(2016) 8819 H1 Econs Paper CSQ 1 Suggested Answers by Mr Eugene Toh (A Level Economics Tutor)
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a. Cost of living increased throughout early 2008 to February 2014.
Cost of living increased at an increasing rate from early 2008 to around July 2008 before increasing at a decreasing rate till around October 2009.
From October 2009 to around September 2011, cost of living, increased at an increasing rate.
From September 2011 to February 2014, cost of living increased at a decreasing rate.
b. With Figure 1, we can find the real incomes of UK citizens by taking the difference between the ‘regular pay’ growth and CPI inflation. If regular pay growth – CPI inflation is negative, this suggests that real incomes are falling. In most periods of the figure, there is a fall in real incomes, hence the purchasing power of UK citizens is falling, leading to a fall in the material standard of living. At the same time, tax revenues will fall due to the falling real incomes, hence the government has less financial resources to provide public amenities or goods such as healthcare. As a result, non-material standards of living will fall as well. An exception would be in early 2008 and October 2009 where regular pay growth exceeds CPI inflation, hence real incomes then were increasing, and the standard of living was higher since they would be able to purchase more goods and services.
ci. Overall inflation rate is measured by CPI inflation which measures a weighted basket
of goods & services. While food & energy prices rose more significantly (30% and
60%) - overall CPI only rose by 20% as food and energy would only account for a
portion of the items measured in CPI. Other items measured may not have increased
significantly.
cii. In absolute terms, the higher-income earners did worse as earnings did not keep pace with inflation, reducing their purchasing power. This is reflected in Extract 1 that the highest 10% were worse off by 9% while the lowest 10% was worse off by 2.4%.
This does not, however, take into consideration the difference in spending or saving
rates. Higher-income earners are likely to save more and spend less as a proportion of their incomes compared to lower-income earners. This will mean that lower income earners will be more affected by price increases of goods & services compared to the higher income earners in relative terms.
d. Persistent deflation creates expectations of a fall in future prices. This expectation causes consumers to hold back on spending in anticipation of a fall in prices. This causes C to fall. Simultaneously, investors' confidence will fall as persistent deflationary pressures can suggest structural issues within the economy, leading to a fall in I. A decrease in C and I causes AD to fall from AD0 to AD1 and RNY to fall from Y0 to Y1. The result is slower economic growth and higher unemployment. At the same time, GPL will fall from P0 to P1, leading to even more deflationary pressures and creating more expectations of falling future prices. The end result is a downward spiral of falling prices that hurts the growth prospects of the economy.
With deflation, real value of debts will increase, which causes owners of mortgaged
homes to pay more for their mortgages. This reduces the purchasing power of homeowners which then leads to a fall in material standard of living. Additionally, C will also fall due to falling household wealth, further exacerbating the problem of low C due to deflation.
e. The Eurozone was experiencing a period of deflationary pressures during the September 2014 period. To restore price stability and achieve low and stable inflation, the EU chose to conduct an expansionary monetary policy. By reducing interest rates, the cost of borrowing decreases. Households will consume more big-ticket items and firms will invest more. C and I increase, leading to an increase in AD from AD0 to AD1. GPL increases P0 to P1, counteracting the deflationary pressures the eurozone is currently facing.
There are two reasons why there are no interest rate cuts in Singapore. Firstly, Singapore does not embark on an interest-rate-focused monetary policy and instead uses an exchange policy to achieve price stability. Hence, Singapore is an interest rate taker and will follow the global rates. Secondly, Singapore did not face any deflation, unlike the eurozone, with all-items CPI rising by 1.2% year-on-year in July. Hence, there was not much need to embark on an expansionary demand-management policy.
f. The MAS core inflation is a measure of prices that excludes both the costs of accommodation and private road transport, which are considered to be influenced by government policies.
The Singapore government can implement wage subsidies as a supply-side policy to reduce the core rate of inflation. This reduces the cost of production hence shifting the SRAS curve rightwards. As seen from the figure, this leads to a fall in GPL from P0 to P1 hence allowing the Singapore government to reduce the core rate of inflation.
However, Singapore's economy is highly open and reliant on trade, with a significant portion of its inflation stemming from imported goods and services. Wage subsidies primarily target domestic labour costs and may not directly address the underlying factors driving imported inflation, such as global commodity or food prices. During the COVID-19 pandemic, disruptions in global supply chains, stemming from port closures, shipping delays, and production stoppages, have profoundly impacted Singapore, leading to shortages and escalated costs for imported goods, notably food and raw materials.
Consequently, the prices of essentials have surged, significantly contributing to core inflation. In this scenario, the primary drivers of inflation are the rising prices of main factor inputs such as raw materials. It is unlikely that wage subsidies will be sufficient to bring down the cost of production sufficiently for core inflation to see significant reductions. Thus, while wage subsidies offer relief to domestic labour costs, they may not directly address the underlying causes of imported inflation.
On top of that, such subsidies can incur significant costs for the government, leaving less financial resources for other expenditures such as healthcare and education.
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