Macroeconomy - Aggregate Demand

Question 1

Explain the aggregate demand and aggregate supply modal.

Answer 1

The aggregate demand and aggregate supply model explains the determination of national income, considering both the demand and supply facotrs. It is useful for understanding the determinants of economic growth, unemployment and inflation. The eqm level of national income and the general price level in an economy are determined by the interaction of aggregate demand AD and aggregate supply AS.

Question 2

Define aggregate demand (AD).

Answer 2

AD refers to the total level of spending for an economy, based on the amount of domestically produced goods and services that households, firms, government and foreigners desire to buy, at each general price level.

In a four sector economy, it reflects the total demand or expenditure on domestically produced goods and services.

Question 3

Explain how AD is computed.

Answer 3

AD = C + I + G + (X-M)

It is computed by summing up the consumer spending by households (C), investment expenditure by firms (I), government spending (G) and net export expenditure (X-M). Import expenditure (M) is subtracted to remove all expenditure made by households’ firms, the government on imported goods and services so as to ensure that the AD only represents the demand for domestically produced goods and services.

Question 4

State the shape of the AD curve and describe the relationship between the general price level (GPL) and real national income/output (RNY).

Answer 4

The AD curve is downward-sloping.

There is an inverse relationship between the general price level and level of real national income or output. The higher the general price level (GPL), the lower the quantity demanded of all goods and services. As the general price level falls from P1 to P2, the quantity demanded of goods and services in the economy increases, and this is shown by a rise in the real value of output demanded from Y1 to Y2.

Question 5

Explain why the AD curve is downward-sloping.

Answer 5

The wealth, interest rate and international trade substitution effect explains the shape of the AD curve (inverse relationship between GPL and real national output)

1) Wealth effect - When the GPL falls, the purchasing power of households will increase. Assuming unchanged nominal income, households will be better off as that income can be used to buy more goods and services. This makes consumers wealthier, encouraging them to spend more. Hence, a larger quantity of goods and services are demanded and this is represented by a downward movement along the demand curve.
2) Interest rate - When GPL falls, households need less money to purchase a given quantity of good and services. Given a fixed supply of money, a fall in demand for money would cause interest rates, which is the price of loans to fall. This encourages borrowing by households for consumption on interest-sensitive items such as new cars as well as by firms for investment in new plants or equipment, Thus, the quantity of goods and services demanded for the purpose of consumption and investment will increase and this is represented by a downward movement along the demand curve.
3) International trade substitution - When domestic GPL falls while foreign prices remain constant, domestically produced goods have become cheaper relative to foreign substitutes. Ceteris paribus, residents are likely to demand less foreign goods, leading to fall in import expenditure. At the same time, foreigners are likely to purchase more of this country-s goods and services which are relatively cheaper, resulting in a higher quantity of domestically produced goods and services being demanded.

Question 6

State what causes the AD curve to shift.

Answer 6

Non-price determinants of AD cause the AD curve to shift to the right or to the left. An increase in AD is reflected by a rightward shift of the AD curve and this implies that at any price level, a larger quantity of real national output is demanded.

Consumer expenditure (C) - Changes in consumer confidence, changes in interest rates, expectations of future prices, distribution of income, changes in wealth, changes in personal income taxes

Investment Expenditure (I) - Changes in interest rates, changes in business confidence and expectations, changes in corporate tax rates, changes in technology

Government expenditure (G) - Fiscal policy

Net Exports (X-M) - Changes in national income of trading partners/domestic households, changes in relative price levels between countries, changes in foreign exchange rates.

Question 7

Define consumption expenditure.

Answer 7

Consumption expenditure is incurred by households when they use their income to purchase final goods and services to satisfy their current wants.

Question 8

Distinguish between the two types of consumption.

Answer 8

Consumption comprises autonomous consumption and induced consumption.

Induced consumption refers to consumption that is dependent on the current level of real national income. When the current level of real national income increases, households’ ability and willingness to purchase consumer goods and services will increase and hence induced consumption rises.

Autonomous consumption, on the other hand, refers to consumption that is independent of the current level of real national income. It is dependent on non-income factors such as consumer confidence and changes in interest rates.

Question 9

State and explain the 6 non-price determinants of (autonomous) consumer expenditure.

Answer 9

Consumer expenditure (C)

1) Changes in consumer CONFIDENCE - Consumer confidence is a measure of how optimistic consumers are about their FUTURE INCOME and the future of the economy. If consumers expect their incomes to increase in the near future or are optimistic about the future of the economy, they will be more willing to spend on goods and services now, hence autonomous consumption increases.
2) Changes in interest rates - A fall in interest rates reduces the cost of borrowing, thus resulting in an increase in borrowing by households to purchase interest-sensitive/big-ticket items such as new cars. Lower interest rates also mean that the returns on their savings are now lower. Hence, instead of putting their money in banks, households will increase their holdings of money and that might lead to more spending on goods and services. Hence, consumption increases.
3) Expectations of future prices - When consumers expect prices to increase in future, they will increase their demand for more goods and services now because these goods and services are cheaper now than in the future, hence, consumption increases, ceteris paribus.
4) Distribution of income - Redistributive measures where income is redistributed from the rich to the poor in the form of higher income taxes (progressive taxes) on the rich and more benefits for the poor can increase the level of consumption expenditure in a country because the rich tend to spend less of any increase in income compared to the poor. Whilst the portion of income taken from the rich might have been saved, almost all the income distributed to the poor will be spent on consumption. Hence, reduced income inequality is likely to increase consumption in the economy.
5) Changes in wealth - Wealth is the value of assets that people own, including their houses, stocks and bonds (excludes rent). An increase in consumer wealth (e.g. increase in value of houses) makes people feel wealthier and financially secure. They will be more willing to purchase goods and services at their prevailing income level. Thus, consumption increases.

(Note: Income is NOT wealth, it is the amount of money received by a person over a period of time e.g. wages)

6) Changes in personal income taxes - When personal income taxes are lowered, individuals have greater disposable income and thus possess greater purchasing power and will increase consumption.

Question 10

Define investment expenditure.

Answer 10

Investment expenditure is the act of acquiring new fixed capital assets like buildings, equipment and machinery by firms (also known as fixed capital formation). It also includes the accumulation of stocks and inventories such as raw materials, semi-finished goods and finished goods held by the producer (also known as changes in physical stocks). why does it include the accumlation of stocks and inventories?

Question 11

State and explain the 4 determinants of (autonomous) investment expenditure.

Answer 11

Draw diagram showing both movement and shift of MEI curve.

1) Changes in interest rates - The Marginal Efficiency of Investment (MEI) theory states that there is an inverse relationship between interest rates and investment. The MEI refers to the expected rate of return of an additional unit of investment while the rate of interest refers to the cost of borrowing. A rational firm will only invest if it makes a profit - meaning that expected rate of return ≥ the cost of borrowing. When the interest rate decreases, the cost of borrowing for firms decreases, so more investment projects become profitable where the expected rate of return (simply means profit) ≥ cost of borrowing. This is represented by a downward movement along the MEI curve as shown in Figure 1 where a fall in interest rate from r0 to r1 will cause more investment projects to become profitable thus investment increases from I0 to I1. Hence, when interest rates fall, level of investments increase and vice versa.

(Note: Change in interest rates will only influence DOMESTIC investment and NOT FDI as FDI has its own source of funding from its home country. The following factors influence both domestic investment and FDI.)

2) Changes in business CONFIDENCE and expectations: Business confidence refers to how optimistic firms are about FUTURE SALES of their goods and services and economic activity. If firms become pessimistic about future sales and economic activity, business confidence falls and they will expect the RATE OF RETURN ON INVESTMENTS to fall, causing MEI curve to shift left from MEI1 to MEI2. For given interest rate r1, this causes investment to fall from I1 to I2.
3) Changes in corporate tax rates - A fall in corporate taxes will lead to an increase in after-tax profits. This increases firms’ willingness and ability to invest, leadning to an increase in investment expenditure, causing a rightward shift of the MEI curve from MEI1 to MEI2.
4) Changes in technology - Improvements in technology stimulate investment spending as the implementation of new technology often requires new capital. It opens up new business opportunities and increases the expected rate of return of investment projects. As such, firms will increase investment in capital to take advantage of technological advancements, for example increasing investment in computers as computer technology improves, thus investment increases.

Question 12

Define government expenditure. How is it determined?

Answer 12

Government expenditure refers to spending by the government on goods and services within a country. It includes payment of salaries of government workers, spending on public works and public investments of infrastructure such as the building of roads and hospitals.

Government changes its expenditure to achieve macroeconomic goals. This is also known as the fiscal policy and is independent of the level of national income in the country (autonomous expenditure)

Question 13

Define Net Exports.

Answer 13

Net Exports is the value of all exports minus imports.

Question 14

Define Export Expenditure.

Answer 14

Export expenditures are purchases of domestically produced goods and services by foreigners (should be included in the measurement of the country’s national output/GDP).

Question 15

Define Import Expenditure.

Answer 15

Import expenditure refers to domestic spending on goods and services that have been produced in other countries and should be subtracted from national output/GDP.

Question 16

State and explain the determinants of Net Exports (X-M).

Answer 16

1) Changes in national income of trading partners/domestic households

Trading partners - If income of A’s trading partners increases rapidly, foreign demand for A g/s may rise due to their higher purchasing power (assuming normal goods), export revenue increase, net export revenue increase cet par.

Domestic households - If A itself experiences a rise in national income, residents have greater purchasing power, demand more imports, import expenditure rises, net export falls cet par.

2) Changes in relative prices between countries (can be due to inflation rate of other countries being higher) - Price level rise relative to that in country A, demand for A g/s will rise (assuming substitutes to the foreign goods) as domestic goods have become relatively cheaper, export revenue rises. At the same time, A residents will buy less of relatively more expensive imported g/s and buy more of relatively cheaper domestically produced import substitutes, reducing A import spending, resulting in a rise in net export earnings for A.

Note: A change in other countries’ GPL relative to domestic country’s GPL (i.e. holding domestic country’s GPL constant) will cause a shift OF the domestic country’s AD curve but a change in the domestic county’s GPL relative to other countries’ GPL will cause a shift ALONG the domestic country’s AD curve (i.e. holding other countries’ GPL constant)

3) Changes in foreign exchange rates (affects prices of imports in terms of domestic currency and price of exports in terms of foreign currency) - If SG$ depreciates relative to that of its trading partners, SG g/s become relatively cheaper in terms of foreign currency and foreigners will switch to buying more SG goods, increasing SG export revenue. Conversely, foreign goods are relatively more expensive in terms of domestic currency causing SG to reduce imports and hence import expenditure. As a result, there is a rise in net exports, increase AD.

Question 17

Define aggregate supply.

Answer 17

Aggregate supply (AS) refers to the total output of goods and services that domestic firms as a whole produce and sell at each general price level.

Question 18

State and Explain the three ranges of the AS curve.

Answer 18

1) Horizontal (Keynesian) range

Over this output, real national output increases without any increase in price (AS is perfectly price-elastic). The real national output is much lower than the full employment level Yf so there is an abundance of spare capacity (un-utilised and under-utilised resources), allowing producers to increase output production easily without incurring higher costs when there is a rise in AD. Hence, there is no pressure on GPL to increase.

2) Intermediate range

Over this output, an increase in real national output is accompanied by rising GPL because resources such as capital goods, raw materials and labour are becoming increasingly scarce as production levels rise and resources are increasingly employed. If AD rises, the increase in output to meet the shortage of goods will cause supply bottlenecks to arise, resulting in a higher cost of production and a higher GPL.

3) Vertical (Classical) range

Beyond this range, there is no possible increases in output while prices continue to rise (AS is perfectly price-inelastic) because the economy has reached full employment and output can no longer rise as resources are fully employed. If AD rises, only GPL would rise with no change in real output (workers move to a different firm that pays more).

(Note: Changes in Yf level can only be brought about by changes in productive capacity of the economy.)

Question 19

State and explain the non-price determinants of AS.

Answer 19

Apart from GPL, changes in non-price factors can cause a shift in the AS curves, altering the amount produced at each price level.

1) Changes in input prices - Rise in input prices increase COP, reduce AS, shift AS up
2) Changes in quality of resources - An improvement in the quality of labour resources leads to an increase in labour productivity. This is can be achieved through education and training (human capital investment). With higher productivity of workers, more goods and services can be produced for every input employed, increasing productive capacity of the economy and full employment level, shifting AS to the right. Higher productivity can also translate to lower unit costs of production, assuming wages of workers are unchanged, this increases AS and shifts the AS curve downwards as firms are more willing to produce more at each given price level as the lower production cost increase possibilities for earning profits.
3) Changes in the quantity of resources - Increase in quantity increases the economy’s ability to produce more goods and services. Ceteris paribus, this will increase the economy’s productive capacity and increase AS, shifting AS to the right.
4) Technological advancements - Improvements in technology allow firms to discover less costly ways of production and reduce their unit costs of production (e.g. Use of 3D printers that utilized precise amounts of inputs to produce any good, minimising wastage of resources). It also increases the productive capacity of firms as machines increase the efficiency at which goods are produced. Thus, AS increases and the AS curve shifts both downwards and rightwards.
5) Government policies - Such policies can influence the cost of production (e.g. Indirect subsidies increase AS, shift AS downwards) and/or productive capacity (e.g. promoting skills-upgrading of workers or providing incentives to healthcare-related companies to invest in R&D during economic restructuring. Proper law enforcement, low crime rates reduce uncertainty arising from loss of property, encouraging savings and investment in long-term capital projects, positively affecting the productive capacity of economy in the long run

Question 20

Explain when the AS curve might shift upwards/downwards/rightwards/leftwards.

Answer 20

A rise in cost of production causes firms to produce less at each given price level as higher production costs reduce their possibilities for earning profits. Thus, AS decreases and the AS curve shifts upwards.

Fall in cost of production incentivises firms to produce more at every given price level, increasing AS, shifting the AS curve downwards.

A rise in productive capacity means that the economy is able to produce more goods and services. In other words, potential economic growth occurs. This shifts the AS curve to the right and the full employment real output frontier is pushed outwards. The reverse is true for a fall in productive capacity.

Question 21

Explain what the equilibrium level of real national income is.

Answer 21

In the macro-economy, the equilibrium level of real national income occurs when AD equates AS as it is the level of income where there is no shortage or surplus and thus, no tendency to change.

Question 22

Explain the impact of a change in AD.

Answer 22

1) Describe change to AD (e.g. increase in AD due to reduced personal income taxes, AD shift right)
2) At prevailing price P0, there will be disequilibrium as the aggregate quantity demanded exceeds the aggregate quantity supplied. This causes consumers to bid higher prices for the goods. As prices rise, demand falls due to the wealth, interest rate and international substitution effects. At the same time, profit-maximising firms are incentivised by the higher prices to increase output and thus employ more workers to increase output. Hence, real national income/output rises towards the new equilibrium level Y1 and GPL rises to P1.

When AD falls, the leftward shift of AD causes firms to reduce prices to clear the excess inventories and stock. Firms reduce production and demand fewer workers. Thus, equilibrium level of real national output/income falls.

Question 23

Explain in the impact a change in AS.

Answer 23

Increase in AS due to fall in COP, AS shift down. At the prevailing price P0, there will be disequilibrium as the aggregate quantity supplied exceeds the aggregate quantity demanded. This causes firms to lower prices to sell off the excess inventories. As GPL falls, demand is incentivised to consume more goods and services. This is represented by a downward movement along the AD curve and continues until the GPL falls to P1, where the equilibrium level of real national output is higher at Y1. Actual economic growth is achieved.

When AS shifts down and right, rise in productive capacity increases the country’s full employment level, resulting in potential economic growth. This alleviates the existing supply bottlenecks and causes GPL to fall and real national output to rise, representing an increase in actual economic growth as well.

Question 24

Explain when actual economic growth occurs.

Answer 24

Actual economic growth occurs when the country’s equilibrium real national output increases. It can be achieved by an increase in AD or AS.

Question 25

Explain when potential economic growth occurs.

Answer 25

Potential economic growth occurs when the country’s productive capacity increases. It can only be achieved when there is an increase in full employment level, represented by the vertical portion of the AS curve.

Question 26

Define and briefly explain the multiplier effect.

Answer 26

Due to the multiplier effect, any increase in AD (due to any component of AD) will lead to a multiplied increase in real national income.

When AD increases, firms see an unplanned rundown in stocks and increase production by hiring more factors of production This generates income for people directly employed. The employed people spend a part of their income on domestically produced goods and services while the remainder leaks out of circular flow, in the form of withdrawals - savings, taxes and import expenditure. The income-induced expenditure creates more employment and income for other people in the economy. The income generated for this next group of people will lead to consumer expenditure and add on to induced consumption once again. This triggers the multiplier process whereby one person’s spending generates income for the next and the process goes through many rounds of induced spending to increase national income by a larger magnitude, compared to the initial increase in autonomous increase in AD. This process continues until the sum of withdrawals equals the initial increase in AD, resulting in a multiplied increase in real national income.

Question 27

Define the multiplier.

Answer 27

The multiplier k is a numerical coefficient by which a change in autonomous spending (autonomous C, I, G, X) is multiplied to give a more than proportionate change in RNY.

Note:

• A small multiplier does NOT mean increase in RNY is less than proportionate to increase in initial AD – there is still a more than proportionate increase but this is relatively small
• What causes an initial change to AD in order to set off the multiplier process has to come from an autonomous aspect of AD. Changes in own country’s real NY will NOT change the autonomous aspect (unchanged with income) components of AD – it will only affect the induced aspect of AD. As such, for example, when autonomous AD increases then RNY increases. This increase in RNY would cause induced consumption to increase and also cause induced imports to increase. Both aspects of this are captured in the multiplier process.

Question 28

State the formula to calculate the value of the multiplier k and explain whether composition of C/I/G/X indicate marginal propensity values.

Answer 28

k = Change in equilibrium national income/Change in AD = 1/MPW = 1/(1-MPC) = 1/(MPS + MPT + MPM) where MPS is the marginal propensity to save, MPT is the marginal propensity to tax and MPM is the marginal propensity to import.

MPM / MPS / MPT are in terms of marginal income – which seeks to measure how these withdrawals change with a change in income.

It is common to get tables on the composition of C/I/G/X/M as percentage of GDP and ask you to infer the size of multiplier – it is incorrect to say that this gives information on MPM → what it gives is rather the APM (average propensity to import) → you will have to use this APM to infer that households are likely to spend significant proportion of additional income on imports so likely that MPM is large

Question 29

State the assumptions of the theory of the multiplier.

Answer 29

1) Availability of spare capacity in the economy
2) No change in GPL
3) Constant state of technology
4) Absence of time lags

Question 30

Using numbers, explain the multiplier process using the circular flow model, assuming the government increases its spending on extending the MRT line by $100m.

Answer 30

Pg 19 of notes

When the government INJECTS $100m into the economy, the firms providing construction and related services would earn $100m. Firms see an unplanned rundown in stocks and inventories and respond to this by stepping up production by employing more factors of production, including labour. As firms PAYS HOUSEHOLDS FACTOR INCOME, RNY increases by $100m. Households do not spend all their income on consumption due to the presence of withdrawals in the form of savings, taxes and import expenditure. Since MPC = 0.6, 60% of their additional income will be spent on consuming domestically produced goods and services. Hence, $60m FLOWS BACK to domestic firms while the remaining $40m is withdrawn. The induced consumption of $60m is RE-INJECTED back into the economy and, leading to another round of increase in national income of $60m. This induces another round of consumption of $36m. This process whereby expenditure generates income and income induces expenditure is repeated. However, it does not continue indefinitely as at each successive round, the rise in national income and induced consumption become smaller and smaller due to withdrawals. Eventually, all the initial injections would be withdrawn when the induced increase in consumption falls to zero.

Question 31

Explain why RNY increases when there is a fall in savings using the circular flow framework.

Answer 31

1. Briefly clarify key terminology in the circular flow
2. Specify which component in injections (J) or withdrawals (W) are affected
3. Explanation of multiplier process where one man’s spending is another man’s income

The circular flow of income explains the relationship between firms, households, government, foreign sector, and financial institutions. Equilibrium RNY is achieved when total injections = total withdrawals. Injections include investment, government expenditure, export revenue while withdrawals include savings, taxation, and import expenditure.

A fall in savings would lead to a fall in withdrawals so total injections is greater than the total withdrawals. Firms see an unplanned rundown in stocks and inventories and respond to this by stepping up production in the next period by employing more factors of production, including labour. As firms pay these workers factor income, RNY increases. This triggers the multiplier process where one man’s spending is another man’s income. This increase in initial RNY causes multiple rounds of increased induced consumption, but each round decreases due to withdrawals. The process continues until the increase in induced withdrawals = initial fall in withdrawals. RNY increased more than proportionately to the initial decrease in withdrawals (or increase in injections, if I/G/X increases).

Question 32

Explain why RNY decreases when there is a fall in export using the circular flow framework.

Answer 32

1. Briefly clarify key terminology in the circular flow
2. Specify which component in injections (J) or withdrawals (W) are affected
3. Explanation of multiplier process where one man’s spending is another man’s income

The circular flow of income explains the relationship between firms, households, government, foreign sector, and financial institutions. Equilibrium RNY is achieved when total injections = total withdrawals, and injections include investment, government expenditure, export revenue while withdrawals include savings, taxation, and import expenditure. (1) A fall in export quantity leads to fall in export revenue thus leading to a fall in injections, so total injections < total withdrawals. (2) Firms see an unplanned accumulation in stocks and inventories and respond to this by cutting back production in the next period by employing fewer factors of production, including labour. As firms receive less income, firms pay fewer workers factor income, RNY decreases. This decrease in initial RNY results in a fall in households’ income-induced consumption. This triggers the reverse multiplier process where a fall in one man’s spending is a loss in another man’s income. This leads to multiple rounds of decreased induced consumption, but the fall in income and induced consumption gets smaller due to withdrawals. The process continues until the initial fall in injections equals the cumulative fall in withdrawals. RNY decreased more than proportionately to the initial decrease in injections.

Question 33

Explain the circular flow of income.

Answer 33

The circular flow of income allows us to arrive at a certain equilibrium level of output, expenditure and income.

in a two-sector economy, the circular flow of income shows the flow of payment from households to firms and from firms to households. When income earned by households is spent on goods and services produced by firms, their consumption expenditure becomes the income of firms. Firms will then pay households factor income, which comprises of wages, rental, interests and profits, for their services provided in producing goods and services. Households then use this income to purchase goods and services from firms and the cycle would continue indefinitely.

However, in reality, households do not spend their income on domestically produced goods and services. A part of households’ income will be set aside for savings (S), payment of taxes (T), and expenditure on imported goods and services (M) which are known as Withdrawals (W). Withdrawals lead to the contraction of the circular flow of income for the domestic economy. For instance, when there is an increase in withdrawals in the form of savings, households will spend less of their income on domestically-produced goods. Firms then receive less revenue to pay income to factor inputs, resulting in less income and expenditure in circulation for the domestic economy.

While there are withdrawals from the circular flow, there are also injections (J). Injections refer to any payment of income to domestic producers that do not arise from domestic household consumption and they come in the form of investment expenditure from financial markets (e.g. banks) (I), government expenditure (G) and export revenue (X). Whenever an injection is experienced, the economy would experience a boost in expenditure and income in circulation for the domestic economy.

Question 34

Define induced consumption.

Answer 34

It is the portion of consumption that varies with disposable income.

Question 35

Using the AD-AS approach, explain how the multiplier process results in a multiplied increase in RNY when there is an increase in government expenditure. Explain how this may achieve actual economic growth.

Answer 35

Pg 18 of notes

1. State change in C/I/G/NX
2. Explanation of multiplier process where one man’s spending is another man’s income
3. Make reference to the diagram

Assume an increase in autonomous government expenditure by $100m. This causes an increase in autonomous AD from AD1 to AD1a by $100m. This is because firms see an unplanned rundown in stocks and inventories and respond to this by stepping up production in the next period by employing more factors of production, including labour. As firms pay these workers factor income, RNY increases by $100m which is the increase in autonomous AD. Households then spend part of their income on domestically produced goods and services and this proportion is based on the marginal propensity to consume. This triggers the multiplier process where one man’s spending is another man’s income. This increase in initial RNY causes multiple rounds of increased induced consumption. Assume that MPC=0.6, so when RNY increases by the initial $100 million, there is an increase in induced consumption by $60m ($100m x 0.6) and this causes AD to increase further from AD1a to AD1b by $60m. Again, in response to rising demand, production and thus income increases. However, the process does not continue indefinitely due to withdrawals in the form of savings, taxes, import expenditure which cause the additional increase in spending and income to be a fraction of the previous addition to the circular flow. This means that the rightward shifts in the AD curve become smaller and smaller with each successive round. Eventually, the process stops when the increase in withdrawals = initial increase in AD and AD increases to AD2. Since MPC = 0.6 and MPW = 0.4, this means the multiplier k = 1 / 1 - MPC = 1 / MPW = 2.5, then RNY would rise by 2.5 times given the autonomous increase in government expenditure (In other words, Y1Y2 should be 2.5 times greater than AD1AD1a) / Thus, RNY increased more than proportionately from Y1 to Y2.

Assuming that there is 1) Availability of spare capacity in the economy, 2) No change in GPL, 3) Constant state of technology and 4) Absence of time lags, the overall increase in AD is from AD1 to AD2 and the multiplied nicrease in RNY is from Y1 to Y2. This reflects that a higher quantity of output has been produced with the employment of previously idle resources, signifying actual economic growth.

Question 36

Explain why RNY decreases when there is a decrease in investment using the AD/AS framework.

Answer 36

1. State change in C/I/G/NX
2. Explanation of multiplier process where one man’s spending is another man’s income
3. Make reference to the diagram

There is a decrease in investment, so AD decreases from AD0 to AD1. (1) Firms see an unplanned accumulation in stocks and inventories and respond to this by cutting back production in the next period by employing less factors of production, including labour. As firms pay fewer workers factor income, RNY decreases. This triggers the reverse multiplier process where a fall in one man’s spending is a loss in another man’s income. This decrease in initial RNY causes multiple rounds of decreased induced consumption, but each round decreases due to withdrawals in the form of savings, taxes, import expenditure. The process continues until the decrease in withdrawals = decrease increase in AD. (2) RNY decreased more than proportionately from Y0 to Y1. (3)

Question 37

When do you use the price adjustment process and when do you use the multiplier process?

Answer 37

Multiplier process is used to explain the more than proportionate increase in RNY and NOT to explain inflation / inflationary pressures – always use multiplier process to explain a change in RNY resulting from a shift in AD

To explain changes in GPL, use the macroeconomic price adjustment process

Question 38

Explain the limitations of the multiplier effect.

Answer 38

1) Size of multiplier k: If MPC is very small in a country, then for a given injection
2) Level of spare capacity in the economy
3) Difficulties in measurement
4) Time lags

Question 39

Explain how government education and retraining causes the AS to shift

Answer 39

If the government adopts education and retraining, this improves the skills of workers and hence their productivity. As such quality of Singapore’s human resources increases and this increases the productive capacity from YF0 to YF1 so LRAS increases (or shifts outward) from AS0 to AS1. Moreover, assuming increase in productivity > increase in wages, there would be a fall in cost of production, so SRAS increases (or shifts downward) from AS0 to AS1.