Internal and External Causes of Deflation in Singapore, and Whether Fiscal Policy Is the Most Effective Response

Answer

Part (a) — Internal and external causes of deflation [10]

Deflation is a sustained fall in the general price level. Singapore’s deflation arose from a combination of supply-side and demand-side forces, internal and external.

External — lower global oil prices. Singapore imports inputs such as crude oil to produce final goods. A fall in the world oil price lowers firms’ costs of production, raising short-run aggregate supply substantially. The resulting surplus exerts downward pressure on the general price level — a cost-push source operating in reverse.

External — challenging external environment. A slowdown among trading partners lowers their real national income and purchasing power, reducing demand for Singapore’s exports and export revenue. Since (X − M) is a large share of GDP for a trade-reliant economy, the fall in net exports lowers AD and pulls the price level down.

Internal — cheaper housing, transport and utilities. These necessities have price-inelastic demand, so when their prices fall, total expenditure on them falls (quantity rises less than proportionately). As they take a large share of household budgets, consumption (C) falls materially, lowering AD and reinforcing the downward pressure on the price level.

These factors act simultaneously: a falling AD and a rising SRAS reinforce one another, producing a large, persistent fall in the price level. Given Singapore’s openness and trade reliance, external factors are likely the stronger cause.

Part (b) — Is fiscal policy the most effective response? [15]

Severe deflation is contractionary — households and firms defer spending in anticipation of further price falls, and rising real debt deters borrowing — so when paired with slow growth it warrants a policy response. The thesis is that expansionary fiscal policy is effective and addresses the root cause where deflation stems from weak C and I, but in Singapore’s context it is not sufficient on its own and must be combined with exchange-rate and supply-side measures.

Fiscal policy works. Higher government spending (e.g. on MRT infrastructure) and lower income and corporate taxes raise C, I and G, lifting AD; via the multiplier, real output rises by more, and the increased resource use raises the price level — countering deflation. This is especially apt where the deflation stems from falling C and I.

But the Singapore multiplier is small. Heavy import dependence and high compulsory saving (CPF) mean large leakages, so each round of induced spending is small and the multiplier process settles quickly. The boost to output is therefore limited, and fiscal policy alone underperforms.

Exchange-rate policy may be more effective here. A zero-appreciation (effectively depreciating) stance makes exports cheaper abroad and imports dearer at home; with price-elastic trade, (X − M) rises, AD rises, and both output and the price level rise. Because (X − M) is a very large share of Singapore’s GDP, this raises output more than fiscal policy — and it targets the root cause when the slump originates in weak external demand. It is also vulnerable to crowding out: if the government borrows to fund spending during a downturn (when tax revenue is weak), interest rates rise and private C and I are deterred, blunting fiscal policy further.

Sustainability cuts the other way. Zero-appreciation is less sustainable: as a heavy importer of inputs, a weaker dollar raises import costs, lowering SRAS and risking inflation that erodes export competitiveness — a serious concern for Singapore, partly masked at present only because oil prices are low. Fiscal policy, by contrast, can raise productive capacity (investment lifts LRAS), keeping inflation in check as AD rises. Supply-side policy — training and retraining idle workers during the slowdown — raises productivity and capacity, addressing deflation and slow growth in the long run, though it suffers a long time lag, acute given an ageing workforce.

Judgement. Expansionary fiscal policy is the most effective tool for raising output and the price level immediately and moderately — evidenced by the 14.7% real GDP rebound in 2010 after the 2009 fiscal stimulus — but it cannot stand alone given Singapore’s small multiplier. Its limitations are best offset by exchange-rate policy (larger short-run impact via (X − M)) and supply-side policy (sustainable long-run capacity). Crucially, because Singapore depends on competitively priced exports, the extent and cause of any rise in the price level must be watched — managing deflation here is trickier than elsewhere. The most defensible position is that fiscal policy is the most effective single instrument in the short run, but the optimal response is a policy mix chosen according to the root cause of the deflation and slowdown.