Explain the factors affecting Aggregate Demand (AD), given the context of Singapore. [10]

This economics paper explains the factors affecting Aggregate Demand (AD) and Aggregate Supply (AS), given the context of Singapore. 

First and foremost, in economic theory, AD and AS represent the aggregate demand (AD) and supply (AS) respectively of all the goods and services in an economy. The level of real national output and the general price level are determined by the intersection of AD and AS on an AD-AS diagram.

THINK: how would you draw an AD-AS diagram to reflect the intersection of AD and AS?

In theory, AD refers to an economy’s total demand for domestically produced goods and services for a given general price level. AD = C + I + G + (X – M), where C represents consumption, I represents investment, G represents government expenditure, X represents exports, M represents imports, and (X – M) represents net exports. Real national output (or real national income) and the general price level is determined by the intersection of the AD and AS curves. The AD curve is downward sloping because the lower the general price level, the greater the quantity demanded for domestic outputs. As AD = C + I + G + (X – M), what affects the AD curve are the factors that influence each individual component, which are C, I, G and (X – M). An increase in any of these components of AD would shift the AD curve to the right, while a decrease would shift the AD curve to the left.

Consumption

First, consumption (C) refers to household’s expenditures on goods and services. Consumption is affected most by income and wealth. For instance, when the Singapore economy is booming, rising wages of workers, rentals of buildings and assets, company profits, and interest will raise households’ incomes, which will then in turn increase consumption. On the other hand, higher personal income taxes and increased social security contributions, for instance in Singapore’s case particularly such as increases in the amount in the Ordinary Account of the Central Provident Fund (CPF) that Singaporean workers have to set aside for their retirement, will lower disposable income, thus dampening consumption. Wealth consists of savings and assets. A booming Singapore stock or property market pushes the value of financial and property assets up, thus making household feel that they are wealthier, which would then cause them to consume more, thus in turn increasing the consumption level. Conversely, if the Singapore stock or property market faces a downturn, Singaporean households will feel that they are less wealthy, and thus they will consume less, thus in turn causing consumption to decrease. As wealth also consists of savings, it is thus also affected by taxes such as property taxes and capital gains taxes; however, in the case of Singapore there are no capital gains taxes. The higher these taxes are, the lower the consumption level will be. Since AD = C + I + G + (X – M), a rise in consumption will increase AD thus shifting the AD curve to the right, a drop in consumption will decrease AD, thus shifting the AD curve to the left.

Investment

Second, investment (I) refers to firms’ spending on capital goods. Investment is affected most by business expectations. For example, if a Singapore firm expects the demand for its goods to rise, it is likely that the firm would invest more currently in machinery and plant to boost its future capacity. This would thus increase the investment level in Singapore, and since AD = C + I + G + (X – M), a rise in investment would increase AD, and shift the AD curve to the right, whilst on the other hand a drop in investment would decrease AD, thus shifting it to the left.

Government expenditure or government spending

Third, government expenditure (G) refers to the government’s spending on publicly provided goods and services. Government expenditure consists of government spending on public goods and services and also on government investment in infrastructure; the amount that the Singapore government spends depends on the state of the economy, as well as the aims and objectives of the government in power. In this case, let us focus on government expenditure in general, for instance spending on teachers’ salaries and on the Singapore Armed Forces, rather than government investment. Since AD = C + I + G + (X – M), a rise in government expenditure would cause a rise in AD, thus shifting the AD curve to the right, whilst conversely, a drop in government expenditure will cause a drop in AD, thus the AD curve will shift to the left.

Net exports

Fourth, exports (X) refer to foreign purchases of domestically produced goods and services while imports (M) refer to domestic purchases of foreign produced goods and services. (X-M) forms the net exports of a country, which in Singapore’s case is very important given that Singapore is a small and open economy. Factors which affect exports and imports are the usual factors which affect demand and supply, such as tastes and preferences, disposable incomes of foreigners who purchase these goods, and prices of related goods to these exports, such as substitutes and complements. Exports may rise due to foreigners developing a preference for Singapore’s exports, possibly due to better marketing or better quality of goods produced. On the other hand, if other countries promote their products more, or have better or new products compared to Singapore, then Singapore will be expected to face rising demand for imports. Since AD = C + I + G + (X – M), a rise in exports would increase AD thus shift the AD curve to the right, if there is a drop in exports, the AD curve will shift to the left as AD decreases. A rise in imports would also cause a drop in AD, thus shifting the AD curve to the left, while a drop in imports would cause an increase in AD, thus shift the AD curve to the right.

  

In conclusion, the factors that affect Singapore’s AD are the factors which affect consumption, investment, government expenditure, and net exports. 

JC Economics Essays - This is a modified economics essay written by student JQ, which was originally written under timed conditions for an economics test. Do remember that it is very important to time yourself whilst practising for the economics essay examination, because you have to craft a well-written economics paper within a given time limit. When practising for any economics test, you could plan a structure or outline for 5 minutes, and then spend the rest of the time crafting your response. Do note that this economics paper has been cleaned up for spelling, grammar, and also for essay structure, and some of his arguments have been repositioned for easier flow. Do you find that this economics paper is easy to read and clear cut? How has the clear and direct structure made it easier for you to read this paper? In addition to these two basic questions on essay structure, when reading this economics essay, the other questions that you could ask yourself are: (1) how would you approach this essay? (2) What economics knowledge or information do you need to answer this essay question properly? (3) Also, should a diagram be drawn? Why or why not? (4) Did the writer of the essay answer the question adequately, not just in theory but also in bringing in the Singapore context? Do remember to read with a questioning mind when thinking through this essay. Thanks for reading and cheers. 

Explain with examples the multiplier effect using the AE-Y diagram (Keynesian cross diagram/ Keynesian 45 degree line diagram). [10]

Introduction to the Keynesian Multiplier Effect

What is the multiplier effect? The multiplier effect can be defined as the total change in income for a given change in injection. The formula for calculating the multiplier, k, is 1/ (1-MPC), where k refers to the multiplier, while MPC refers to the marginal propensity to consume out of national income on domestically produced goods. Alternatively, the multiplier can also be defined as 1/ MPW, where MPW is the marginal propensity to withdraw.

However, because not all of income is spent on domestically produced output, therefore, 1 - MPC =  MPS + MPT + MPM, where MPS, MPT, MPM refer to the marginal propensities to save, tax and import, respectively. Therefore, MPS + MPT + MPM = MPW, the marginal propensity to withdraw. Hence, more importantly, the final multiplier formula discussed in this Economics paper would be k = 1/MPW.

The Keynesian Cross Diagram (AE-Y)

(THINKING QUESTION: How would you draw the AE-Y diagram, and how would it look like? Do please be sure that you can draw and illustrate the various Economics diagrams properly. Perhaps you can try crafting the diagram under timed or simulated examination conditions.) 

In the AE function graph, Aggregate Expenditure is drawn against nominal National Income. 

Aggregate Expenditure refers to the total planned expenditure on domestic output for a given level of national income, whereas nominal national income (Y) refers to the total nominal income or total nominal value of output generated by the economy.

In the AE-Y graph, as the national income rises, the AE also rises. This is due to an increase in national income which leads to similarly an increase in personal income, therefore household consumption increases with a greater amount of money to spend. When consumption increases, induced expenditure also increases, where induced expenditure means that spending is income-dependent. 

It should be noted that the gradient of the graph is determined by the MPC. A higher MPC means that the graph would be steeper. However, households do not spend all their income on consumption on domestically produced goods. They also have to pay income tax, reducing their disposable income. Within their disposable income, a portion is saved and another is spent on imported goods. Therefore MPC < 1 where MPC = 1 - MPW. This explains why the AE curve is less steep than the Y=AE line.

(A numerical illustration could shed some light on the question.) The multiplier effect can be calculated using such a method. Suppose that the government spends $100 and assuming that the MPC = 0.8, induced consumption would rise by $80 (0.8x100). This would boost AE and cause consumption to rise again by $80, where (0.8x80)=$64 would be spent on consumption. After repeated rounds, the total income would increase by $500 (80+64+..). Therefore the multiplier effect is calculated by 500/100 (the original injection)= 5.

Insert AE-Y Diagram/Model with Corresponding Economics Explanation - Think: How Would It Look Like?

The size of the multiplier effect affects the usefulness of expansionary fiscal policy. Expansionary fiscal policy refers to the increase in government spending and/or a reduction in direct taxes, to achieve demand management at the macroeconomic level. With a large multiplier, the impact of expansionary fiscal policy would be greater. This is because a large multiplier would mean that nominal national income increases by a greater factor relative to the size of the injection. 

Comment on Singapore's Economy - Her Small Multiplier, k

However, it has to be said that in the case of Singapore, Singapore has a small multiplier due to our MPW being high. After all, Singapore is import dependent due to her lack of natural resources and has relatively high savings due to compulsory savings schemes such as CPF (Central Provident Fund), and thus has relatively high MPM and MPS, thus resulting in a high MPW. Therefore, the multiplier effect on Singapore would be limited to a very large extent. 

JC Economics Essays: (H2, H3 A Levels) Economics Tutor's Comments - This is a very short, sharp, and accurate Economics paper that addresses the requirements of the question posed directly. The Economics topic here is on the multiplier effect and the AE-Y diagram/ model. This is the basis of Keynesian economics. Students can learn a lot from this essay style of direct writing. However, the usual tutor's question applies: how can I make this Economics essay better? What can I learn from it, and what would I have written that the author missed? Or what has the author written here that I have not addressed? Special thanks to A. C. who contributed this Economics article (write up). Thank you for reading, and cheers. 

Discuss monetary policy and fiscal policy’s importance for the USA, in the light of stagflation.

Introduction to Monetary and Fiscal Policy, and Stagflation

Monetary policy means to control the money supply and interest rates to affect aggregate demand (AD) in an economy, according to what is known as demand-management. Fiscal policy is another demand-management policy that deals with manipulating government spending and direct taxes so as to affect AD. Stagflation is defined as a situation of low economic growth with high inflation - both stagnation and inflation. Inflation is defined as a persistent and sustained increase in the general price level (GPL), that poses a problem to society because this increase in GPL is sustained and inordinate. 

This Economics paper discusses the strengths and limitations of monetary and fiscal policy, each in turn, in relation to stagflation in the USA. This paper concludes that both policies are equally important for the US, but they should be used in conjunction with supply side policy. 

Monetary Policy

Monetary policy works, in theory, by two ways. First, according to the classical direct transmissions mechanism, increases in money supply help consumers spend more and firms invest more directly because they have more money and they feel richer. Second, according to the indirect transmissions mechanism, increases in the money supply lower the interest rate, which lowers the cost of borrowing. Since it is cheaper for households to borrow money to consume, and cheaper for firms to borrow money to invest, C and I both increase, and since AD = C + I + G + (X-M), then AD increases, which helps to solve unemployment and which also causes actual economic growth. 

Unemployment is defined simply as the situation where people who are able and willing to work cannot find jobs, or they are unwilling to take up the jobs at the wage rate given to them. Actual economic growth merely refers to increases in real output at the macroeconomic level caused by increases in AD. Hence, it would seem that prima facie, monetary policy can help solve unemployment and lack of growth in the USA, and hence fight stagflation by countering the “stagnation” part.  

Limitations of Monetary Policy

However, monetary policy might suffer from the liquidity trap, which means that beyond a certain point interest rates cannot be lowered further, thus hampering the workings of monetary policy. If interest rates cannot be lowered, the costs of borrowing cannot be reduced. This can be seen in an analysis of the liquidity preference theory put forth by Keynes. 

Fiscal Policy

On the other hand, Keynesian fiscal policy works when governments spend more, for instance on national defence and education, or when they tax less, through lowering income and corporate taxes. Increasing G raises AD directly given that G is one of the components of AD. Lowering direct taxes cause C and I both to increase, and since AD = C + I + G + (X-M), then AD also increases, which helps to solve unemployment and which also causes actual economic growth. Because of the multiplier effect, where the multiplier means that national income increases by a factor more than the initial increase in the injections into the economy, the USA’s AD will increase, promoting and boosting growth. 

In the USA, both C and I are large components of the AD. It can also be argued that G is also a big component given that the USA has a large military. Hence, it would seem that prima facie, fiscal policy can also help solve unemployment and lack of growth in the USA, and thus fight stagflation by countering the “stagnation” part.  

Limitations of Fiscal Policy

However, there are also limitations to fiscal policy, one of which is the famous “crowding out effect”. If governments run a budget deficit, and the USA is arguably famous for running both a budget as well as a trade deficit for many years, then they will have to borrow money. According to the loanable funds theory, this increase in demand for funds by governments will crowd out private consumption and investment, and hence C and I will fall despite G increasing, thus negating the effects of fiscal policy. The US government would be “crowding out” private consumption and investment. 

Supply Side Policies?

Hence, supply side policies that target the aggregate supply (AS) curve, which is affected by the factors of production which are land, labour, capital, and enterprise, could be better for the USA in handling stagflation. Subsidies for energy and other natural resources, increases in the US labour force in both numbers and quality, for instance by increasing American high school education and human capital, and increases in both the quantity and quality of American capital, plus encouraging immigration especially of entrepreneurial foreigners, would help massively. 

These methods and means would shift the AS curve both down and to the right and help solve cost push inflation in the USA. These would be better because they would solve both the “lack of growth” and “high inflation” aspects. 

Conclusion

In conclusion, perhaps both demand side and supply side policies should be used hand in hand, and together they can help solve stagflation because they encourage both potential and actual growth, which is great for the American economy. 

JC Economics Essays: Tutor's Comments - This Macroeconomics essay on monetary policy and fiscal policy, set in the context of the USA, is interesting and provides a suitable level of analysis. There are consistent references to the USA as well as relevant macroeconomic policies, and the underlying economic reasoning behind those policies. There are also well-defined terms that are explained clearly. Note: this particular Economics essay on the USA is related to the earlier Economics question on stagflation: Explain possible causes of stagflation in the USA. However, my usual question applies here: if you were the Economics tutor grading this Economics paper, what areas of improvement would you suggest? Let's look, for example, at the conclusion. While this essay's conclusion makes a good argument and tries to justify the argument made, there is a lack of detailed evaluation which could possibly make it an even better essay. What other areas of improvement for this Economics essay do you observe or notice? Thanks for reading and cheers!

Explain carefully what causes inflation [10]

Explain carefully what causes inflation. [10]

Inflation is a persistent and sustained increase in the general price level, or also defined by a persistent and sustained rise in the consumer price index. Inflation is caused by demand side factors or supply side factors, and these are called demand-pull inflation and cost push inflation respectively. A concatenation of increasing aggregate demand and rising costs cause inflation, although it is possible to have entirely demand pull inflation or cost push inflation. This paper discusses all these.

The AD-AS diagram below demonstrates demand pull inflation.

Insert diagram, AD-AS diagram: showing only demand pull inflation

AD comprises C + I + G + (X-M), which are consumer spending, investment spending, government spending, and net exports. If consumers spend more because of low interest rates encouraging borrowing, or if firms feel positive about future economic outlook, or if governments spend more money on military forces, or there is an export boom for local products exported overseas, then AD will shift to the right. Therefore, AD moves to AD’ and then AD’’, causing an upward shift in the general price level and therefore inflation, ceteris paribus. Hence, it is clear that excessive C, I, G or high exports with low imports will lead to demand pull inflation.

On the other hand, there is cost push inflation as well, where AS moves upwards from AS to AS’ and to AS”. This is demonstrated in the diagram below:

Insert AD-AS diagram showing cost push inflation

This is due to rising costs, and since the aggregate supply of goods and services in the economy is made up of various inputs, increases in the various inputs lead to rising costs. The supply of goods and services result from labour, capital, land and entrepreneurship. There are internal cost push factors. Rising wages or the rising power of trade unions demanding higher salaries, rising capital costs, and increasing scarcity of land and various input resources make cost push inflation a pertinent possibility. There are also external cost push factors. Exchange rates and the foreign sector can also lead to inflation if much of the goods produced use foreign inputs; hence there might be imported price push and exchange rate depreciations causing cost push inflation as well.

Thus, inflation can be caused by demand pull factors, cost push factors, or most probably and most conceivably, a combination of both. It depends on the particular situation.

JC ECONOMICS ESSAYS

PS Tutor's Note: Some Keynesian economists argue that it is primarily excess demand for goods and services that lead to such demand pull inflation, and other economists, namely the monetarists, claim that demand pull inflation is caused by excess money supply.

Tutor's Comments: A very well written essay! Well developed and relevant materials. Note: This economics essay paper was also written under examination conditions.