PRESBYTERIAN HIGH SCHOOL
ECONOMICS
DEMAND-PULL AND COST-PUSH INFLATION
Name: ____________________________(
)
Class: 4F Date: ______________
Answer the following questions on foolscap paper.
1. With the aid of an AD/AS diagram, evaluate the effectiveness of demandside policies to help make exports more competitive in a country that is
suffering from high inflation. [8m]
Key word: Evaluate – the question expects you to give your opinion on
whether demand-side policies are effective in making exports more
competitive given high inflation. This also means that you need to weigh the
pros and cons of using demand-side policies.
[2m – Complete diagram, with correct labelling and markings – the diagram is
supposed to show how the demand-side policy reduces inflation]
General Price
Level
AS1
E1
GPL1
E2
GPL2
AD1
AD2
GDP2 GDP1
Gross Domestic Product
Assume that the equilibrium price and quantity is at GPL1 and GPL1
respectively. At GPL1, the country is already experiencing high inflation,
which is a sustained and continuous increase in the general price levels of
goods and services in the country. [1m – definition of inflation].
This would also mean that exports, which are goods and services produced in
the local economy to sell to international economies [1m – definition of
exports] are affected by the high prices due to inflation.
By using demand-side policies such as a contractionary fiscal policy to reduce
aggregate demand, the original aggregate demand curve AD1 will shift
leftwards to AD2 [1m – describing what happens to the AD curve after
implementation of demand-side policies].
A contractionary fiscal policy is where the government increases tax rates to
deter consumers and firms from over spending to reduce inflation. For
instance, an increase in corporate tax will cause cost of production to increase
and firms will therefore have fewer funds to overspend. [1m – explaining how
the demand-side policy helps to reduce GPL] Therefore, aggregate demand
will fall when investment from firms decrease.
However, as seen in the diagram, while the general price level will fall from
GPL1 to GPL2, the Gross Domestic Product (GDP) of the economy also falls
from GDP1 to GDP2. This is an undesirable effect of using demand-side
policies as economic growth will be reduced. Moreover, increasing corporate
tax on firms will increase their cost of production, making the prices of exports
in the local economy to increase. [1m – explaining the downside of using
demand-side policies]
Therefore, I think that while the demand-side policies are able to help the
economy as a whole to achieve lower inflation, it is not effective (answer the
question) as there are negative effects on the firms producing export goods as
increase in taxation will ultimately cause firms to experience a reduction in
their profits and reduce the country’s economic growth. [1m – coming up with
a conclusion on whether demand-side policies are effective or not]
**Some of you also mentioned exchange rate policy. It is also valid and
accepted as a demand-side policy to increase the competitiveness of exports.
By decreasing interest rates, foreign investors will pull out investments from
the country, causing exchange rate will fall. With a lower exchange rate, the
prices of exports become more competitive (lower) as price falls. Some of you
also argued that with exports becoming more competitive, more jobs are
created as a result, reducing unemployment. This is also correct. However,
most of you fail to mention that the use of exchange rate policy has its
downside, which is that imports become more expensive as the exchange
rate falls. This will also hinder the economic growth of the country, especially
if they are dependent on other countries for resources.
2. Assuming that there is an increase in the price of oil internationally, explain
how this will affect the general price levels in Singapore. [4m]
Key word: Explain – the question expects you to give reason to how an
increase in price of oil affects general price levels in Singapore. To show that
you are giving reasons or explaining, use words such as “because”, “as”.
An increase in the price of oil internationally will increase the cost of
production of firms [1m] because oil is a common factor of production in many
goods [1m].
This is known as imported inflation [1m].
As a result, firms will raise the prices of goods and services to cut profit losses,
increasing the general price levels in Singapore [1m].
3. Using a diagram, explain two policies that can be used to reduce the negative
effects of cost-push inflation. [6m]
Key word: Explain – the question expects you to give reason to show how
these two policies can reduce the negative effects of cost-push inflation,
which is essentially, to shift the AS curve to the right.
[1m – Complete diagram, with correct labelling and markings – the diagram is
supposed to show how supply-side policy shifts the AS curve to the right,
reducing GPL]
General Price Level
AS1
AS2
E1
GPL1
E2
GPL2
AD1
GDP1
GDP2
Gross Domestic Product
Cost-push inflation is defined as a sustained increase in price of goods and
services, caused by the passing of increased production costs to the
consumers by the producers [1m – definition of cost-push inflation].
One policy that can be used to reduce the negative effects of cost-push
inflation is for the government to give subsidies to firms so that they are able
to invest in technologies to improve their productivity [1m – naming a relevant
supply-side policy]. Therefore, the aggregate supply curve will shift to the right
from AS1 to AS2 because firms are able to produce goods and services at a
lower cost, reducing cost-push inflation. Hence, the general price level will be
reduce from GPL1 to GPL2 [1m – explaining how the policy causes the AS
curve to shift right].
Another policy that can be used is to reduce the negative effects of cost-push
inflation is for the government to introduce labour market reforms to reduce
power of trade unions which may demand for unreasonable wage increases
for workers [1m – naming another relevant supply-side policy]. Hence, by
being able to control wages from increasing, firms will reduce the problem of
wage-push inflation, which is also a type of cost-push inflation, hence shifting
the AS curve from AS1 to AS2 [1m – explaining how the policy causes the AS
curve to shift right]. Therefore, the general price level will be reduced from
GPL1 to GPL2, reducing cost-push inflation.
**While it is ok to give demand-side policies such as decrease in corporate tax,
you are essentially shifting the AD curve to the right. Hence, you need to
explain that the decrease in corporate tax will also lower the firm’s cost of
production which affects the AS curve. Failing to explain that will not render
you marks in the exam.
4. Explain how inflation is measured. [7m]
Key word: Explain – the question expects you to list the steps of how a
country calculates inflation, the tool or measure used to calculate inflation.
Inflation is defined as a situation where is is a sustained and continuous
increase in the general price level of goods and services over a specific
period [1m- definition of inflation].
To measure inflation, countries may use a Consumer Price Index (CPI) or a
Retail Price Index (RPI) [1m – mention the tool used to calculate inflation].
[4m – for each step of calculating the CPI of the country, 4 steps in total]
Firstly, to calculate the CPI of a country, a base year is selected and it will
serve as the year against which prices of all other years are compared to. The
CPI assigned to the base year is 100 and price changes in other years are
expressed as a ratio of base prices.
Secondly, basket of goods and services purchased by typical households in
the country are chosen to be considered for the calculation of the CPI. The
commodities selected in the basket should be sufficiently large to reflect the
spending habits of the population in the country.
Thirdly, weights are assigned to represent the relative importance of goods
and services in households. These weights are usually obtained from the
average monthly expenditure of households on each group of items selected.
Lastly, accurate and reliable information on price quotations are obtained for
the selected basket of goods and services. Data on prices are collected from
a range of shops to reflect the importance of each type of outlet in the total
expenditure of households.
The formula of calculating CPI is as follows:
CPI =
[1m – formula for CPI]
Current Year's Price
Base Year's Price
x 100