Book 7 II D - Effect of AD shocks

Describe US multiplier size + compare with SG

• For US: Larger multiplier size -> US has a rich resource endowment leading to a low MPM + higher MPC due to western consumerism culture

• The same initial rise in AD will lead to less income flowing back to domestic firms -> less income generation for subsequent parties in the economy in Singapore than the US -> smaller cumulative increase in real GDP for Singapore compared to US

MPS is affected by:

MPS (savings) affected by: 

Country’s attitude towards thrift	Americans have more consumerism compared to Asians (saving is a virtue) -> US k larger than Asian
Social security system	Governments with lack of strong social security net (pension benefits or free healthcare for its citizens) -> higher saving rate to prepare for retirement -> k smaller
Government policy	In SG, compulsory savings in Central Provident Fund (CPF) contributions
Distribution of income	Since higher income groups have higher MPS than lower income, a more inequitable distribution of income -> increase MPS -> lowers k

MPT and MPM affected by:

MPT (tax) affected by: Country’s tax system 

• Higher personal income tax rate -> higher MPT -> small k 

MPM (import) affected by: Country’s factor endowment 

• SG lack of raw natural resources -> import most goods -> high MPM -> smaller k as there are higher leakages

Elaborate on extent on AD shift (size of k, spare capacity, time lag, structural stuff)

Leakages (Size of k)	Higher MPW -> more of increase in income is leaked out of circular flow of income each round and less is spent on induced consumption of domestically produced goods and services -> reduces round of spending in multiplier process -> overall increase in national income smaller
Lack of spare capacity	Once economy reaches full employment, further increase in expenditure will only increase nominal national income -> no more increase in real income
Structural rigidities	Structural bottlenecks (lack of skilled labour) limit multiplier effect even if there is excess capacity
Time lag	Several weeks or months for multiplier to work

Describe impact of a fall in AD when the economy is below full employment + why GPL doesnt fall

• If the economy is initially in equilibrium at below full-employment level of output (there is spare capacity in the economy), Y0, when AD falls from AD0 to AD1 (due to fall in autonomous C, I, G or X), general price level does not fall

• Equilibrium is restored by adjustment in output level from Y0 to Y1

• This is due to downward inflexibility of factor prices

• In particular, wage rates may be fixed by contracts in the short run, so when AD falls, firms are not able to respond by lowering prices to sell off the unsold goods, since their unit costs cannot be changed in the short run -> firms have to lower output and retrench workers

• Real GDP falls by a multiple of the initial fall in AD via the downward multiplier process

Describe impact of a rise in AD when the economy is near or at full employment: (To show inflation)

• AD initially intersects AS at E0 where the economy is nearing the full employment level of output

• An AD shock causes AD to rise from AD0 to AD1, actual GDP rises to Yf

• This rise in AD will create shortages and cause an unplanned fall in inventories of stored unsold goods -> Firms would respond by increasing production and raising employment FOP

• However, as the economy is nearing full employment, firms will be forced to use resources that are less and less suitable for their production

• Thus, increasingly larger amounts of labour and other inputs are required per additional unit of output produced -> unit cost of production to increase (movement along intermediate range of AS curve)

• Firms will only produce extra output if it can be sold at higher prices

• Equilibrium is restored partly by the increase in the GPL from P0 to P1 and partly by the increase in the country’s output level from Y0 to Yf

Describe GDP and GPL effect when economy near Yf and at Yf

1. When an economy is nearing Yf

• An increase in AD results in minimal rise in real GDP and rise in GPL

2. Once the economy is already at full employment level of output, Yf

• Any further increases in AD from AD1 to AD2 will not cause real GDP to rise as all factors of production have been fully utilised

• Instead, equilibrium is restored by adjustment in the general price level, resulting in demand-pull inflation as GPL rises along the vertical segment of AS from P1 to P2

Describe 2-sector closed economy

2-sector closed economy (no gov)

Firms hire FOP (labour) from households (paying income, Y) Households spend this income on goods and services produced by firms (consumption expenditure, C) Model has no savings The entire income is spent: C=Y

Draw CFOI

Define W

• (Def.): are household’s income that is NOT passed on to domestic firms through spending on goods and services produced by these domestic firms

• W = savings (S) + taxes (T) + import expenditure (M)

Define J

• (Def.): Income receipts by domestic firms that do not arise through households’ spending

• J = investment expenditure (I) + government expenditure (G) + export revenue (X)