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H1 (8816) 08 Case Study Question 1 (a)(i) There has been an overall upward trend in UK inflation from 1997 to 2006,

starting from about 1.8% in 1997 and falling to about 0.8% in 2000, before rising to just above 2% in 2006. On the other hand, there is an overall downward trend in UK unemployment from 1997 to 2006, starting from above 5% in 1997 and falling to just above 3% in 2006. (a)(ii) Figure 1 displays a generally positive relationship between inflation and unemployment, with the exception of 1997-1998 & 2005-2006, where there is an inverse relationship between the two. On the other hand, although inflation and unemployment have a positive relationship in Figure 2 from 1997 to 2000, with both falling during these 4 years; inflation and unemployment display an inverse relationship from 2001 onwards, with unemployment continuing its downward trend from 2001 to 2006, while inflation rises from 2001 to 2006. Therefore, both Figures 1 & 2 seem to suggest a rather stable positive relationship between inflation and unemployment. However, the years after 2001 in Figure 2 and some exceptions in Figure 1 seem to suggest a generally stable but inverse relationship between the two. (b) In 2006, Singapore was experiencing economic growth, as can been seen from Extract 1, where real GDP in the 4th quarter of 2006 is 5.9% greater than the 4th quarter of 2005. In addition, Singapores total trade grew by 13% in 2006, further contributing to growth since Singapore is a small and open export-oriented economy, dependent on trade for its growth. In addition, according to Figure 1 Singapore experienced a lower unemployment rate of 2.7% in 2006, compared to the 3.2% in the year before, indicating that less people are unemployed in 2006 and that a higher percentage of the population have jobs, earn incomes and hence have higher purchasing power and greater abilities to spend, increasing consumption and their standards of living, as well as contributing to economic growth, since consumption is one of the four components of aggregate demand.

However, Figure 1 also shows that Singapores inflation rate of 0.8% in 2006 was slightly higher than the 0.5% in the year before. Nonetheless, the 0.8% inflation rate can still be regarded as rather low, and hence there is little cause for worry. All in all, Singapore has had a good economic performance in 2006, as can been concluded from the higher economic growth & lower unemployment rates that she experienced in 2006. Even with the slight increase in inflation rates in 2006 which may seem to suggest otherwise, the fact remains that despite the slight increase from 2005, inflation rates still remain generally low, so they do not really detract from Singapores overall economic performance in 2006. (c)(i) Strong borrowing in the UK suggests greater availability of credit available for consumers, firms and the government, thereby increasing their ability and willingness to consume, invest and spend respectively. As such, this may result in an increase in consumption (C), investment (I) and government spending (G) respectively, and since they are all components of aggregate demand (AD), an increase in these 3 components will bring about an increase in AD, shifting the AD curve to the right from AD1 to AD2, causing an increase in prices from P1 to P2, bringing about demand-pull inflation. GPL


P2 P1 AD2 AD1 0 (c)(ii) The lack of spare capacity in the economy suggests that most of the resources in the economy have been fully utilized and that the economy is operating near to full employment level. As a result, any increase in AD as mentioned in (c)(i), especially when the economy is near to full employment level, will bring about a significant increase in the price level, causing demand-pull inflation, hence causing inflation to rise above the target figure of 2%. Real Output Yfe Real Output

(d)(i) There is an inverse relationship between the rate of interest and the rate of inflation, as shown in Extracts 2 and 3. In Extract 2, we are told that the third such increase in UK interest rates since August 2006 clearly reflects fears that inflation is on the rise, suggesting that the increase in interest rates was put in place so as to try and reduce the rising inflation or at least prevent it from rising further. A similar link between the rate of inflation and the rate of interest can be seen in the case of Taiwan in Extract 3, where we are told that there are speculations the central bank of Taiwan might consider pausing its habit of raising interest rates since the annual inflation rate had not risen but instead remained below 1% for the seventh consecutive month there is no need to raise interest rates to lower the inflation rate in Taiwan, since the inflation rate has not increased for 7 months. In the case of Indonesia, the central bank decided to cut the rate of interest as it was already able to achieve its inflation target (consumer prices rose only 6.3% in February compared with a year earlier, as against the 6.7% which was expected) and prevent the inflation rate from rising, as shown in Extract 3. In China, a tightening of monetary policy to deal with the rapidly overheating economy suggests that an increase in the rate of interest is once again implemented to try and reduce the inflation rate in China, or at least prevent inflation in China from rising beyond a targeted level. All in all, the rate of interest has been used as a tool to achieve the desired target rate of inflation for the various countries mentioned in Extract 2 & 3. If the inflation rate in the country is higher than the desired target rate of inflation, the rate of interest will be decreased and vice versa, hence further emphasizing the inverse relationship between the two. (d)(ii) When a central bank adopts a tight monetary policy, this means that it has either decreased the money supply or raised the interest rates in the country. An increase in interest rates would result in a higher opportunity cost of consumption, giving consumers a greater incentive to save rather than spend, thus causing consumption to fall. In addition, higher interest rates result in higher costs of borrowing, causing consumers to decrease their more expensive purchases because it is now more expensive to consume. The higher costs of borrowing will also cause firms to be faced with higher costs of production, lower profits and hence being profitmaximisers, they will invest less.

Since consumption (C) and investment (I) are both components of aggregate demand (AD), the combined fall in consumption and fall in investment will lead to a consequent fall in aggregate demand (AD), and this shift in the AD curve leftwards will lead to a fall in prices, reducing demand-pull inflation and hence helping the central bank to control the rate of inflation. An increase in interest rate will attract capital inflow into a country leading to an increase in demand and hence appreciation for the currency. An appreciation of currency will result in a countrys exports being more expensive in terms of foreign currency and its imports being cheaper in terms of local currency. Assuming an elastic demand for both exports and imports, the quantity demanded of exports will fall more than proportionately and the quantity demanded of imports will rise more than proportionately, causing export revenue to fall and import expenditure to rise, leading to an overall fall in net exports (XM). Since net exports is also a component of aggregate demand (AD), AD will also fall, shifting the AD curve leftwards and leading to a fall in prices, reducing demand-pull inflation and hence helping the central bank to control the rate of inflation. (e) In a small and open economy like Singapore which is very dependent on external demand (both export-oriented and import-dependent), traditional monetary policy instruments such as interest rates and money supply, which largely affect domestic demand, have a smaller influence on the overall level of economic activity and therefore, inflation in Singapore. Being a price taker in world markets because it is too small to influence world prices, producers in Singapore have to accept prices dictated by global demand and supply conditions. In addition, the high import content of domestic demand means that changes in world prices and the exchange rate have a powerful influence on domestic prices. As such, the MAS aims to implement a modest appreciation of the Singapore dollar in order to make our imports affordable so as to curb imported inflation. On one hand, with a managed appreciation of the exchange rate, Singapores exports become relatively more expensive. Assuming an elastic demand for Singapores exports because of the availability of substitutes available for Singapores exports, the quantity demanded of exports will fall more than proportionately causing export revenue to fall, leading to an overall fall in net exports (X-M). Since net exports is also a component of aggregate demand (AD), AD will also fall, shifting the AD curve leftwards and leading to a fall in prices, reducing demand-pull inflation and hence helping the central bank to tackle the problem of inflation. In addition, a managed appreciation of the exchange rate

also results in Singapores imports becoming relatively cheaper, helping to reduce imported inflation in Singapore as well. However, since Singapore is an import-dependent country with an inelastic demand for imports, the relatively cheaper imports would mean relatively cheaper finished goods as well as raw materials. This would bring about a less than proportionate increase in quantity demanded of imports, causing overall import expenditure to fall. Nonetheless, with relatively cheaper raw materials, the costs of production can be lowered, and producers can pass on these lower costs of production to consumers in terms of lower prices, hence enhancing the price competitiveness of goods produced in Singapore for domestic consumption and for export purposes. With more price competitive local goods and exports, consumption may increase and there would also be a more than proportionate increase in the quantity demanded of Singapores exports and hence export revenue increases. The increase in consumption and net exports here would then lead to an increase in AD, shifting the AD curve to the right, bringing about demand-pull inflation. Consequently, because of the export-oriented and importdependent nature of the Singapore economy, even using a managed appreciation of its exchange rate may have certain limitations in tackling the problem of rising inflation. Furthermore, to manage an appreciation of a countrys exchange rate over time requires the central bank to have adequate foreign reserves in order to intervene in the foreign exchange market as frequent buying to prop up the value of Singapore dollar may deplete the foreign reserves. Hence, this measure will not have a permanent effect as foreign reserves that are used to artificially support the currency will be exhausted at a certain point in time. Thus, such a measure is only feasible when it is supported by positive economic conditions of the country. All in all, a managed appreciation of its exchange rate may be the most effective measure of tackling the problem of rising inflation, but like all other measures it does have its limitations. The extent of success of the policy depends on how much the exchange rate is allowed to appreciate or depreciate, this would require the accurate analysis of the level of world inflation and likely movements of other exchange rates. If the Singapore dollar is too strong, it will discourage Foreign Direct Investment (FDI) as the cost of wages, raw materials and capital goods will be relatively higher when expressed in home currency. Nevertheless, besides the exchange rate, there are also other determinants of investment. On the other hand, if the Singapore dollar is too weak, it may lead to domestic inflationary pressures.