Macroeconomic models

Question 1

What is the circular flow of income model?

define

Answer 1

The circular flow of income model illustrates the relationship betwee various economic agents and how income flows around the economy to arrive at an equilibrium level of national income

Question 2

What are the characteristics of the circular flow of income model

Answer 2

1. Consumption expenditure (C) of domestic goods and services: households to GnS market to firms
2. National income (NY): firms to factor market to households
3. withdrawals (from households): savings (into financial instituitions) + taxes (to government) + import expenditure (to foreigners) W = S+T+M
4. injections (to firms): investment expenditure (from financial instituitions) + government expenditure (from government) + export revenue (from foreigners) J = I+G+X

Question 3

What happens when withdrawals is not equal to injections in the free market economy?

Answer 3

W>J: planned expenditure is insufficient to buy up GnS, firms are faced with mounting stocks of unsold goods, cut back on output and reduce employement of FOPs, income of households decrease, income falls causes withdrawals to fall and further rounds of income decrease until W=J again

W< J : planned expenditure is greather than output, firms will expand output by hiring more FOPs to replenish depleting stocks and HHs income increase, withdrawals in economy increases and further rounds of income increase until W=J

Question 4

What are the characteristics of an AD-AS diagram

Answer 4

1. AD curve (negative gradient): Aggregate Demand
2. AS curve (horizontal then turns to a vertical line): Aggregate supply
3. x-axis: national output/time OR real GDP/time
4. y-axis: General price level/$

Question 5

What happens when there is a change in GPL

3 things (State)

Answer 5

1. wealth effect/real balances effect
2. interest rate effect
3. international substitution (net exports effect)

Question 6

Explain the wealth effect

Answer 6

The wealth of households includes the value of financial assets and physical assets

Assuming unchanged nominal wealth, a fall in the GPL will increase the real value of household’s wealth. A their purchasing power has increased, they are thus more willing to consume more goods and services at this lower GPL. Hence, consuption rises, causing a rise in real GDP

Question 7

Explain the interest rate effect

Answer 7

When the average price of everything is lower, households and firms will need less money to conduct their activities. This enables them to save more, increasing the supply of loanable fund in the loanable fund market. This effectively plces downward pressure on interest rates.

The fall in interest rates will make it cheaper for households to borrow to purchase consumer GnS on credit and for firms to borrow for investment since the cost of borrowing money has fallen. Thus, C and I rise, causing a rise in real GDP

Question 8

Explain the international substituiton effect

Answer 8

When domestic GPL falls, assuming no change in the foreign exchange rate and foreign prices, the price of domestic goods relative to foreign goods falls and domestic goods become more price competitive then foreign goods.

This import expernditure (M) decreases as households switch to buying relatively cheaper domestic goods whilst export revenue increases as foreigners buy more local goods. Hence, net export revenue increases causing a rise in real GDP

Question 9

What are components that affect the shift of AD curve

AD = ?

Answer 9

AD = C +I +G + (X-M)
consumption expenditure, investment expenditure, government expenditure, net exports expenditure

I and G affect shift of AS as well

Question 10

What are factors that affect consumption expenditure

6 factors

Answer 10

1. expectation about future income level: consumer confidence and consumer pessimism
2. expecation of changes in households’ real wealth: if they expect stock markets to do well or for asset prices to increase, current consumption increases
3. expectation about future changes in GPL: if inflation is expected, current consumption increases
4. availability of credit: When banks are more cautious about lending money, ability of consumers ot obtain loans decrease, leading to lesser consumption
5. interest rate: when interest rate falls, cost of borrowing is lower and returns on savings are lower (encourages consumption)
6. personal income tax rate: if income tax rate increases, disposable income is lesser, consumption decreases

Question 11

What are the factors affecting investment expenditure?

3 in total

Answer 11

1. Interest rate: lower interest rate, cost of borrowing decreases, investements that were previously unprofitable are now profitable as the expected rate of returns are higher than interest rate.
2. availability of credit: credit crunch, banks less willing to provide credit, investments are curtailed.
3. expected rate of returns of investment:
   - expectations of future business conditions
   - technological advancement
   - corporate rate tax

Question 12

What affects planned government expenditure?

2 in total

Answer 12

1. Government policy in response to state of the economy: Some governments actively intervene to stabilise fluctuations in AD. When governments adopt an expansionary fiscal policy by increasing G, the result is a rightward shift in AD
2. Access to credit: when government revenue < expenditure (i.e. government is in a budge deficit) the government borrows money from individuals and banks, by issuing government bonds or securities. When governments persistently run big budget deficits, banks stop lending to the government in an attempt to reduce government expenditure

Question 13

What are factors that affect planned net exports expenditure?

4 in total

Answer 13

1. Foreign income levels: foreigners income levels affect their purchasing power
2. Prices of foreign goods relative to domestic prices:

• increase in foreign prices, households increase their pruchase of the noe relatively cheaper domestically produced goods (if demand for imports is price elastic then increase in foreign prices will lead to a more than proportionate fall in quantity demanded, and import expenditure decreases)
• foreigners to increase their purchase of now relatively cheaper imports instead of their domestically produced goods, demand for exports and hence export revenue increases.

3. Exchange rate: changes in exhcange rate will change the relative price of exports and imports
   - if the currency depreciates (weakens in value) foreigners will purchase more of these goods and services which are relatively cheaper than their own domestically produced goods

• on the other hand, the residents of the country will purchase more of the domestically produced goods than imported goods as they seem relatively more expensive in domestic currency and reduce their quantity demanded for imported goods.

4. protectionism: governments may adopt protecionist policy measures to restrict free trade to overcome neagtive impact that free trade bring

Question 14

What is the multiplier effect?

Answer 14

The multiplier effect occurs because injections of new demand into the circular flow of income stimulate further rounds of spending as expnditure by one party is income to another

When households buy goods and services, they incur expenditure. This spending by households would stimulate production. Firms and thus workers producing these goods and services would receive income, which would then be used to buy other goods and services. Process continues until new equilibrium is reached.
Overall, income would have risen across multiple rounds of induced spending

Question 15

What are the formulas for finding multiplier constant (k) ?

Answer 15

k = 1/(1-MPCd) = 1/MPW = 1/MPS+MPM+MPT

MPW = MPS+MPM+MPT

Question 16

What are things that affect SIZE of multiplier?

MPS factors

Answer 16

1. Country’s attitude towards thrift: Westerners attitude towards consumerism vs Asian mentality of saving for a rainy day
2. Social security system : Some countries have higher savings rate as their governments do not provide a social safety net (such as pension benefits, or free healthcare). Households in such countries are compelled to save more to prepare for old age and retirement (China)
3. Government policy: Singapore has one of the highest saving rates in the world due to compulsory savings in the form of Central provident fun (CPF) contributions
4. Distribution of income: Since higher income groups have higher MPS than lower income groups, a more inequitable distribution of income increases (more people with higher income more people with lesser income) and lowers the multiplier value

Question 17

What are factors that affect the SIZE of the multiplier value?

MPT and MPM factors

Answer 17

MPM factors:
- largely dependent on a country’s tax system; a country with higher tax rates will have higher MPT and thus a smaller multiplier size

MPM factors:
- largely depedent by a country’s factor endowment; lack of natural resources, import consumer goods and industrial raw materials, MPM higher compared to countries with large factor endowment
- openness to trade

Question 18

What are the factors that affect the EXTENT of the multiplier

4 in total

Answer 18

1. Leakages: dependent on the size of MPW
2. Lack of spare capacity: Multiplier effect can generate increases in real income, employment and output only if there is spare capacity in the economy. (Once an economy reaches full employment level, Yf, any further increases in expenditure only result in increase of nominal national income)
3. structural rigidities: Despite the presence of spare capacity, multiplier effect can be limited due to structural bottlenecks like a lack of skilled labour, fixed capital, or supply disruptions of raw materials
4. Time lag: Multiplier effect takes time to work in the real weorld, this could mean that several weeks or months for each successive round of spendings to happen.

Question 19

effects of AD shocks

full employement vs below full employment

Answer 19

below full employment:
- when AD falls, general price level does not fall, eqm is restored solely due to change in output
- reason for this is due to stickiness of factor prices (or inflexibility) which means that firms cannot reduce the prices to sell unsold goods hence they lower output and retrench workers

near/at full employment:
- rise in AD causes shortages and an unplanned fall in inventories of sotred unsold foods Firms ould respons by increasing productio and raising employment of FOPs. However, as economy is nearing full employment, firms are forced to use FOPs that are less and less suitable for production UCOP increeases, which means firms will only produce extra id it can be sold at higher prices.

Question 20

Causes in shift of AS

horizontal (short-run)

Answer 20

1. price of factor inputs: increase in px of dometic or imported inputs like crude oil or other raw materials will drive up the firms’ UCOP cause AS to fall
2. exchange rate: depreciation in value of the domestic currency will mean that domestic firms face a higher price for imported inputs in terms of domestic currency, thus driving up UCOP
3. government policies:
   - indirect tax rates
   - regulations

Question 21

Causes in shift of AS

vertical shift (long-run)

Answer 21

1. government policies that affect quantity of resources: governments provide tax incentives that attract foreign direct investment. This will increase the countr’s rate of capital accumulation, and if gross investment exceeds capital depreciation, capital stock will rise or immigration policies that affect a country’s labour resources
2. a change in quality of labour input: an increase in the educational levels and training in an economy due to an increase in investment of human capital will increase the skills of its people
3. change in technology: investment in new technology improves capital productivity and increases potential output of goods and services
4. Incidence of natural disasters: natural disasters like earthquakes and tsunamis may cause destruction and permanent decrease in the capital stock of a country. This lowers the firms’ ability to produce, reducing productive capacity of the economy and leading to decrease in AS