H2 Econ Ch6 Lecture Notes (Students) 2025 PDF

CHAPTER 6 National Income and Determination Contents 1. INTRODUCTION & PRELIMINARY CONCEPTS.............................................................................................................. 2 1.1 KEYNESIAN THEORY OF INCOME DETERMINATION.................

CHAPTER 6 National Income and Determination Contents 1. INTRODUCTION & PRELIMINARY CONCEPTS.............................................................................................................. 2 1.1 KEYNESIAN THEORY OF INCOME DETERMINATION................................................................................... 2 1.2 THE CIRCULAR FLOW OF INCOME AND EXPENDITURE............................................................................. 3 1.3 LIMITATIONS OF THE CIRUCLAR FLOW OF INCOME MODEL................................................................... 8 2. AGGREGATE DEMAND AND AGGREGATE SUPPLY...................................................................................................... 9 2.1 REAL versus NOMINAL VALUES........................................................................................................................10 2.2 THE AGGREGATE DEMAND CURVE..................................................................................................................11 2.3 KEY DETERMINANTS OF AD...............................................................................................................................12 2.3.1 CONSUMPTION..................................................................................................................................................12 2.3.2 INVESTMENT......................................................................................................................................................17 2.3.3 GOVERNMENT EXPENDITURE......................................................................................................................22 2.3.4 EXPORTS AND IMPORTS.................................................................................................................................23 2.4 NON-PRICE FACTORS THAT SHIFT THE AD CURVE...................................................................................25 2.5 KEY DETERMINANTS OF AGGREGATE SUPPLY...........................................................................................26 2.6 EQUILIBRIUM REAL NATIONAL INCOME AND GENERAL PRICE LEVEL..............................................32 3. EXTENT OF CHANGES IN THE EQUILIBRIUM LEVEL OF NATIONAL INCOME..................................................34 3.1 THE MULTIPLIER...................................................................................................................................................35 3.2 THE WORKINGS OF THE MULTIPLIER IN A 4-SECTOR ECONOMY........................................................36 3.3 FACTORS THAT DETERMINE MAGNITUDE OF CHANGE IN NATIONAL INCOME..............................38 3.4 LIMITATIONS AND IMPORTANCE OF THE MULTIPLIER PRINCIPLE...................................................41 4. MACROECONOMIC AIMS....................................................................................................................................................43 4.1 SUSTAINABLE and INCLUSIVE ECONOMIC GROWTH................................................................................44 4.2 PRICE STABILITY OR LOW RATE OF INFLATION.......................................................................................45 4.3 LOW UNEMPLOYMENT........................................................................................................................................46 4.4 FAVOURABLE BALANCE OF TRADE POSITION............................................................................................46 5. DECISION-MAKING EXAMPLE..........................................................................................................................................47 2024 SH2 H1/H2 Economics Chapter 6 OVERVIEW OF CHAPTER All governments around the global economy will face economic problems and have to make decisions which aim to maximise the welfare of their economy and society by achieving their desired macroeconomic goals (i.e. price stability, low unemployment, favourable balance of trade position (H2 only), and sustainable and inclusive economic growth.. However, the achievement of a macroeconomic goal / aim / objective may result in unintended conflict and trade-off with other macroeconomic or microeconomic objectives of the government. As such, it may be necessary for the government to weigh the benefits and costs of their decision in macroeconomic policy-making to achieve the best outcome for the economy. KEY DECISIONS RELATED TO THIS CHAPTER * Households/Consumers decide whether to increase or decrease consumption (whether on domestically produced goods or imported goods) given the changes in income and/or non-income determinants. * Firms/Producers decide whether to increase or decrease investment given the changes in income and/or non-income determinants. * Governments decide whether to increase or decrease fiscal spending depending on the economy’s current economic conditions, and the intended macroeconomic goal. * Foreigners decide whether to increase or decrease consumption of other countries’ exports given the changes in relative incomes, relative prices, quality of goods and exchange rates. KEY ECONOMIC AGENTS * Households/Consumers * Firms/Producers * Governments * Foreign Sector National Junior College: Economics Department H1/H2 Economics (8843/9570) 1 2024 SH2 H1/H2 Economics Chapter 6 1. INTRODUCTION & PRELIMINARY CONCEPTS Learning Objectives: ❖ Illustrate and explain the circular flow of income for a 4-sector economy. ❖ Demonstrate an awareness of injections to and withdrawals from the circular flow of income. In Chapter 5 on National Income and Standard of Living, we examined how national income is measured, the usefulness of national income statistics, and the limitations of using it as a measure of living standards. In this chapter, we are concerned with what determines the size of the national income since the size has a significant influence on our living standards. 1.1 KEYNESIAN THEORY OF NATIONAL INCOME DETERMINATION The Keynesian Theory of National Income Determination was developed by John Maynard Keynes during the Great Depression in the 1930s when there was massive unemployment. Contrary to classical economists at that time, Keynes did not believe that the economy would return to full employment by itself. He argued that “demand creates its own supply” and “one man’s spending is another man’s income”. Hence, a nation’s production, employment and income depend on the level of aggregate expenditure or aggregate demand (AD). The fundamental problem causing the Great Depression was an insufficient demand for goods and services. Keynes argued that if there were a fall in demand, firms would respond by producing less and employing less people. The economy would not improve unless consumers increase their demand, but they would not do so as their incomes have fallen. Hence, the economy could settle down in an equilibrium situation that is below full employment. National Junior College: Economics Department H1/H2 Economics (8843/9570) 2 2024 SH2 H1/H2 Economics Chapter 6 Keynes’ key point was that an unregulated market economy could not ensure sufficient demand to achieve full employment. Governments should therefore intervene by increasing their expenditure and reducing taxes (fiscal policy) to increase the aggregate demand for goods and services that could lead the economy to full employment level. To understand how Keynes perceived the economy, we will first need to understand the circular flow of income and spending, look at what make up AD, and examine why and how changes in AD will change the equilibrium level of national income. John Maynard Keynes (1883-1946) was born in Cambridge and attended King’s College, Cambridge, where he earned his degree in Mathematics in 1905. He studied under Alfred Marshall and Arthur Pigou, whose scholarship on the Quantity Theory of Money led to Keynes’s Treatise on Money in 1930. In 1925 he married the Russian ballet dancer Lydia Lopokova. He was made a lord in 1942 and died on April 21, 1946. Keynes’s General Theory of Employment, Interest and Money revolutionised economic thinking. It was path-breaking in several ways, in particular because it introduced the notion of aggregate demand as the sum of consumption, investment, government spending and net exports, and showed that full employment could be maintained only with the help of government spending. So influential was Keynes in the middle third of the twentieth century that an entire school of modern thought bears his name. 1.2 THE CIRCULAR FLOW OF INCOME AND NOTE: EXPENDITURE Circular flow of income and expenditure is not in The circular flow of income shows how incomes are generated from the the H1 syllabus but it is important to have a basic understanding to production of goods and services and how the incomes generate facilitate future learning. spending on goods and services that are produced. It shows the sources of spending flow and the uses of income generated by the spending flow. Recall that in Chapter 5, we have looked at the circular flow of income for a 2-sector economy. The following is a simple diagrammatic illustration of this flow. National Junior College: Economics Department H1/H2 Economics (8843/9570) 3 2024 SH2 H1/H2 Economics Chapter 6 For a start, we consider again a 2-sector economy with no saving. Here, we assume: 1. A simple 2-sector economy made up of only the household sector and the firm sector. 2. Consumers spend all their income on goods and services produced by firms. 3. There is no government sector. 4. The economy is closed, i.e. no foreign sector/trade. Factor payments to households Provide factor services to help in the production of goods and services Households (Consumers) Inner Flow Firms (Producers) Real flow Provide final goods and services to households Payment for final goods and services Money flow Firms produce goods and services. To do so, they hire factors of production – labour, land, capital, and enterprise – from households. These factor services will then generate their respective income payments – wages, rent, interest, and profits. Households in turn spend their factor income on the consumption of goods and services. From this analysis, we can see that for an economy as a whole, all expenditure on the final output of a nation, which is equal to the money value of that output, ends up as someone’s income. However, households may decide to save part of their income, so not all the income is spent on goods and services. In this case, the savings go into the financial market (an intermediary), which in turn channels them into productive investments by the firms. The economy is at equilibrium when total saving is equal to total investment expenditure, since the total income (made up of Consumption and Saving) is equal to total spending National Junior College: Economics Department H1/H2 Economics (8843/9570) 4 2024 SH2 H1/H2 Economics Chapter 6 (made up of consumption expenditure by households and investment expenditure by firms). Here, in a 2-sector economy, total expenditure or spending is made up of: Basic flow of household spending - Consumption (C) spending Injections - Investment expenditure by firms/business (I) Expenditure on output flows as incomes (wages, profits, interest, and rent), and income is disposed of on consumption and savings. When expenditure equals to the money value of output, there is no change in the circular flow of income i.e. the circular flow of income is in equilibrium. Hence, the three values are equal due to the circular flow of national income. National Output = National Income = National Expenditure Factor incomes (wages, rent, interest, profits) HOUSEHOLDS FIRMS Consumption expenditure on goods and services Savings Investment expenditure Financial market Figure 1: The Circular Flow of Income in a 2-Sector Economy NATIONAL INCOME refers to the income generated from the production of goods and services by residents of a country within a specific period, normally a year. It is often used as a measure of the level of economic activities in a country. National Junior College: Economics Department H1/H2 Economics (8843/9570) 5 2024 SH2 H1/H2 Economics Chapter 6 In the real world, it is not as simple as this, i.e. the economy does not only consist of 2 sectors. In addition, not all income is passed on round the inner flow; some is withdrawn. Simultaneously, incomes are injected into the flow from outside. The extended circular flow model given below paints a more realistic picture of the real world, involving 4 sectors – households, firms, a government sector and the foreign/international sector. Injections Firms Investment Government Export Expenditure (I) Expenditure (G) Revenue (X) Factor Consumption of Payments domestically Financial Government Other produced Market Countries Inner Flow goods and services (Cd) Import Saving (S) Net Taxes (T) Expenditure (M) Households Withdrawals Figure 2: The Circular Flow of Income in a 4-sector economy In this 4-sector economy, total expenditure or spending is made up of: (a) Basic flow of household spending - Consumption (C) expenditure (b) Injections (J) (i) Investment expenditure by firms/business (I) (ii) Government expenditure by the government sector (G) (iii) Export revenue received from foreign buyers (X) National Junior College: Economics Department H1/H2 Economics (8843/9570) 6 2024 SH2 H1/H2 Economics Chapter 6 Spending may not be equal to the money value of output because of withdrawals and injections. 1. Withdrawals / Leakages A leakage is a withdrawal of potential spending from the circular flow of income. It occurs when any part of income, which results from the production of domestic goods and services, is not used to buy domestic goods and services. It contracts the income-expenditure stream. The three leakages are saving (S), net taxes (T) and import expenditure (M). 2. Injections An injection is an addition of spending to the circular flow of income. It consists of any expenditure on domestic goods and services other than consumption expenditure. It increases the income-spending stream. The three injections are investment expenditure (I), government expenditure (G) and export revenue (X). Firms may choose to invest more or less than what households wish to save; governments can spend more or less than what they receive in taxes; and export revenue can exceed import expenditure or vice versa. Thus planned injections may not equal planned withdrawals. A net withdrawal contracts the income-expenditure stream thus reduces the level of income. A net injection would increase the level of income. When spending is not equal to money value of output, the circular flow of income is in disequilibrium. Fluctuations in the level of economic activities will arise e.g. increase / decrease in production, employment, etc. Fluctuations in the level of economic activities represent the changing gap between the full capacity level of output (potential output/ full employment output) and actual output of a nation. Such economic fluctuations i.e. trade/ business cycles differ in their severity and duration, with periods of expansion alternating with periods of depression. The phases are boom (prosperity/expansion), recession (downswing), depression (trough/slump), and recovery (revival/upswing). National Junior College: Economics Department H1/H2 Economics (8843/9570) 7 2024 SH2 H1/H2 Economics Chapter 6 The economy is at equilibrium again when the total injections equals the total withdrawals. Thus, an additional condition for equilibrium of national income for a 4-sector economy is: Total injections = Total withdrawals 1.3 LIMITATIONS OF THE CIRCULAR FLOW OF INCOME MODEL 1. In macroeconomics, when assessing the performance of an economy, we would look at other macroeconomic indicators such as unemployment rate, inflation rate and balance of trade position (H2 only) other than national income statistics (for economic growth). As a model, the circular flow of income does not capture these indicators and therefore, we have to turn to the aggregate demand/aggregate supply model. 2. In addition, suppose the economy experiences a sudden large inflow of injections through surge in export revenue, does this mean that the economy’s income will definitely increase by the same change in injections? Here is a similar situation: Suppose that during your next PE lesson, you are offered $2 for every round you run around a jogging track in the next 24 hours. Would you be able to earn infinitely? The answer is clearly no! This is because you are constrained by your fitness, energy and of course, your time. By the same extent, the economy is constrained by the amount of resources that it has at its disposal, as there is a finite amount of factors of production that reside within any economy. However, the circular flow of income model does not capture the limits due to resource constraints very well. This brings us to the AD-AS model below. National Junior College: Economics Department H1/H2 Economics (8843/9570) 8 2024 SH2 H1/H2 Economics Chapter 6 2. AGGREGATE DEMAND AND AGGREGATE SUPPLY Learning Objectives: ❖ Explain the definition, formula and slope of AD. ❖ Identify and explain the components of AD, including the determinants of each component of AD. ❖ Distinguish between what causes a movement along and a shift of the AD curve. ❖ Distinguish between autonomous and induced expenditure. ❖ Explain the definition and slope of AS. ❖ Identify and explain the determinants of AS. ❖ Distinguish between what causes a movement along and a shift of the AS curve. ❖ Explain how equilibrium national income and general price level is determined in the AD-AS model. ❖ Apply the AD-AS model to explain how equilibrium national income and general price level is determined and analyse the effect of a shift in AD curve. The concepts of aggregate demand (AD) and aggregate supply (AS) can be used to show the impact of changes in variables on the real economy such as the equilibrium real national income and general price level. Using the AD-AS model, we will also be able to demonstrate how macroeconomic policies affect the general price level as well as output, illustrating the trade-offs policy makers sometimes face. We will start off with the definition, slope and components of AD before understanding the key determinants of each AD component and then distinguishing between what causes a movement or a shift in the AD curve. In the later section, we will repeat the same process to understand what the aggregate supply of the economy is to complete our understanding of the AD-AS model. DEFINITION: Aggregate Demand (AD) is the total value of domestically produced final goods and services demanded by households, firms, the government and foreign countries at each price level in a given time period. National Junior College: Economics Department H1/H2 Economics (8843/9570) 9 2024 SH2 H1/H2 Economics Chapter 6 Before we look into the key determinants of aggregate demand and aggregate supply of the economy, an important distinction needs to be made between nominal national income (nominal /money value of output) versus real national income (real output). 2.1 REAL VERSUS NOMINAL VALUES Nominal national income, sometimes called ‘money national income’ or ‘national income at current prices’, measures national income in the prices ruling at the time (i.e. current prices) and thus does not take into account inflation. Real national income measures national income in the prices ruling at some particular year – the base year. Thus, we could measure each year’s national income in, say, 1990 prices. It is sometimes referred to as “national income at (base year) prices” or “national income at constant prices”. By keeping prices constant at the base year level, we are able to see how much real income or output had changed from one year to another. In other words, it would eliminate increases in money national income that were merely due to an increase in prices so that we can get a true picture of how a country’s output has changed. Real national income thus takes inflation into account by deflating the nominal national income by the change in price level. The formula for estimating change in real national income is as follows: % Change in Real Income = % Change in Nominal Income – % Change in Price Level As we proceed on to look at the key determinants of aggregate demand, it must be noted that only real values will be addressed. But first, let us understand why the AD is downward sloping i.e. the slope is negative. Recall that Aggregate Demand (AD) shows the total value of final goods and services that households, firms, the government and foreign countries want to buy at each price level in a given time period. National Junior College: Economics Department H1/H2 Economics (8843/9570) 10 2024 SH2 H1/H2 Economics Chapter 6 This spending consists of 4 elements: consumer expenditure (C), investment expenditure (I), government expenditure (G), and the expenditure by foreign residents on the country’s goods and services (i.e. their purchases of the country’s exports) (X). From these expenditures, any expenditure on imports (M) must be subtracted since import expenditure ‘leaks’ abroad, and thus is not therefore spent on domestic goods and services. Hence: AD = C + I + G + (X – M) 2.2 THE AGGREGATE DEMAND CURVE Like the demand curve for a good, the aggregate demand (AD) curve is drawn downward-sloping with respect to the general price level in the economy, as seen in Figure 3. The AD shows the total amount of real output all economic agents would like to purchase at different price levels within the economy, ceteris paribus (i.e. all factors influencing AD, except the price level, are held constant). General Price level P1 P2 AD 0 Real National Output Y1 Y2 Figure 3: Aggregate Demand Curve National Junior College: Economics Department H1/H2 Economics (8843/9570) 11 2024 SH2 H1/H2 Economics Chapter 6 There are a few reasons for the inverse relationship between general price level and real output. One reason is that consumers keep some of their wealth in dollar amount, such as cash, savings accounts etc. Whenever the price level falls, the purchasing power of such wealth rises, causing consumers to increase their expenditure, resulting in higher real output/income. Another reason is that, as domestic price level falls, ceteris paribus, the country’s exports become more competitive and so quantity demanded for our exports rises abroad. At the same time, as imports are now relatively more expensive, domestic consumers will purchase more domestically produced goods and less imports, thus (X-M) increases, resulting in an overall rise in real output. NOTE: 2.3 KEY DETERMINANTS OF AD AD refers to the expenditures on the domestic output produced within the economy and excludes Aggregate demand is the total planned expenditure, in real terms, on expenditures on imports. This is because import expenditure is domestically produced goods and services in an economy and consists of: spending that ‘leaks’ abroad and is not therefore spent on domestic Consumption expenditure by households (C) goods and services. Investment expenditure by firms (I) Government expenditure by the government (G) Net Exports (X-M) by the international sector → which is expenditure by foreigners on domestically produced goods and services (i.e. export revenue, X) MINUS local expenditure on goods and services produced overseas (i.e. import expenditure, M) AD = C + I + G + (X – M) 2.3.1 CONSUMPTION Households buy goods and services ranging from cars and food to theatre performances and electricity. Indeed, consumption is the single most important factor and the cornerstone underlying Keynesian economics because: a) C is the largest component of aggregate demand; b) It increases as national income increases, which leads to further increase in national income. National Junior College: Economics Department H1/H2 Economics (8843/9570) 12 2024 SH2 H1/H2 Economics Chapter 6 The relationship between consumption and income is expressed as: C = a + bY [a = autonomous consumption; bY = induced consumption, i.e. consumption that is dependent on income] Consumption is determined by 2 factors: a) income determinant b) non-income determinant Consumption A: Income determinant  Induced C B: Non-income determinants  Autonomous C Income Expectations of future prices and incomes Changes in interest rates / Cost and availability of credit Wealth effects Movement along the C function Income distribution Government policy (Fiscal Policy) Note: The impact on (induced) Lifestyle, habits and attitudes consumption depends on the slope Demographics of the C function, which is given by the marginal propensity to consume (MPC). Shifts in the C function Figure 4: Flowchart on Consumption Determinants A. Income Determinant of Consumption It is observed that consumption is primarily dependent on income. The relationship between consumption and income is known as the consumption function. The consumption function shows that as national income increases, so does consumption because as households earn more, they can afford to spend more. This increase in consumption caused by an increase in income is called induced consumption. National Junior College: Economics Department H1/H2 Economics (8843/9570) 13 2024 SH2 H1/H2 Economics Chapter 6 Consumption C = a + bY C MPC = slope of C line Y a Nominal national income 0 Figure 5: The Consumption Function The Marginal propensity To Consume (MPC) The marginal propensity to consume is the proportion of any increase in national income that is spent on consumption. It shows the change in consumption expenditure as a result of a change in income. That is, MPC = C/Y. MPC can be shown by the slope of the consumption function. It is a constant for straight-line consumption function. With a curved consumption function, MPC diminishes with increasing income. The Marginal Propensity To Save (MPS) The marginal propensity to save shows the change in savings as a result of a change in income. That is, MPS = S/Y. Note that MPC + MPS = 1 (as Y = C + S in a simple 2-sector economy). On the other hand, the proportion of income spent on consumption (C/Y) is known as Average Propensity to Consume (APC) while the proportion of income that is saved (S/Y) is the Average Propensity to Save (APS). Empirical studies show that as income increases, both savings and consumption rise but the percentage of income used for consumption (i.e. Average Propensity to Consume (APC)) decreases whereas the percentage of income saved (i.e. Average Propensity to Save (APS)) increases as the level of income increases. The higher the income, the larger the APS, and the smaller the APC. National Junior College: Economics Department H1/H2 Economics (8843/9570) 14 2024 SH2 H1/H2 Economics Chapter 6 Movements Along and Shifts in the Consumption Function The effect on consumption of a change in the national income [income determinant] is shown by a movement along the consumption function. A change in any of the non-income determinants is shown by a shift in the consumption function. Consumption Consumption C1 C C C1 C2 C2 C2 C1 C3 0 Nominal 0 Nominal Y1 Y2 National Y0 National income income Figure 6: Movement along vs. Shifts in the Consumption Function B. Non-Income Determinants of Consumption Expectations of future prices and incomes If people expect the prices of consumer durables to rise in the future, they will tend to buy them now before the prices actually increase. If people expect their future incomes to rise, they are likely to spend more now. Conversely, if people expect an impending recession and their incomes to fall or fear that they may lose their jobs, they are likely to reduce their consumption spending. Changes in interest rates / Cost and availability of credit If the interest rate falls, the cost of borrowing falls and people are encouraged to borrow more for spending on consumer durables like washing machines, furniture and cars. The ease of credit also encourages more spending. If the interest rate falls, the returns on saving deposits fall and the opportunity cost of spending thus falls. As a result, savings may fall, and individuals may increase current consumption. National Junior College: Economics Department H1/H2 Economics (8843/9570) 15 2024 SH2 H1/H2 Economics Chapter 6 If the interest rate falls, there is a rise in ‘discretionary incomes’. Mortgage and other loan repayments may fall which means that consumers have more money in their pockets at the end of each month and consumer expenditure may rise. Wealth effects Wealth refers to the total value of assets owned by an individual at a point in time. The more wealth people have, whether in the form of real assets (houses, television sets and other durables) or financial assets (accumulated savings, shares, etc), the more likely they are to spend out of current income. For example, when the value of housing and other assets is rising faster than income, individuals see a rise in their net worth (the difference between the value of their assets and liabilities) and this increases consumer confidence and causes consumer expenditure to rise. Income distribution The poor tend to have a higher MPC as they are less likely to have met all their needs due to their lower income. When they experience an increase in incomes, they are likely to spend a greater proportion of the increased income on consumption. The rich, on the other hand, are likely to save a larger proportion of any increase in their income, as their consumption needs are likely to have been met. Hence, a distribution of income from the rich to the poor is likely to raise consumption spending in the economy. Government policy (Fiscal Policy) If the government raises the income tax, a fall in consumption is likely to occur as disposable income falls. Disposable income refers to income after the deduction of personal income taxes and the addition of transfer payments such as unemployment and welfare benefits. National Junior College: Economics Department H1/H2 Economics (8843/9570) 16 2024 SH2 H1/H2 Economics Chapter 6 Lifestyle, habits and attitudes The more materialistic the society is, the more the people are likely to spend. Conversely, if the people in a society are generally thrifty and financially prudent, consumption spending will be lower. Demographics The age structure of the population has an impact on household consumption. Consumer spending in future years may be limited by the rising number of 30–50 year-olds and pensioners in the population of a country. Young consumers between the ages of 18 – 30 will spend more than their current income. They undertake a large number of credit- financed purchases especially relating to housing. In middle age, consumers spend less than their current income. They repay their mortgage and other loans and increase savings for retirement. When consumers reach pensionable age, they spend more than their current income as their incomes fall sharply and they use up savings. Changes in consumption due to non-income determinants are termed as changes in autonomous consumption. 2.3.2 INVESTMENT Investment is the act of acquiring new fixed capital assets (e.g. new plants, new machinery) and accumulating physical stocks and inventories (e.g. raw materials, semi-finished goods and finished goods held by the producer). Economists separate investment into fixed capital formation and changes in stocks. National Junior College: Economics Department H1/H2 Economics (8843/9570) 17 2024 SH2 H1/H2 Economics Chapter 6 For Conceptual Understanding: Investment refers to an increase in the stock of capital. Capital may be defined as man-made goods that are used in the production (or supply) of goods and services. Examples are machinery and equipment, raw materials, intermediate products and factory buildings. Finished goods which are stored as inventories are also considered as capital since they can be used to increase the supply of the goods in future. “Fixed capital” refers to capital that is not used up in the production cycle (apart from wear and tear) and can continue to be re-used for the same production process e.g. machines. “Circulating capital” refers to capital that is used up directly in the production cycle and cannot be re-used once it is used e.g. raw materials, intermediate goods and inventories of finished goods. Types of Investment a) Fixed Investment – refers to the acquisition of fixed capital assets such as machinery and equipment, buildings and infrastructure. Fixed investment may be undertaken by private firms e.g. a company setting up a new factory, or by the government e.g. building a new road or MRT line. b) Inventory Investment – refers to an increase in inventories of circulating capital, which may include stocks of raw materials, intermediate goods, semi-finished goods and finished goods c) Foreign Direct Investment – refers to the acquisition of a controlling ownership (and thus significant influence) of an enterprise in a country by a foreign firm or investor. This may include a foreign investor buying over an existing firm in the country, or establishing a new firm in the country that is wholly owned by the foreign investor e.g. setting up an office or factory in the country by a foreign firm. The former may not involve any fixed investment as it is only a change in ownership, while the latter would result in an increase in fixed investment as there would be an increase in fixed capital goods such as plant and machinery. The total investment expenditure in the country may include both domestic and foreign investment. d) Investment in human capital – “Human capital” refers to the knowledge, skills and attributes of a person that can be used for the production of goods and services and are acquired through training and experience. Investment in human capital thus refers to the act of increasing the competencies (knowledge, skills and attributes) of a worker through spending on education and training. THINK ABOUT IT: How is the economic definition of investment different from “financial investment” as commonly used by the layman or in financial planning? National Junior College: Economics Department H1/H2 Economics (8843/9570) 18 2024 SH2 H1/H2 Economics Chapter 6 Fixed capital such as plant and machinery is subjected to wear and tear and needs to be replaced eventually. This is known as “capital consumption” or “depreciation”. Part of the investment is used to replace worn out capital and does not mean an actual increase in the stock of capital. The total amount of investment is known as Gross Investment. The net addition to capital stock (or Net Investment) is thus obtained by deducting capital depreciation (replacement investment) from Gross Investment. Net Investment = Gross Investment – Depreciation. Why do firms invest? The reasons for undertaking an investment project may be varied. They may include the following: To take advantage of higher expected profits from expanding output To generate a rise in productive capacity to meet increased demand To improve efficiency via technological progress To exploit economies of scale As a barrier to entry (some investment projects may give firms significant cost advantages which may deter new firms from entering a market) As part of a long run process of capital/labour substitution (higher wage costs relative to capital costs would encourage this strategy) Determinants of investment: a) income determinant b) non-income determinants National Junior College: Economics Department H1/H2 Economics (8843/9570) 19 2024 SH2 H1/H2 Economics Chapter 6 Investment (I) determinants Income determinant  Induced I Non-income determinants  Autonomous I I = aY Interest rate The accelerator principle (this Business expectations is not required in the current Cost and efficiency of capital / syllabus) Technological progress Government policies Figure 7: Flowchart on Investment Determinants A. Income Determinant of Investment Investment that is dependent on the rate of change in income is known as induced investment. The theory that explains the relationship between changes in investment and the rate of change in income is the accelerator theory, which is not required in the current syllabus. B. Non-income Determinants of Investment Autonomous investment is defined as investment that responds to firms’ long-term profit outlook as influenced by technical progress, population growth, and so forth, and therefore bears little or no systematic relationship with national income. Some non-income factors that may affect investment are given below. Interest rate determinant of Investment Interest rate The higher the interest rate, the higher the cost of borrowing and therefore the more expensive will it be for firms to finance investment projects. Given lower expected rate of return on investment, the less profitable will the investment be. This reduces investment in the economy. When interest rate rises, the opportunity cost of using internal funds to finance investment projects also rises. Some marginal investment projects may not take place if firms decide that they can attain a better rate of return by depositing their funds in a bank. National Junior College: Economics Department H1/H2 Economics (8843/9570) 20 2024 SH2 H1/H2 Economics Chapter 6 The relationship between the level of investment and the interest rate is given by the Marginal Efficiency of Investment function [MEI function]. Investment Function Investment function is represented as an inverse relationship between the rate of interest and the value of planned investment. This relationship is also known as marginal efficiency of investment (MEI). Interest rate r0 MEI 0 Planned I0 investment per year Figure 8: Marginal Efficiency of Investment Non-interest rate determinants of Investment Business expectations If business prospects were good, ceteris paribus, firms would not be deterred from investing further. They may even expect demand for their products to rise, and therefore increase investment to expand their production capacity. Cost and efficiency of capital / Technological progress If technology improves such that capital becomes more efficient, thereby increasing the returns from investment, investment is likely to increase. If the cost of capital increases eg. machines become more expensive, the expected rate of return from the investment will fall, hence investment decreases. Government policies Government policies that are pro-business can increase investment. For example, the government may lower corporate tax rates to increase the after-tax profitability of firms, thus encouraging investment. In the short run, non-income variables are the main determinants of investment. Investment is assumed to be autonomous in the short run. National Junior College: Economics Department H1/H2 Economics (8843/9570) 21 2024 SH2 H1/H2 Economics Chapter 6 2.3.3 GOVERNMENT EXPENDITURE When the government spends money in return for goods and services produced by firms, this counts as an injection. Examples of such government expenditure include spending on furniture, equipment, stationery supplies, utilities, building roads, hospitals and schools, and wages of civil servants. Government expenditure may include spending on consumption good and services as well as spending on investment / capital goods such as roads and railways. It is important to note that government expenditure in this model does not include state benefits and transfer payments. These transfer payments are the equivalent of negative taxes and have the effect of reducing the net taxes (T) component of withdrawals. Government expenditure depends on present and past government policy. As such, it is considered as autonomous expenditure (i.e. not dependent on the level of national income). Although we would expect the government in a poor country to spend less since it has lower tax revenue, it does not have to be so. A government can also borrow money to finance its expenditure. Ultimately, it is the government’s decision whether it wants to spend more or less than its tax revenue. Governments can run a budget deficit or surplus. There is no direct link between tax revenues and government spending. Government can always raise or lower taxes if necessary. In the short run, government expenditure can thus be regarded as independent of the level of national income and tax revenue. In our discussion here, G is assumed to be autonomous. The government will increase or decrease G in order to achieve an economy’s macroeconomic goals. National Junior College: Economics Department H1/H2 Economics (8843/9570) 22 2024 SH2 H1/H2 Economics Chapter 6 2.3.4 EXPORTS AND IMPORTS Four factors affecting exports and imports: 1. Income [at home and abroad] The amount that foreigners spend on domestic exports depends largely on their national income. Therefore, export revenue (X), depends largely on foreign incomes, not on domestic incomes. Import expenditure (M) however responds to changes in domestic national income. In Keynesian model, we assume that export revenue (X) is independent of domestic national income, i.e. autonomous. There are also 2 indirect links between a country’s national income and its export revenue (X). These indirect links will be covered in greater depth in later chapters e.g. Ch11b under changes in exchange rate and Ch15 under arguments against protectionism. If domestic incomes rise, more will be spent on imports. Domestic imports are other countries’ exports, thus there is an injection into other countries’ circular flow of income. This will cause a rise in other countries’ incomes and lead them to buy more imports, part of which will be domestic exports. A rise in domestic income will lead to a rise in imports. Ceteris paribus, this will lead to a depreciation in the exchange rate (due to supplying more domestic currency to buy foreign currencies in order to pay for the imports) and make it cheaper for people in other countries to buy this country’s exports. Export sales will rise. National Junior College: Economics Department H1/H2 Economics (8843/9570) 23 2024 SH2 H1/H2 Economics Chapter 6 2. Relative prices When domestic goods become relatively cheaper (perhaps due to lower inflation rate) as compared to foreign goods, then the differences in prices will lead foreigners to increase the quantity demanded of a country’s exports while domestic residents will reduce demand of imports and switch to consuming cheaper domestically produced goods instead. 3. Relative quality If domestic goods worsen in quality as compared to foreign goods, it is expected that demand of exports will fall and demand for imports will increase as consumers’ switch due to the change in tastes and preferences brought about by the differences in quality. 4. Exchange rate An appreciation of exchange rate will make exported goods more expensive in foreign currencies and imported goods cheaper in domestic currency. Thus, there will be a fall in export demand and increase in quantity demanded of imports due to the change in relative prices. National Junior College: Economics Department H1/H2 Economics (8843/9570) 24 2024 SH2 H1/H2 Economics Chapter 6 2.4 NON-PRICE FACTORS THAT SHIFT THE AD CURVE If there are changes to any of the components of AD due to a change in non-price and non-income factors, it would lead to a shift in the AD curve. Changes in these non-price, non-income factors are referred to as autonomous changes. Autonomous changes in C, I, G, (X-M) will cause a shift in the AD curve. Some examples of non-price, non-income factors that shift the AD curve: 1) Changes in Economic Outlook Changes in business confidence can exert a powerful effect on aggregate demand because of its effect on the rate of investment. When firms feel confident of buoyant sales, they will be encouraged to increase their investment, causing the AD to shift to the right, as shown in Figure 10. A surge in consumer confidence, e.g. they anticipate future incomes to increase, will increase consumption and also cause AD to shift to the right. The converse will happen when investors and consumers are pessimistic about the economic outlook. 2) Changes in Interest Rate With a fall in interest rate, it becomes less costly to borrow money for consumption and investment, hence, the aggregate demand for goods and services rises. However, the extent of the increase in investment and consumption will still depend very much on the predicted economic outlook. 3) Changes in Foreign Incomes When the incomes of other countries fall, demand for one country’s exports decreases, ceteris paribus, net exports will fall, shifting the AD curve to the left. An increase in our trading partners’ income (e.g. China) will lead to an increase in their demand for our exports (from Singapore), causing AD to shift right. National Junior College: Economics Department H1/H2 Economics (8843/9570) 25 2024 SH2 H1/H2 Economics Chapter 6 General Price Level P AD1 AD AD2 Real National Income / 0 Y2 Y Y1 Output Figure 10: Shifts in the Aggregate Demand Curve 2.5 KEY DETERMINANTS OF AGGREGATE SUPPLY DEFINITION: Aggregate Supply (AS) is the total value of final goods and services firms in an economy would like to produce at different general price levels. Note that there are important differences between the aggregate supply curve in the short run and the aggregate supply curve in the long run. The Short-Run Aggregate Supply (SRAS) Curve In the short run, economists believe the AS curve slopes upwards: as price level rises, more goods will be supplied. Clearly, as price level rises, firms have a greater incentive to supply more as they can make more profit. A rise in a firm’s output will lead to a rise in its marginal cost of production – to produce extra units of a good is more expensive due to higher input prices as shortages and bottlenecks in the factors of production arise, therefore, the firm requires a higher price to induce it to increase production. In Figure 11, a rise in the price level from P1 to P2 leads to an increase in the amount of goods firms plan / would like to produce, in a given time period, from Y1 to Y2. National Junior College: Economics Department H1/H2 Economics (8843/9570) 26 2024 SH2 H1/H2 Economics Chapter 6 General SRAS Price Level P2 P1 0 Real National Income / Y1 Y2 Output Figure 11: Movement along the Short Run Aggregate Supply Curve The Long Run Aggregate Supply (LRAS) Curve In the long run, when the economy reaches full employment at YF, all its resources are fully utilised. With the given state of technology and resources, it is not possible to increase output any further. The economy is said to have reached its productive capacity or full employment level of output. Since it is not possible for output to increase beyond this level, the long run aggregate supply is vertical, as shown in Fig 12. General LRAS Price Level PE AD 0 Real National YF Income / Output Figure 12: Determination of Long Run Equilibrium income using AD and AS analysis In Figure 12, the long run AS is a vertical line. It is not influenced by price level. It is determined by the productive capacity of the economy, which is determined by real factors such as the labour force and the skill it possesses, the size of the capital stock, technological progress that increases the productivity level. Hence, the LRAS is vertical or perfectly price inelastic with respect to the general price level. YF is thus referred to as the long run equilibrium output at full employment level, i.e. the National Junior College: Economics Department H1/H2 Economics (8843/9570) 27 2024 SH2 H1/H2 Economics Chapter 6 output at which the economy is operating at full capacity when the AS intersects AD. In addition, many economists also argue that at very low levels of aggregate output (e.g. when the economy is in a severe recession or depression), the AS is fairly flat as there is sufficient excess capacity for output to increase without any increase in prices. In order to capture this diversity of views, we can think of the AS curve as comprising 3 distinct segments as shown in Figure 13: the horizontal segment known as the Keynesian range; the positively sloped segment known as the intermediate range; the vertical segment known as the Classical range. General AS Price Level Classical Range: no excess capacity (during a boom) Keynesian Range: excess capacity (during a depression) P1 Intermediate Range: some excess capacity 0 Y1 Yf Real National Income Figure 13: Different ranges along the AS Curve Referring to Figure 13, Starting out at a price level of P1, the AS curve is a horizontal line up to real output level Y1, as there exists excess capacity such that any increase in production does not raise per unit costs. In this range, there are large amounts of unused capacity and significant unemployment. National Junior College: Economics Department H1/H2 Economics (8843/9570) 28 2024 SH2 H1/H2 Economics Chapter 6 Output level Y1 – Yf is where some sectors experience spare capacity but others do not. In other words, bottlenecks start to appear as the economy moves closer towards maximum capacity/ full employment Yf. Those sectors experiencing near-full capacity will find their per unit costs rising, and therefore prices charged for their commodities will rise. The general price level will therefore rise as output rises from Y1 to Yf. At Yf, there is no excess capacity - the economy is experiencing full employment of all its resources and using its technology to its fullest. The only thing that can happen is for prices to rise. Output cannot increase beyond Yf, which is the full capacity output level, also known as the potential output. Aggregate supply is therefore perfectly price inelastic. Factors that ONLY Shift the Short Run Aggregate Supply (SRAS) Curve As with the AD curves, we draw AS curves with just the general price level in the economy varying – other factors (including the nominal wage, cost of raw materials, technology, etc) are held constant. If there is a change in any of these factors, then the SRAS will shift (reference to Figure 14). 1) Changes in Input Prices or Costs of Production The prices of inputs will affect the SRAS if they do not reflect permanent changes in the quality of the factors of production. For e.g. if wages increase without corresponding increase in labour productivity, it will become more costly for suppliers to produce goods and services at every price level, causing the SRAS curve to shift to the left. The long-run supply curve (LRAS) will not shift since with the same supply of labour as before, potential output does not change. 2) Short Term Supply Shocks A short-term supply shock causes an unanticipated but temporary shift in the SRAS curve. It causes a significant but temporary increase or drop in aggregate supply. Examples of short-term supply shocks are bumper harvests and natural disasters such as floods. The former implies an increase in aggregate supply and the latter a decrease. In such cases, the effects of the harvests and disasters are only temporary, with no substantial change in the long run productive capacity, leaving the LRAS unchanged. National Junior College: Economics Department H1/H2 Economics (8843/9570) 29 2024 SH2 H1/H2 Economics Chapter 6 General SRAS2 Price Level SRAS SRAS1 P 0 Real National Income / Y2 Y Y1 Output Figure 14: Shifts in the SRAS Curve Factors that Shift BOTH the SRAS and LRAS Curves 1) Capital Stock The nation’s output depends on its stock of capital (K). Changes in the stock of capital will alter the amount of goods and services the economy can produce, ignoring problems of machines wearing out or becoming obsolete and needing replacement. Investing in capital improves the quantity and quality of the capital stock, increasing the SRAS (due to lower unit cost of production arising from higher efficiency) and LRAS (due to increase in factors of production and improved productivity that increase productive capacity) in the economy. 2) Labour Force An increase in the working population will tend to depress wages and increase the SRAS, ceteris paribus. The expanded labour force will also increase the economy’s potential output (i.e. total output the economy can produce in the long run), shifting the LRAS curve rightwards. A rise in the working population may be the result of an increase in total population or labour force participation rate. National Junior College: Economics Department H1/H2 Economics (8843/9570) 30 2024 SH2 H1/H2 Economics Chapter 6 3) Changes in Productivity of Factors of Production Increase in productivity can be due to: Increase in skills of the workforce e.g. through education and training Improvement in technology e.g. use of better machinery and equipment Better organisation of the factors of production e.g. better management methods, streamlining of processes A rise in the productivity of factors of production due to training of labour resources, technological advancement, infrastructure upgrade, increases in healthcare and educational investments etc. means that more output can be produced with the same amount of resources, thus leading to long term rise in aggregate supply and sustainable economic growth. At the same time, average cost of production falls as the same amount of input cost is divided by a larger output, the SRAS will increase too. 4