“Inflation is harmful to an economy and hence it should be the priority of the Singapore government to reduce inflation.” Discuss.

Inflation has many adverse effects which is harmful to an economy. This includes adverse consequences on economic growth, employment, balance of payment and exchange rate.

  • Consequences of inflation which are harmful to economy:
  1. Investment: Domestic investment will fall if inflation is high and erratic or due to cost-push inflation. Moreover interest rate is high during inflation and this further discourages investment.
  • Savings: Savings tend to fall during inflation.  People are not willing and unable to save more during inflation as the real value of savings keep falling and prices keep rising. A fall in savings would mean less investment funds for capital formation.
  • Inflation causes a worsening of current  account as export revenue falls and import expenditure rise. Explain
  • Since demand for exports fall, this will lead to a fall in the demand for the Sin $ in the foreign exchange market. The increase in import expenditure also means that more Sin $ has to be supplied to exchange for foreign currencies in order to pay for the higher import expenditure

à currency depreciate à worsen imported inflation

v  Explain that mild demand-pull inflation may not be harmful to the economy. (Optional)

  • Explain that while inflation has many harmful effects, the government needs to weigh the importance of achieving the other macroeconomic goals in the current situation:

Hence it can be seen from the above that inflation is harmful to an economy. However whether it then becomes the priority of the Singapore government to reduce inflation depends on the current economic priority of the government. There are other goals that the government may seek to achieve such as economic growth, full employment and obtaining a healthy balance of payment.

Achieving economic growth can be important to the Singapore government

  • Growth in real output à people enjoy a higher level of income à C increasesà improve SOL
    • Government can collect greater tax revenue
    • If higher cost of living is mainly due to imported inflation, it is important for the government to ensure the continuous growth of the economy so that income increases to help people cope with the situation.

Achieving full employment is important as unemployment can lead to:

  • Waste of resources and a loss of potential output
    • Greater government expenditure as a result of higher welfare payouts
    • Reduction in tax revenue collected from income tax and consumption tax.
    • Individuals losing their sense of self-worth.
    • Social unrest and increase in social problems

Achieving a healthy balance of payment is important

  • Higher net exports and FDI à increase in AD à increase in NY via the multiplier process
    • Increase consumer and investors’ confidence
    • Employment increases
    • Currency appreciates
  • Possible conflicts arise from the achievement of low inflation and high growth rate If the aim of the Singapore government is to reduce inflation, it employs the exchange rate policy of a gradual appreciation of the SGD to control inflation. This leads to a fall in prices of imports in domestic currency and a rise in prices of exports in foreign currency. Assuming Marshall Lerner’s condition holds, net exports fall causing a fall in AD and a contractionary effect on the economy thus slowing growth. This will also cause a worsening of the BOP position for Singapore. Due to this conflict, the government needs to weigh its  priority carefully.

v  In deciding which is the priority of the government, one needs to consider the current economic conditions and the magnitude and root cause of the current problems.

If inflation rate is very high and there are many domestic factors that contribute to such a problem, perhaps it should be the priority of the Singapore government to deal with it. We have seen how high inflation has lead to social unrest in Egypt and Haiti in the past and certainly high inflation must be dealt with seriously. On the other hand, if the rate of growth has fallen significantly and unemployment is high such as in the case in 2009, it is important that the government gives priority to deal with such issues first.

v  Conclusion

Due to the trade-offs in achieving all the macroeconomic objectives simultaneously, the Singapore government has to consider the current economic conditions and the magnitude of the problems when deciding on whether reducing inflation should be the priority. Given  that growth is negative for the 2nd quarter of 2012 and that the world economy is still rather weak due to the Euro zone debt crisis and a weak US recovery, the Singapore government may be more concerned with the objectives of economic growth and unemployment currently. Nonetheless history has also shown that high inflation can very quickly dampen  growth and confidence in the country too. With the anticipation of further rise in global prices of oil and food in the coming months ahead, it is important for the Singapore government to also continue to adopt appropriate measures to ensure that inflation is kept at bay.

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