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Inflation
Sustained, inordinate, general increase in GPL over a period…
Inflation
- Sustained, inordinate, general increase in GPL over a period of time
TYPES
Cost-Push Inflation
- Due to increase in COP not associated with excess DD (usually cost of raw material and wages)
- If COP rise, SRAS decreases (ie shift up) bc firms pass on some of the costs to pdrs (Px rise) and reduce o/p
External Causes
- Higher Px of imported raw materials i.e. imported inflation
- Prevalent in ctys where final G&S have high M content; e.g. crude oil, coal
- Note: Refined crude oil is impt factor i/p in almost all industries
- e.g. adverse weather in China/Msia, affects agri. commodities and increase Px
- e.g. Crude oil price hike bc of SS disruptions in Mid. East
Internal Causes
- Tight lbr mkt, DD>SS, wages rise; wage-push inflation maybe due to action of powerful trade unions that negotiate for exc. wage increases or e.g. foreign wkr levy
- EV: consider tax rebates/cash grants to companies based on a % of their revenue to increase AS (decrease COP)
Note
- Possible wage-price spiral:
- as Px increase, unions will demand for further increase in wage to maintain PP
- force firms to have to pass higher wages onto conrs
- Prices and Wages will "chase" each other
DD-Pull Inflation
- Due to strong AD
Explanation (essay 2006)
- Explain how each comp. of AD may increase (C bc of Yd, I bc of sentiments, or both bc of EMP, X bc of foreigners increase Y)
- Assume initially at curved regn of AS (AD0):
- At AD0, capacity constraints bc most resources are Ned, likely shortage of skilled lbr
- As increase to AD1: sharp increase in Px but marginal increase in op to Yf, firms have to bid up prices of scarce resources or increase wages to draw wkrs away from existing jobs
- Rise in wages leads to increase in AD, blabla and AD continues to rise
- If sustained rise until AD2: Px will increase w/ no corresponding increase in N
- Bc all FOPs employed
Internal Causes
- Strong C, e.g. in hsg or priv transport (cars)
- May also be due to increase in Yd
External Causes
- Foreigners DD for SG X very strong
CONSEQUENCES
Internal
Redistribution of Y
Fixed Y earners like pensioners, wage earners, salaried wkrs:
- Be able to purchase fewer G&S (Real Y falls)
- If anticipated, wkrs will try to protect themselves thru unions that negotiate COL clauses in their contracts so Y rise when inflation
Businessmen/Variable Y earners (Entrepreneurs)
- DD- pull inflation: they will gain as while pdt Px increases, pdtn costs lag behind
- bc WRIP are fixed by agreements, takes time to revise
- Raise Px faster than increase in COP, increases profit
- Cost-push inflation: Profits squeezed; no excess DD but COP increase; diff to pass higher cost to conrs
Debtors/Creditors
- Redistributes Y as inflation benefits debtors at the expense of creditors
- If anticipated, creditors will increase nominal ir to maintain real ir (real = nominal - inflation)
- Savers also lose out as PP of savings decreases
O/p and Employment
- DD pull: Profits tend to rise as COP lags behind; given strong DD and higher returns, pdtn likely to increase (hence N)
- Cost push: Firms may try to reduce costs by economising their use of lbr; leads to unN; may also try to reduce pdtn
Investment and EG
- DD pull stimulates increased business activity and I (e.g. expand factory/equipment to meet strong DD), leads to EG
- But can also result in uncertainty among business community if inflation is high and unanticipated, as potential investors are uncertain abt future costs
- Reluctant to take risks and I, may reduce EG in LR
Resource Allocation
- Causes allocative inefficiency bc when all Px are rising, pdrs cnot distinguish betwn rise in Px due to increased DD or due to inflation
- Firms might increase o/p thinking society has strong DD for the gd, causes too many resources to be allocated to pdtn of a gd that society does not desire
Others
- Menu costs: Firms have to change Px more frequently; reprinting menus or posters
- Shoe-leather costs: Anticipated inflation leads to higher nom. i/r, induces people to put money in bank, increases occurrences of visiting bank
External
Impact on external value of cty currency
- Internal value = PP, external value = X change rate
- Inflation = US buy less SG good, SG buy more US good
- Decrease DD and Increase SS of SGD
- SGD depreciates
Impact on BOT
- BOT = diff betwn value of X of G and value of M of G
(PxQx-PmQm)
- A has persistently higher rate of inflation than trading partners; X of A becomes relatively more ex, M of A becomes relatively cheaper
- Assuming PEDx > 1, leads to decrease in X revenue of A, while increase in DD for M from trading partner cause increase in M (PEDm doesn't matter bc increase DD for M immediately leads to increase M)
- Fall in X, Rise in M, worsens A's BOT
- If deficit persists, A needs to borrow to finance its spending
Attracting FDI
- Stable prices attract FDI
EVALUATION
Characteristics of an economy
- Small dom. open economy, X is the main engine of growth and highly reliant on M
- Makes external effects more significant; as X-M makes up high % of GDP
BOT doesn't deteriorate (PEDx)
- For oil; PEDx <1 in SG as we are world's third largest exporter of refined oil
- Hence, X rev does not decrease
- However in MLC, PEDx > 1 as many of our X have substitutes (for high end mfg good e.g. semiconductors)
Severity and anticipation of inflation
- Mild inflation may create environ. for EG (DD pull)
- Very severe reduces I confidence
- Very severe rec. also eliminates Xchange rate policy as a sustained policy bc cannot appreciate SGD forever as it affects X comp.
Addressing the Root Cause
- If qn states cost-push inflation is due to wage pressure
- Policies like Xchange rate that decrease Px of FOP will tackle inflation but not address root cause (union)
Trends in Population
- SG ageing population and falling BR; leads to shrinking lbr force
- SS side policies may tackle this root cause better than Xchange; SS side increases pdtivity to tackle shrinking lbr force
Policies to Tackle
Exchange Rate Policy for external sources of inflation:
- Best policy to manage infl. when it stems from higher px of Med i/ps (external) or when strong foreign DD for our X
How it works to reduce inflation
- Grad. appn stance relative to basket of currencies of SG's trading partners
Cost push
- M cheaper in SGD, helps keep COP for firms low
- Increase SRAS, reduce GPL
- Px of basic nec.s also made more affordable for HHs
DD pull
- X more expensive in FC, M cheaper in DM, since MLC holds in SG (PEDx>1)
- NX fall and dampens AD and reduce inflation\
EV
- SG small and open nature, heavily dep. on Ms of raw mat and finished gds; trade vol/GDP is almost 3: extremely susceptible to rising Px of food and oil; hence ERP will be more suitable
- Also more strategic than using MP bc (MEI curve, hot $$ flows)
Limitations
- Refer to ERP notes: go-to limitations
OR Diversify import sources
- Reduce exposure to high commodity prices from specific trading partners
EV
- this strategy is ineffective in the event of a global increase in Px of commodities, which is increasingly prevalent
SS side policy for cost-push inflation
- For both LRAS and SRAS
Note:
- These have no effect on external cost-push inflation!
Increase SRAS
- Price ceiling, wage ceiling, to restrict the increase in wages
- CIT rebates, to lower COP
- Increase SRAS, shift it down, reduce GPL
EV:
- Only effective in SR: after inflation passes, policies relax and unions bargain for higher wages again, causing CP inflation again
- Only temp. reduce COP, unlikely to be permanent by govt
- Costly for govt to fund, strain on G budget and divert resources from other areas
- Px controls suppress inflation but not eliminate; create shortages that lead to black mkt activities (that are counterpdtive)
Increase LRAS
- Encourage training and skills upgrading to increase pdtivity and qly of lbr force
- e.g. WTS: subsidised training costs, cash payouts for wkrs who complete training
- Encourage R&D, innovation to improve qty and qly of capital and tech
- e.g. PIC: tax deductions and cash payouts for pdtivity-related activities like spending on automation and R&D
- Leads to increase in Yf, increased pdtivity also means lower unit COP
- LRAS shift right, GPL decrease
EV
- SS side policies are costly
- Ineffective in SR as much time needed before results are felt
- Effects not guaranteed; depends on receptiveness of wkrs, suitability of course to their ed. level
DD-mgt policies for DD-pull inflation
1) Contractionary FP/MP
2) Macroprudential policies
Note:
- These have no effect on external DD-pull inflation
EV: FP
- Substantial time lag before FP effects are felt, effects may only result after inflation is over; which will be counterpdtive
- Not easy for govt to cut spending or abandon projects halfway
- -ve effects on cty's LT growth if reduce G on infra/edu
- Rise in tax disincentivises work and investment
EV: MP
- Small open econ (SG): open to capital flows, any change in i/r causes hot money flows that negate
- esp. in SG: Rely on Xchange rate policy to tackle inflation
Macroprudential Policies
- Measures that directly target spec. sectors to dampen AD
- e.g. if internal DD-pull infl. is largely due to rise in price of assets due to overheated property mkt
- Cooling measures used:
- By increasing min. down-payment
- Decrease in loan-to-value ratio to reduce avail. of credit
- To reduce speculative DD
- Supplemented by other measures like increase in SS of public hsg (to drive Px down)
EV
- Effects of cooling measures wear off over time; need continual reviewing to make then more relevant to changing econ. conditions (seen by SG; has had series of cooling measures for the past 6 yrs)
-
Inflation in SG
- CPI tracks changes in avg price of G&S consumed by a typical HH
- Hsg, transport and food are given higher weights as they take up higher propn of Y
- Hence usually increase in CPI is due to rising hsg rents, more ex priv transport and rising oil costs
- Increase in CPI is then indic. of inflationary pressures