income & employment (green book) Flashcards
Circular flow of income: Households role
supply FOPs like labour, land, capital and entrepreneurship to firms which will utilise these factor inputs to produce G&S
Explain circular flow of income (indefinite circulation)
2 sector economy
- refers to how income (Y) earned by households are spent (as consumption expenditure C) on firms output of G&S
- the consumption expenditure is received by firms as their revenue, from which firms will make payment to the households in return (eg. wages, rental, interest and profits)
- these incomes earned by households will again translate into consumption expenditure which becomes the firms revenue for their output and thereafter firms will pay income to households
- if households spend all their incomes earned on buying domestically produced G&S, and if firms pay out all revenue to domestic households, the flow will continue indefinitely
Explain circular flow of income (reality, definite circulation)
4 sector economy
- households
- firms
- government
- foreign sector
- only part of the income received by households will be spent on G&S by domestic firms will the remainder will be set aside for savings (S), taxes (T) and expenditure on imported G&S (M)
Draw circular flow of income + explain
Diagram 1
- Savings, taxes and imports are leakages/withdrawals that lead to a contraction in income
- if there is an increase in withdrawals, households will spend less out of their given income on domestic goods
- domestic firms will produce less output and receive less revenue to pay income/FOPs leading to lower output, income and expenditure in circulation for the domestic economy
- Investment expenditure, government expenditure and export expenditure are injections
- these DO NOT arise from domestic household consumption
- will lead to an increase in expenditure and firms will hire more FOPs, which will increase output which generates more income and in turn, spending
Equilibrium level of real national income
reached when there is no tendency for national income to change
firms have no incentive to increase or reduce production in the next time period when there is no accumulation/rundown of inventories
- total spending by the 4 sectors of the economy = total income earned by FOPs
- all G&S produced by firms are bought up by the different sectors of the economy (if not, there will be an accumulation of inventories which will cause firms to reduce production in the next time period, causing the economy to contract)
- withdrawals = injections
Formula for AD
C + I + G + X - M
What is SRAS linked to
COP
What is LRAS linked to
QQT (quality, quantity, tech)
linked to productive capacity
Aggregate demand definition
–> total level of spending for an economy, based on the amount of domestically produced goods and services which households, firms, government and foreigners desire to buy, at each general price level
- reflects total demand or expenditure on domestically produced G&S
- C + I + G + X - M
Explain downward sloping AD curve
INVERSE RELATIONSHIP BETWEEN GPL AND RNY)
- Wealth effect
- when GPL falls, the purchasing power of households will increases
- assuming unchanged nominal income, households will be better off as that income can be used to buy more G&S
- this makes them wealthier and encourages them to spend more hence demand for G&S increases - Interest rate effect
- when GPL falls, households need less money to purchase a given quantity of G&S
- given a fixed supply of money, a fall in demand for money would cause interest rates to fall
- a lower interest rate encourages borrowing by households for consumption on interest sensitive items (eg. cars, houses) and by firms for investments
- quantity of G&S demanded for consumption and investment then increases - International substitution effect
- When GPL falls while foreign prices remain constant, domestic goods are cheaper than foreign substitutes and residents demand less foreign goods, hence M decreases
- foreigners also purchase more of this country’s G&S which are relatively cheaper
- hence greater quantity of domestic G&S demanded
Draw AD/AS curve
Diagram 2
Non price determinants of AD cause what kind of shift
RIGHT OR LEFT shift of AD curve
Non price determinants of AD: Consumer expenditure (C) (Autonomous/induced consumption)
–> incurred by households when they use their income to purchase final G&S to satisfy current wants
Autonomous consumption: consumption that is independent on the current level of RNY (dependent on non income factors eg. change in consumer confidence/interest rate)
Induced consumption: consumption that is dependent on the current level of RNY. (when the current RNY increases, households are more able and willing to purchase G&S)
Non price determinants of AD: Consumer expenditure (C) –> AUTONOMOUS consumption determinants
- Economic outlook + consumer confidence
- how optimistic consumers are about the future economy/income
- if they expect incomes to increase, they will be more willing to spend and C increases - Interest rates and access to credit
- fall in interest rates reduces the costs of borrowing, leading to an increase in borrowing by households to purchase interest sensitive items or big ticket items
- Returns on savings are also lower and opportunity cost of current consumption falls hence instead of saving in banks, households will increase consumption instead - Expectations of future prices
- if consumers expect prices to rise, they will buy more now because the G&S are cheaper now - Distribution of income
- redistribution from rich to poor in the form of higher income taxes for the rich and more benefits for the poor increases C
- the rich tend to spend less of any increase in income compared to the poor
- almost all income that the rich might save that has been distributed to the poor will be spent - Wealth
- value of assets that people own
- an increase in consumer wealth (eg. value of house increases), makes people feel wealthier and more willing to purchase G&S - Personal income tax
- if it falls, there will be more disposable income and purchasing power will increase, increasing C
- also leads to fall in MPT and less withdrawals
Explain Marginal efficiency and investment (MEI) + Diagram 3
according to the MEI theory, there is an inverse relationship between interest rate and investment
- 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
- at any instance, there will be many investment opportunities with varying MEI or expected rate of returns
- by ranking these opportunities from highest to lowest MEI, a downward sloping MEI curve will be derived (diagram 3)
- to decide whether to undertake an investment project, the rational firm will conduct a cost benefit analysis and only invest if it makes a profit (MEI > cost of borrowing)
- firms will undertake additional investment projects until Io units because MEI of these profits ≥ rate of interest and any investment beyond it will be unprofitable
Non price determinants of AD: Investment expenditure (I)
Diagram 4
–> act of acquiring new fixed capital assets (eg. buildings and machines) and accumulation of stocks and inventories (eg. finished, semi finished goods)
- Interest rates and access to credit
- the higher the interest rate, the more costly it is for firms to finance investment and hence the investments become less profitable
- follow MEI theory (look at MEI card)
- when interest rate falls, there will be more investment projects that would yield a MEI ≥ new lower interest rate
- hence fall in interest rate will lead to an increase in level of investments - Business confidence and expectations
- how optimistic firms are about their future sales and level of economic activity
- firms form their expectation by looking at the current state of the economy, political factors and global situation
- if firms become more optimistic, they will expect the MEI to increase (shift of MEI curve to the right) and investments will increase (diagram 4) - Corporate tax rates
- if the govt reduces the tax on profits of firms, their after tax profits increase, increasing their ability and willingness to invest causing a shift in MEI curve (diagram 4) - Tech changes
- improvements in tech stimulate investment spending because implementing new tech often requires new capital
- if cost of capital equipment falls or machines become more efficient due to tech, then ROI increase and MEI shifts (diagram 4)
Non price determinants of AD: Government expenditure (G)
- spending by govt on G&S within a country
- includes payment of salaries of govt workers (operational expenditure) and spending on public works and public investments on infrastructure (developmental expenditure)
- increases/decreases depending on how the govt plans spending to achieve goals/priorities (fiscal policy)
Non price determinants of AD: Net Exports (X-M)
- export expenditure are on G&S produced within the country and sold to foreigners and should be included in measurement of GDP/RNY
- import expenditure refers to domestic spending on G&S that have been produced in other countries and should be subtracted from GDP/RNY
- National income of trading partners/domestic households
- if income levels of trading partners increase rapidly, foreign demand for our G&S may rise due to their higher purchasing power hence our X increases and vice versa
- if we experience a rise in NY, residents have greater purchasing power and might demand more imports, causing M to rise
- WHILE NET EXPORTS WILL FALL DUE TO THE RISE IN IMPORT EXPENDITURE, THE INCREASE IN CONSUMPTION ON DOMESTIC GOODS DUE TO RISE IN NY WILL CAUSE AD TO INCREASE - Changes in other countries GPL
- if GPL in other countries rise, then demand for our G&S will rise if they are substitutes to the foreign g&s as they are relatively cheaper compared to foreign substitutes and X will increase
- however, residents will buy less of the relatively more expensive imported g&s and buy more of the domestic import substitutes hence M falls
- net exports rise - Exchange rates
- if SGD depreciates relative to trading partners, our g&s becomes cheaper in terms of foreign currency
- more foreigners switch to buying our goods and X increases
- foreign goods are now more expensive in SGD and residents reduce purchase of imports and switch to local products and M decreases
- net exports rise - Trade policies (Protectionism)
- tariffs or quotas on imports and export subsidies
- imposition of such policies by trading partners may reduce export revenue as it is harder to sell exports
- imposition of such policies by us reduce import expenditure and cause ppl to switch to domestic g&s, increasing AD
Definition of AS + diagram 5 + explanation
–> total value of output of g&s that domestic firms as a whole produce and sell at each GPL
diagram 5
- Horizontal/Keynesian range
- Real national output can increase without any increase in price
- AS is perfectly price elastic
- Real national output is much lower than the full employment level (Yf) and there is an abundance of un utilised and underutilised resources (SPARE CAPACITY)
- When AD increases, the abundance in spare capacity will allow producers to increase output production easily without having to increase the prices of g&s hence there is no pressure for GPL to increase - Upward sloping/intermediate range
- increase in real national output is accompanied by rising GPL
- resources like capital goods and raw materials become increasingly scarce as production levels rise and there is less spare capacity as resources are increasingly employed
- if AD increases, the increase in output to meet the shortage of goods will cause supply bottlenecks (eg. shortage of skilled labour) to emerge
- these bottlenecks force firms to rely on less efficient resources (like hiring less skilled workers), making it increasingly difficult to expand output
- however, the rise in prices makes production more profitable, incentivising firms to increase output despite constraints
- overall, there is a partial raise in prices and partial increase in output - Vertical/classical range
- beyond this, there is no possible increase in output while prices continue to rise
- AS is perfectly price inelastic
- economy has reached full employment and output can no longer rise as resources are fully employed
- if AD were to increase, only GPL would increase with no change in output
- Changes in Yf can only be brought about by changes in the productive capacity of the economy
How does the AS curve move
Increase/Decrease in GPL –> movement along AS curve
Non price determinants –> movement of AS curve (affects COP and productive capacity)
COP (input prices, govt policies) –> upward/downward shift of AS curve
Productive capacity (QQT, govt policies) –> leftward/rightward shift of AS curve
Explain upward/downward shift and left/right shift of AS curve + Diagram 6, Diagram 7
Diagram 6: COP
- increase in COP, curve shifts up and vice versa
- firms are willing to produce less at each given price level as the higher production cost will reduce possibilities for earning profits and vice versa
Diagram 7: Productive capacity
- increase in productive capacity, curve shifts right
Non price determinants of AS: Government expenditure (G)
- Change in input prices
- increase COP, AS shifts up - Change in quantity of resources
- increase the economy’s ability to produce more g&s, AS shifts right - Change in quality of resources
- increase in labour productivity
- can be achieved through human capital investment
- with greater productivity/efficiency, more g&s can be produced for every input employed (more output per unit input) , increasing productive capacity and AS shifts right
- the higher productivity also means lower unit COP if the wages of workers remain constant and AS shifts down as firms are willing to produce more at each price level as profits increase - Tech advancements
- Discovery of less costly ways of production and productive capacity increases, unit cost of production also falls
- Discovery of more efficient methods
- AS shifts down and right - Govt policies
- Influences the costs of production (eg. indirect subsidies lower COP and AS shifts down)
- well established property rights and contracts, proper law enforcement and crime prevention can lower business costs and reduce uncertainties arising from loss of property and personal injury
- will also encourage savings and investments in long term capital projects from local citizens and foreigners which increase productive capacity
eqm level of national income
When AD = AS
Effects of change in AD + Diagram 8
If AD increases, there will be disequilibrium as the aggregate quantity demanded exceeds aggregate quantity supplied
- there will be a rundown on the firms inventories which will cause these firms to step up on production in the next time period by hiring more FOPs like labour
- since NY is the monetary value of all g&s produced within the economy, when production level increases, RNY increases
- as the economy moves closer to full employment along the intermediate range of the AS curve, supply bottlenecks occur, forcing firms to rely on less efficient resources, making it increasingly difficult to expand output
- however, the rise in prices makes production more profitable, incentivising firms to increase output despite the constraints
- leads to movement along AS curve
- overall, firms respond to rise in AD by partially raising prices and partially increasing output
Diagram 8
- As GPL increases, the level of AD falls because of the wealth, interest rate and international substitution effects
- the shortage is eliminated when RNY increases to the new eqm level Y1 and GPL rises to P1
- the rise in eqm RNY from Y0 to Y1 reflects ACTUAL ECONOMIC GROWTH
Effects overall:
- increase in RNY –> actual econ growth and fall in unemployment
- Rise in GPL –> inflation
Effects of change in AS + Diagram 9 (up/down shift)
- At the initial GPL, AS > AD
- leads to an accumulation of stocks and inventories and will cause firms to lower prices to sell off the excess inventories
- as GPL falls, consumers are incentivised to consume more g&s due to wealth, interest rate and international substitution effect, represented by a downward movement along the AD curve
as GPL fall, firms will decrease output, represented by movement along the new AS curve) until the GPL falls to P2 where the eqm of RNY is higher at Y2 - Actual economic growth is achieved
Overall:
- increase in RNY –> actual econ growth and fall in unemployment
- Fall in GPL –> fall in inflationary pressure
Effects of change in AS + Diagram 10 (down and outward shift)
- tech change, increase in productive capacity and fall in COP
- at original P0, surplus is formed
- firms lower prices to clear stocks
- when GPL falls, all sectors of economy are incentivised to increase spending (movement along AD curve) due to wealth, i/r and international substitution effects
- as GPL falls, firms lower output (movement along new AS curve) until the new GPL, P1 and NY Y1 is achieved where the surplus is cleared and actual economic growth is achieved
- results in potential economic growth as Yf increases
- this expansion in productive capacity will also alleviate the existing supply bottlenecks and this would cause GPL to fall and RNY to rise
Overall effects:
- Increase in productive capacity: potential growth
- Increase in NY: actual growth
- Fall in GPL: fall in inflationary pressure
Multiplier
