaxed, unions could bargain for higher wages to make up for the loss in the past, starting a new round of wage push inflation.

Question 46

What are the unintended consequences of Imposing Price Controls?

Answer 46

Imposing price controls may lead to black market activities.
Price ceiling -> shortages.
If the government does not practice rationing, people may engage in illegal activities and sell on the black market

Question 47

What are the unintended consequences of enforced savings policies?

Answer 47

Enforced savings polices may not work if people do not have enough money for day to day needs. Increased in savings may lead to decrease in interest rates, which may encourage more borrowing by people