Explain the potential effects of stagflation on both Singapore’s domestic economy and its external sector.

Life in Singapore has largely returned to the way it was before COVID-19. However, there remains a risk of stagflation—a rare economic condition where sluggish growth occurs alongside rising inflation.

a. Explain the potential effects of stagflation on both Singapore’s domestic economy and its external sector. [10]

Introduction

Stagflation refers to an economic condition where an economy experiences slow or negative growth alongside persistently high inflation. This situation is particularly challenging as traditional demand-management policies often fail to simultaneously tackle both issues. The domestic economy encompasses internal economic activities such as production, consumption, investment, employment, and price levels, while the external economy refers to a country’s economic interactions with the global market, including trade flows, foreign direct investment (FDI), and the balance of payments (BOP). In Singapore, stagflation could be triggered by a slow increase in aggregate demand (AD) while the economy is already near full employment, or a fall in AD combined with a leftward shift in short-run aggregate supply (SRAS) due to rising production costs. The impact of stagflation is significant, as it weakens consumer and business confidence, reduces economic activity, erodes external competitiveness, and worsens the overall balance of payments.

Impacts of Stagflation on the Domestic Economy

1. Decline in Consumption Spending

Stagflation leads to rising prices (inflation) without a corresponding increase in wages, reducing consumers’ real purchasing power. This deterioration in household finances often results in consumers cutting back on discretionary spending, expecting future economic conditions to worsen.

  • A fall in consumption (C) leads to a decrease in aggregate demand (AD), causing a multiplied decline in real national income (NY).

  • As AD contracts, firms experience lower revenues, leading to lower economic growth and potentially deepening the recession.

2. Decline in Investment Spending

Uncertainty about future economic conditions and rising costs of production discourage businesses from investing in capital expansion and hiring. Firms may delay or cancel planned investments due to fears of persistently high inflation and weak consumer demand.

  • A fall in investment (I) results in a reduction in AD, further lowering real national income and economic growth.

  • Lower investment in capital goods and infrastructure causes a decline in long-run aggregate supply (LRAS), reducing the economy’s future potential growth.

  • The decline in real output forces firms to cut back on hiring, leading to higher cyclical unemployment, exacerbating economic hardships.

Impacts of Stagflation on the External Sector

1. Decline in Export Competitiveness and Worsening Balance of Payments

If inflation in Singapore rises faster than in its major trading partners, domestic goods and services become relatively more expensive in international markets.

  • Higher prices lead to a decrease in export competitiveness, as foreign buyers find cheaper alternatives elsewhere.

  • A rise in the price of exports (Pₓ) leads to a decline in net exports (X-M), causing a fall in AD and a multiplied decline in real national income, further slowing economic growth.

  • The deterioration of net exports results in a worsening balance of trade (BOT), which negatively affects the current account of the balance of payments (BOP).

2. Decline in Foreign Direct Investment (FDI) and Worsening Capital Account

The uncertainty and economic instability caused by stagflation can deter foreign investors from investing in Singapore, particularly if they anticipate rising costs, weak growth, and policy uncertainty.

  • A fall in FDI leads to a reduction in investment (I), which negatively affects AD and real national income, further weakening economic expansion.

  • Lower FDI also means reduced long-term capital inflows in the capital and financial account of the balance of payments (BOP), contributing to a worsening of Singapore’s external position.

  • With reduced FDI, there is less spending on capital goods and infrastructure, limiting productivity growth and reducing long-term potential economic expansion (LRAS shift leftward as seen in Figure 1).

Conclusion

Stagflation presents significant challenges for Singapore’s domestic and external economy, as it combines weak economic growth with persistent inflation, making it difficult to implement effective policy responses. Domestically, stagflation reduces consumption and investment, leading to lower aggregate demand, falling national income, and rising unemployment. Externally, higher domestic inflation erodes export competitiveness, leading to a worsening trade balance and overall balance of payments. Additionally, economic uncertainty reduces foreign direct investment, further limiting long-term economic potential. Given Singapore’s high reliance on trade and investment-driven growth, stagflation can significantly weaken economic resilience, requiring a mix of targeted supply-side policies and external trade strategies to mitigate its adverse effects.

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