Economics Lecture Notes – Chapter 9

NATIONAL INCOME DETERMINATION will be covered in the third, fourth, and fifth weeks of term 1 in economics tuition.

Students can refer to Economics – A Singapore Perspective for the diagrams. The book is available in the major bookstores in Singapore.

1          INTRODUCTION

In Chapter 8, we learnt that national output/national income is an important economic variable which is used for several purposes such as measuring the size of an economy and the standard of living. However, the determination of national output/national income is omitted from the chapter. In order to have a good understanding of national output/national income, we need to understand how national output/national income is determined. Different schools of economic thought such as the Classical school, the Keynesian school and the Neoclassical school have different views of how national output/national income is determined. This chapter provides an exposition of the determination of national output/national income.

2          THE CLASSICAL THEORY VERSUS THE KEYNESIAN THEORY

‘Classical economists’ is a term coined by Karl Marx to refer to economists who founded Ricardian economics. These economists include David Ricardo and his predecessors. John Maynard Keynes included in the Classical school economists who adopted and developed Ricardian economics. These economists include John Stuart Mill, Alfred Marshall, Francis Ysidro Edgeworth and Arthur Cecil Pigou. The above list of names may seem confusing but they are not important for the examination. Nevertheless, it is useful to have a basic understanding of Classical economics. For this purpose, one can think of Classical economists as those who were writing before John Maynard Keynes.

Classical economists believe that the economy is a self-correcting mechanism and hence it is always at the full-employment equilibrium. According to Classical economists, this is because prices and wages are totally flexible. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. Suppose that the economy is at the full-employment equilibrium. Further suppose that aggregate demand falls. When aggregate demand falls, firms will decrease production which will lead to a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income. When national output falls from the full-employment level, unemployment will occur which will lead to a downward pressure on wages. As wages are totally flexible, in Classical economists’ view, they will fall immediately which will lead to an immediate fall in the cost of production in the economy. When this happens, firms will increase production resulting in national output and hence national income returning to the full-employment level. Therefore, the Classical aggregate supply curve is vertical at the full-employment national output/national income. Aggregate supply is the total supply of goods and services in the economy over a period of time and is determined by the production capacity and the cost of production in the economy. With a vertical aggregate supply curve, an increase in aggregate demand will only lead to a rise in the general price level without having any effect on national output and hence national income. National output and hence national income will rise only when there is an increase in aggregate supply. As the Classical aggregate supply curve is vertical, it is only determined by the production capacity in the economy. A change in the cost of production in the economy will not affect a vertical aggregate supply curve.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 does not have any effect on national output and hence national income (Yf). It only leads to a rise in the general price level (P) from P0 to P1.

In the above diagram, an increase in the production capacity in the economy and hence aggregate supply (AS) from AS0 to AS1 leads to an increase in national output and hence national income (Yf) from Yf0 to Yf1. Therefore, Classical economists argue that the government should focus on increasing the production capacity in the economy and hence aggregate supply to increase the amount of goods and services available for consumption and hence the standard of living. In this sense, Classical economics is supply-side economics. Supply-side policies to increase the production capacity in the economy and hence aggregate supply will be explained in greater detail in Chapter 12.

Classical economists were challenged when the market economies were hit by the Great Depression in the 1930s during which there was prolonged and mass unemployment. The Great Depression proved that the economy was not a self-correcting mechanism, at least not in the short run. For example, the national output and hence the national income of the United States stayed below the full-employment level for most part of the 1930s. The Great Depression gave John Maynard Keynes a ready audience. In 1936, John Maynard Keynes published the book ‘The General Theory of Employment, Interest and Money’ to explain the prolonged and mass unemployment in the Great Depression.

Unlike Classical economists, Keynes believes that the economy is not a self-correcting mechanism and hence it can stay at a below-full-employment equilibrium. According to Keynes, this is because prices and wages are rigid, especially in the downward direction.  Suppose that the economy is at the full-employment equilibrium. Further suppose that aggregate demand falls. When aggregate demand falls, firms will decrease production which will lead to a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income. When national output falls from the full-employment level, unemployment will occur which will lead to a downward pressure on wages. As wages are rigid, in Keynes’s view, they will not fall and hence the cost of production in the economy will not fall. In the absence of a fall in the cost of production in the economy, firms will not increase production and therefore national output and hence national income will stay at a below-full-employment level. Keynes attributes the prolonged and mass unemployment in the Great Depression to a prolonged and huge deficiency in aggregate demand and downward rigidity of wages. Unlike the Classical aggregate supply curve which is vertical, the Keynesian aggregate supply curve is inverse L-shaped. When national output is below the full-employment level resulting in unemployment, firms can increase output without pushing up wages. Therefore, although an increase in national output will lead to an increase in the total cost of production in the economy, it will not affect the average cost of production in the economy. As the average cost of production in the economy will remain the same, firms will not need to increase prices to maintain profitability. Therefore, the Keynesian aggregate supply curve is horizontal at the general price level up to the full-employment national output/national income. Once full employment is reached, the economy cannot expand output any further and hence the Keynesian aggregate supply curve is vertical at the full-employment national output/national income. Therefore, the Keynesian aggregate supply curve is inverse L-shaped. Keynes believes that unemployment is the normal state of the economy which means that the economy generally produces on the horizontal portion of the aggregate supply curve, and this is not surprising given that he is writing against the backdrop of the Great Depression. With an inverse L-shaped aggregate supply curve and unemployment in the economy, an increase in aggregate supply due to an increase in the production capacity in the economy will not lead to an increase in national output and hence national income. National output and hence national income will rise only when there is an increase in aggregate demand.

In the above diagram, an increase in aggregate supply (AS) from AS0 to AS1 does not have any effect on national output and hence national income (Y).

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to an increase in national output and hence national income (Y) from Y0 to Y1. Therefore, Keynes argues that the government should focus on increasing aggregate demand to increase the amount of goods and services available for consumption and hence the standard of living. In this sense, Keynesian economics is demand-side economics. Expansionary demand-side policies to increase aggregate demand will be explained in greater detail in Chapter 12.

The Keynesian aggregate supply curve encountered a problem when an economist at the London School of Economics and Political Science, A.W. Phillips, published a paper in 1958 titled ‘The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957’. Using UK Data from 1861 to 1957, A.W. Phillips found an inverse relationship between the rate of change of money wage rates and the unemployment rate. In 1960, two economists at Massachusetts Institute of Technology, Paul Samuelson and Robert Solow, reasoned that since wages were a major component of costs and since higher costs get reflected in higher prices, the inflation rate should also be inversely related to the unemployment rate. Looking at US data from 1933 to 1958, they indeed found such a trade-off, and in honour of A.W. Phillips, named it the Phillips curve.

In the above diagram, the short-run Phillips curve (SRPC) is downward sloping due to the short-run inverse relationship between inflation and unemployment. A fall in the unemployment rate (m) from m0 to m1 will lead to a rise in the inflation rate (p) from p0 to p1. Conversely, a fall in the inflation rate (p) from p1 to p0 will lead to a rise in the unemployment rate (m) from m1 to m0.

The implication of the downward-sloping short-run Phillips curve is that the aggregate supply curve cannot be inverse L-shaped. If the economy is producing on the horizontal portion of an inverse L-shaped aggregate supply curve, an increase in aggregate demand will lead to an increase in national output resulting in lower unemployment. However, it will have no effect on the general price level and hence there will be no inverse relationship between inflation and unemployment. If the economy is producing on the vertical portion of an inverse L-shaped aggregate supply curve, an increase in aggregate demand will lead to a rise in the general price level resulting in higher inflation. However, it will have no effect on national output and hence unemployment. Therefore, there will be no inverse relationship between inflation and unemployment. To overcome this problem, Keynesian economists modified the aggregate supply curve. Instead of inverse L-shaped which consists of two portions, the modified Keynesian aggregate supply curve consists of three portions: the horizontal portion which is commonly known as the Keynesian range, the upward-sloping portion which is commonly known as the intermediate range and the vertical portion which is commonly known as the Classical range. If the economy is producing on the upward-sloping portion of the aggregate supply curve, an increase in aggregate demand will lead to higher national output and higher general price level. As an increase in national output will lead to lower unemployment and a rise in the general price level will lead to higher inflation, there is an inverse relationship between inflation and unemployment.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to an increase in national output and hence national income (Y) from Y0 to Y1 and a rise in the general price level (P) from P0 to P1, assuming the economy is producing on the upward-sloping portion of the aggregate supply curve.

Using empirical evidence, economists have found out that an increase in aggregate demand always leads to a rise in the general price level resulting in higher inflation. This proves that the horizontal portion of the Keynesian aggregate supply curve does not exist in reality. Furthermore, as the economy can produce more than the full-employment national output in reality, which will be explained in greater detail in Chapter 11, the aggregate supply curve is not vertical at the full-employment national output/national income. This proves that the vertical portion of the Keynesian aggregate supply curve is misaligned. As a result, the Keynesian aggregate supply curve has virtually fallen into disuse. However, it is still being taught in some elementary courses on economics such as the Singapore-Cambridge GCE ‘A’ Level Economics. Classical economics and Keynesian economics are traditional schools of thought in macroeconomics. Today, no economist subscribes to these precise collections of economic views. Instead, what is taught to students today is Neoclassical economics which is the mainstream economics. Neoclassical economics will be explained in greater detail in Section 4.

Note:   Keynesian economics is short-run economics. Therefore, the Keynesian aggregate supply curve is a short-run aggregate supply curve. There is no long-run aggregate supply curve in Keynesian economics. Classical economists make no distinction between the short run and the long run as they believe that prices and wages are totally flexible. Therefore, the Classical aggregate supply curve is simply aggregate supply curve. 

Although there is a trade-off between inflation and unemployment in the short run, such trade-off does not occur in the long run. In other words, although the short-run Phillip curve is downward sloping, the long-run Phillips curve is vertical at the natural rate of unemployment. However, students are not required to explain this in the examination.

Keynesian economics will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

3          THE KEYNESIAN THEORY IN GREATER DETAIL

3.1       Aggregate Expenditure

Aggregate expenditure is the planned total expenditure on the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, planned investment expenditure, government expenditure on goods and services and net exports. The aggregate expenditure function shows aggregate expenditure at each national output/national income. The aggregate expenditure function can be expressed as

AE = C + I + G + (X – M)

where AE = aggregate expenditure, C = consumption expenditure, I = planned investment expenditure, G = government expenditure on goods and services, X – M = net exports, X = exports and M = imports.

As expenditure on goods and services constitutes demand, aggregate expenditure is the same as aggregate demand but with one difference. Although aggregate expenditure refers to the PLANNED total expenditure on the goods and services produced in the economy, aggregate demand refers to the ACTUAL total demand for the goods and services produced in the economy. This difference occurs due to the potential difference between actual investment expenditure and planned investment expenditure which will be explained in greater detail in Section 3.3. It is also important to note that aggregate expenditure refers to the planned total expenditure on domestic goods and services and does not include imports as imports are foreign goods and services which are produced in other economies. However, the components of aggregate expenditure which are consumption expenditure, planned investment expenditure, government expenditure on goods and services and exports include imports. Therefore, imports are subtracted from consumption expenditure, planned investment expenditure, government expenditure on goods and services and exports to derive aggregate expenditure. Similarly, imports are subtracted from consumption expenditure, investment expenditure, government expenditure on goods and services and exports to derive aggregate demand.

Aggregate Expenditure Function

In the above diagram, which is known as the Keynesian cross model or the 45-degree line model, the aggregate expenditure function (AE) is upward sloping as aggregate expenditure increases with national output/national income. The equilibrium national output/national income where aggregate expenditure (AE) is equal to national output/national income (Y) is Y0. Aggregate expenditure and the equilibrium national output/national income will be explained in greater detail in the following sections.

Note:   Economics textbooks typically make the assumption that only consumption expenditure includes imports. Although this is not the case in reality, the assumption helps facilitate the development of the subject matter which will become obvious in the later part of the chapter. This book also makes the assumption that only consumption expenditure includes imports.

Traditionally, in the Keynesian cross model, nominal national output/national income was plotted on the horizontal axis. However, over the years, it has become increasingly common to plot real national output/national income on the horizontal axis as economists are more concerned with real national output/national income than with nominal national output/national income.

3.1.1    Consumption Expenditure

Consumption expenditure is the expenditure made by households on goods and services. The consumption function shows the consumption expenditure of households at each disposable income. The Keynesian consumption function can be expressed as

C = a + bYd

where C = consumption, a = autonomous consumption, bYd = induced consumption, b = marginal propensity to consume out of disposable income and Yd = disposable income.

From the above equation, it can be seen that consumption is comprised of two components: autonomous consumption and induced consumption. Autonomous consumption refers to consumption that is independent of disposable income and is determined by consumer sentiment, the wealth of households, interest rates, expectations of price changes, the availability of credit and the distribution of income. Autonomous consumption is positive (a > 0). Induced consumption refers to consumption that is dependent on disposable income. According to Keynes, consumption will increase with an increase in disposable income (b > 0) but the increase in consumption will be less than the increase in disposable income (b < 1).

Consumption Function

In the above diagram, the consumption function (C) is upward sloping as consumption expenditure increases with disposable income. The slope of the consumption function is (b) which is known as the marginal propensity to consume out of disposable income (MPCYd). The marginal propensity to consume out of disposable income is the proportion of an increase in disposable income that is spent on consumption (ΔC/ΔYd).

Savings are the excess of disposable income over consumption expenditure. The savings function shows the savings of households at each disposable income. The Keynesian savings function can be expressed as

S = -a + (1 – b)Yd

where S = savings, -a = autonomous savings, (1 – b)Yd = induced savings, (1 – b) = marginal propensity to save out of disposable income and Yd = disposable income.

From the above equation, it can be seen that savings are comprised of two components: autonomous savings and induced savings. Autonomous savings refer to savings that are independent of disposable income and are determined by consumer sentiment, the wealth of households, interest rates, expectations of price changes, the availability of credit and the distribution of income. Autonomous savings are negative (a > 0). Induced savings refer to savings that are dependent on disposable income. According to Keynes, savings will increase with an increase in disposable income [(1 – b) > 0] but the increase in savings will be less than the increase in disposable income [(1 – b) < 1].

Savings Function

In the above diagram, the savings function (S) is upward sloping as savings increase with disposable income. The slope of the savings function is (1 – b) which is known as the marginal propensity to save out of disposable income (MPSYd). The marginal propensity to save out of disposable income is the proportion of an increase in disposable income that is saved (ΔS/ΔYd).

As any additional amount of disposable income will either be spent or saved, the sum of the marginal propensity to consume out of disposable income and the marginal propensity to save out of disposable income is equal to one (MPCYd + MPSYd = 1). The average propensity to consume out of disposable income (APCYd) is the proportion of disposable income that is spent on consumption (C/Yd). The average propensity to save out of disposable income (APSYd) is the proportion of disposable income that is saved (S/Yd). As any amount of disposable income will either be spent or saved, the sum of the average propensity to consume out of disposable income and the average propensity to save out of disposable income is equal to one (APCYd + APSYd = 1).

Apart from disposable income, the marginal propensity to consume and the marginal propensity to save can also be defined in terms of national income. The marginal propensity to consume out of national income (MPC) is the proportion of an increase in national income that is spent on consumption (ΔC/ΔY). The marginal propensity to save out of national income (MPS) is the proportion of an increase in national income that is saved (ΔS/ΔY). The marginal propensity to tax (MPT) is the proportion of an increase in national income that is taxed (ΔT/ΔY). As any additional amount of national income will either be spent, saved or taxed, the sum of the marginal propensity to consume out of national income, the marginal propensity to save out of national income and the marginal propensity to tax is equal to one (MPC + MPS + MPT = 1). Similarly, the average propensity to consume and the average propensity to save can also be defined in terms of national income. The average propensity to consume out of national income (APC) is the proportion of national income that is spent on consumption (C/Y). The average propensity to save out of national income is the proportion of national income that is saved (S/Y). The average propensity to tax is the proportion of national income that is taxed (T/Y). As any amount of national income will either be spent, saved or taxed, the sum of the average propensity to consume out of national income, the average propensity to save out of national income and the average propensity to tax is equal to one (APC + APS + APT = 1).

Determinants of Induced Consumption

Induced consumption is positively related to disposable income. In other words, an increase in disposable income will lead to an increase in induced consumption and vice versa. An increase in induced consumption can be shown by an upward movement along the consumption function.

In the above diagram, an increase in disposable income (Yd) from Yd0 to Yd1 leads to an upward movement along the consumption function (C) resulting in an increase in consumption expenditure (C) from C0 to C1. The extent of the effect of an increase in disposable income on consumption expenditure depends on the marginal propensity to consume out of disposable income (MPCYd). Given any increase in disposable income, the larger the MPCYd, the larger the increase in consumption expenditure. Disposable income may increase due to several reasons. For example, disposable income will increase when national income increases. A decrease in direct taxes such as personal income tax and corporate income tax, or an increase in transfer payments such as unemployment benefits, social security benefits and interest payments on national debt will lead to an increase in disposable income.

The marginal propensity to consume out of disposable income in Singapore is low due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. The main determinant of disposable income in Singapore is national income. As expansion is the normal state of the Singapore economy, disposable income generally rises due to an increase in national income. Although the Singapore government does decrease direct taxes and increase transfer payments, these do not happen frequently and hence do not affect disposable income to a large extent.

Determinants of Autonomous Consumption

Autonomous consumption is determined by consumer sentiment, the wealth of households, interest rates, expectations of price changes, the availability of credit and the distribution of income. An increase in autonomous consumption can be shown by a vertical upward shift in the consumption function.

In the above diagram, a vertical upward shift in the consumption function (C) from C0 to C1 leads to an increase in consumption expenditure (C) from C0 to C1 at the same disposable income (Yd0). Autonomous consumption may increase due to several reasons. When households are more optimistic about the economic outlook, they will expect their income to rise and hence increase consumption expenditure. Households hold their wealth mainly in the form of bank savings, properties and financial assets such as stocks and bonds. When the wealth of households increases due to an increase in bank savings, property prices or the values of financial assets, consumption expenditure will increase. A fall in interest rates will decrease the incentive to save and the costs of borrowing and this will induce households to increase consumption expenditure. When households expect prices to rise, they will bring forward the purchases of some durable goods which will lead to an increase in consumption expenditure. Many consumer durables are purchased on credit and hence an increase in the availability of credit will allow households to increase consumption expenditure. Lower income groups have a higher marginal propensity to consume than higher income groups and hence a redistribution of income from higher income groups to lower income groups will lead to an increase in consumption expenditure.

The major determinants of autonomous consumption in Singapore are consumer sentiment and the wealth of households. Consumption expenditure depends to a large extent on expected future income. Therefore, an increase in consumer sentiment in Singapore which will increase expected future income is likely to lead to a relatively large increase in consumption expenditure. For example, the global economic recovery in 2010 from the 2008-2009 Global Financial Crisis led to an increase in consumer sentiment in Singapore resulting in a relatively large increase in consumption expenditure. The residents in Singapore hold a large proportion of their wealth in the form of properties. Therefore, a property bubble is likely to lead to a large increase in the wealth of households which will lead to a relatively large increase in consumption expenditure. For example, the substantial rise in the prices of residential properties from 2010 to 2012 led to a large increase in the wealth of households resulting in a relatively large increase in consumption expenditure. Although interest rates, expectations of price changes, the availability of credit and the distribution of income do affect consumption expenditure in Singapore, they do so to a smaller extent. For example, interest rates and inflation in Singapore are low and hence are generally stable. Therefore, they seldom change substantially and hence do not affect consumption expenditure to a large extent.

Note:   In the Keynesian theory, the marginal propensity to consume is assumed to be constant. In reality, the marginal propensity to consume falls when income rises. This means that higher income individuals have a lower marginal propensity to consume than lower income individuals. 

Large economies are generally more dependent on consumption expenditure than on exports. For example, consumption expenditure accounts for the largest proportion of aggregate expenditure/aggregate demand in the United States. In contrast, small economies are generally more dependent on exports than on consumption expenditure. For example, exports account for the largest proportion of aggregate expenditure/aggregate demand in Singapore.

Consumption expenditure will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

3.1.2    Planned Investment Expenditure

Investment expenditure is the expenditure made by firms on goods produced not for their present use but for their use in the future.

In economics, investment is comprised of business fixed investment (i.e. new factories and machinery), residential investment (i.e. new houses, apartments and condominiums) and inventory investment (i.e. the change in the value of unsold goods). There are two types of investment: autonomous investment and induced investment.

Autonomous Investment

Autonomous investment refers to investment that is independent of national income and is determined by interest rates, business sentiment, business costs, capital costs, corporate income tax, technological advancements and the availability of credit. According to the marginal efficiency of investment theory, originally known as the marginal efficiency of capital theory developed by John Maynard Keynes, the marginal efficiency of investment function is the investment function. The investment function shows the investment expenditure of firms at each interest rate. The marginal efficiency of a type of capital is the discount rate which equates the cost of the type of capital to the present value of its stream of expected returns. The marginal efficiency of investment is the summation of the marginal efficiencies of all types of capital in the economy.

Consider a type of capital which will generate returns for three years.

        Returns (Year 1)         Returns (Year 2)         Returns (Year 3)

Cost = ———————— + ———————— + ————————

(1 + r*)                        (1 + r*)2                      (1 + r*)3

In the above equation, r* is the marginal efficiency of the type of capital. As more of a type of capital is employed with a given amount of other types of capital, each additional unit of the type of capital will have less of other types of capital to work. Therefore, the additional expected returns resulting from investing in one more unit of the type of capital will fall. To put it somewhat differently, the marginal efficiency of a type of capital function is downward sloping due to diminishing marginal returns.

With some financial and mathematical knowledge, one can see that the marginal efficiency of a type of capital is the internal rate of returns. The money that is invested in a type of capital can be loaned out if it is not invested in the type of capital and hence the interest rate is the external rate of returns. Therefore, a firm should invest in a unit of a type of capital if the marginal efficiency (i.e. internal rate of returns) is higher than the interest rate (i.e. external rate of returns). Conversely, a firm should not invest in a unit of a type of capital if the marginal efficiency is lower than the interest rate. It follows that a firm should invest in a type of capital up to the unit where the marginal efficiency is equal to the interest rate.

As the marginal efficiency of investment is the summation of the marginal efficiencies of all types of capital in the economy, the marginal efficiency of investment function is also downward sloping.

Marginal Efficiency of Investment Function

In the above diagram, the marginal efficiency of investment function (MEI) is downward sloping due to diminishing marginal returns. Given the interest rate (r0), the marginal efficiency of investment is higher than the interest rate from the first unit of investment to I0. Therefore, the optimal level of investment is I0. As investment depends on the marginal efficiency of investment, the marginal efficiency of investment function is the investment function.

Determinants of Autonomous Investment

A fall in interest rates which will decrease the costs of borrowing will lead to more profitable planned investments resulting in an increase in investment expenditure and vice versa. An increase in investment expenditure due to a fall in interest rates can be shown by a downward movement along the marginal efficiency of investment function.

In the diagram above, a fall in the interest rate (r) from r0 to r1 leads to a downward movement along the marginal efficiency of investment function (MEI) resulting in an increase in investment expenditure (I) from I0 to I1.

In addition to a fall in interest rates, the number of profitable planned investments and hence investment expenditure will increase when expected returns on planned investments increase due to an increase in business sentiment, lower business costs such as decreases in oil prices and wages or lower capital costs such as decreases in the costs of factories and machinery. Furthermore, a decrease in corporate income tax which will increase expected after-tax returns on planned investments, technological advancements and an increase in the availability of credit will also lead to an increase in investment expenditure. An increase in investment expenditure due to a non-interest rate factor can be shown by rightward shift in the marginal efficiency of investment function.

In the above diagram, a rightward shift in the marginal efficiency of investment function (MEI) from MEI0 to MEI1 leads to an increase in investment expenditure (I) from I0 to I1 at the same interest rate (r0).

Interest rates do not affect investment expenditure in Singapore to a large extent. A change in interest rates in Singapore is unlikely to lead to a significant change in investment expenditure as a large proportion of it is made by foreign firms with foreign sources of funds. The major determinants of autonomous investment in Singapore are business sentiment and corporate income tax. Investment expenditure depends to a large extent on expected returns on planned investments. Therefore, an increase in business sentiment in Singapore which will increase expected returns on planned investments is likely to lead to a large increase in investment expenditure. For example, the global economic recovery in 2010 from the 2008-2009 Global Financial Crisis led to an increase in business sentiment in Singapore resulting in a large increase in investment expenditure. A decrease in corporate income tax will increase expected after-tax returns on planned investments which will lead to an increase in foreign direct investments. This is particularly true in view of the progressive nature of corporate income tax and the high profits of multinational corporations. As foreign direct investment accounts for a large proportion of investment expenditure in Singapore, this is likely to lead to a large increase in investment expenditure. For example, the decrease in the corporate income tax rate from 40 per cent in 1986 to 17 per cent currently has led to an increase in foreign direct investments resulting in a large increase in investment expenditure. Although business costs, capital costs, technological advancements and the availability of credit do affect investment expenditure in Singapore, they do so to a smaller extent. For example, business costs and capital costs in Singapore are generally stable. Therefore, they seldom change substantially and hence do not affect investment expenditure to a large extent.

Induced Investment (Optional but good to know)

Induced investment refers to investment that is dependent on national income. According to the accelerator theory of investment, net investment is determined by the rate of change of national income. When national income rises at an increasing rate, net investment will increase. A more rapid increase in national income will lead to a more rapid increase in consumption expenditure. To increase production at a faster rate in order to meet the faster increase in consumption expenditure, firms will increase production capacity at a faster rate resulting in an increase in net investment. However, when national income rises at a decreasing rate, net investment will decrease.

Determinants of Induced Investment

The size of the accelerator effect depends on the capital-output ratio. The higher the capital-output ratio, the larger the accelerator effect.

In Singapore, the manufacturing sector is capital intensive. Therefore, the capital-output ratio is high resulting in a large accelerator effect.

Note:   Students are not required to explain the MEC/MEI theory in the examination. However, they are required to be able to state that the MEC/MEI function is the investment function and explain the factors that lead to movements along and shifts in the MEC/MEI function. 

In the Keynesian theory, planned investment expenditure is assumed to be autonomous. In reality, planned investment expenditure is affected by national income which is explained by the accelerator theory of investment. Although the accelerator theory of investment has been removed from the Singapore-Cambridge GCE ‘A’ Level Economics syllabus, it is good for students to include it in their responses to explain induced investment. 

Students should understand that investment expenditure includes both domestic investment and foreign direct investment.

Investment expenditure will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

3.1.3    Government Expenditure on Goods and Services

Government expenditure on goods and services is the expenditure on goods and services made by the government.

Government expenditure consists of two main components: government expenditure on goods and services and government expenditure on transfer payments. Although government expenditure on goods and services is a component of aggregate expenditure, government expenditure on transfer payments is not. Nevertheless, government expenditure on transfer payments does affect aggregate expenditure through its effect on disposable income and hence consumption expenditure. Government expenditure on goods and services is largely determined by the objective of the government. For example, the government may increase expenditure on infrastructure to attract foreign direct investments. In a recession, the government may increase expenditure on goods and services to increase economic growth and hence decrease unemployment. When the economy is overheating where aggregate demand is rising rapidly relative to aggregate supply resulting in high inflationary pressures, the government may decrease expenditure on goods and services to reduce inflation.

The Singapore government adopts a prudent fiscal policy which means that fiscal policy is mainly used to provide essential goods and services in Singapore. Therefore, government expenditure on goods and services is the smallest component of aggregate expenditure/aggregate demand in Singapore. It follows that changes in government expenditure on goods and services generally lead to small changes in aggregate expenditure/aggregate demand. Fiscal policy will be explained in greater detail in Chapter 12.

Note:   In the Keynesian theory, government expenditure on goods and services is assumed to be autonomous. In reality, government expenditure on goods and services is affected by national income which has been explained above.

Government expenditure on goods and services will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

3.1.4    Net Exports

Exports are the expenditure made by foreigners on domestic goods and services. Imports are the expenditure made by domestic residents on foreign goods and services. Net exports refer to exports minus imports.

Determinants of Net Exports

Income

An increase in foreign income will lead to a rise in exports. The converse is also true. An increase in domestic income will lead to a rise in imports. The converse is also true.

Domestic Inflation Relative to Foreign Inflation

When domestic inflation is lower than foreign inflation, domestic goods and services will become relatively cheaper than foreign goods and services. When this happens, exports will rise and imports will fall. The converse is also true.

Exchange Rate

When domestic currency depreciates, domestic goods and services will become relatively cheaper than foreign goods and services. When this happens, exports will rise and imports will fall. The converse is also true.

Other Factors

Exports and imports are also affected by factors such as comparative advantage, trade policy, quality of goods and services, tastes and preferences, etc.

Although exports are affected by foreign income, they are autonomous which means that they are independent of domestic income. Imports, in contrast, consist of an autonomous component that is independent of national income and an induced component that is dependent on national income. According to Keynes, imports will increase with an increase in national income. Therefore, the net exports function can be expressed as

X – M = X – (m0 + m1Y) = X – m0 – m1Y

where X – M = net exports, X = exports, M = imports, m0 = autonomous imports, m1Y = induced imports, m1 = marginal propensity to import (MPM) and Y = national income.

Net Exports Function

In the above diagram, the net exports function (X – M) is downward sloping as exports (X) are independent of national income and imports (M) increase with national income.

Singapore is a small economy that is highly dependent on external demand. Exports are the largest component of aggregate expenditure/aggregate demand in Singapore. The exports of Singapore are over 200 per cent of the national income with the domestic exports accounting for about 55 per cent of the total exports and the re-exports accounting for about 45 per cent of the total exports. Therefore, changes in exports generally lead to large changes in aggregate expenditure/aggregate demand.

Note:   Domestic exports are exports of domestic goods and services. Re-exports are exports of foreign goods in the same state as they were imported.

Net exports will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

3.2       The Circular Flow of Income and Expenditure

The circular flow of income and expenditure shows the flow of income and expenditure between the different sectors in the economy.

In the above diagram, households provide factors of production which include labour, land, capital and enterprise to firms and in return, they receive factor income (Y) in the form of wages, rent, interest and profits. Firms provide goods and services to households and in return, they receive payments known as consumption expenditure on domestic goods and services (CD). However, not all the factor income received by households return to domestic firms as revenue. Rather, some of it goes to the government in the form of taxes (T), some of it goes to the financial sector in the form of savings (S) and some of it goes to the foreign sector in the form of imports (M). Taxes, savings and imports are known as withdrawals. Withdrawals are the factor income received by households that does not return to domestic firms as revenue. Furthermore, some of the payments received by domestic firms do not come from households. Rather, they come from the government in the form of government expenditure on goods and services (G), the financial sector in the form of loans to finance investment expenditure (I) and the foreign sector in the form of exports (X). Government expenditure on goods and services, investment expenditure and exports are known as injections. Injections are the payments received by domestic firms that do not come from households. Equilibrium is established when injections are equal to withdrawals. This will be explained in greater detail in Section 3.3.

Note:   The circular flow model which is presented above assumes that households do not receive transfer payments from the government. In reality, households do receive transfer payments from the government. As taxes flow from households to the government and transfer payments flow from the government to households, we can incorporate transfer payments into the circular flow model by subtracting them from taxes to derive net taxes.

The circular flow of income and expenditure will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

3.3       Equilibrium National Output/National Income

The equilibrium national output/ national income is the national output/national income that has no tendency to change and it can be determined in three ways: the expenditure-output/expenditure-income approach, the injections-withdrawals approach and the aggregate demand-aggregate supply approach.

Expenditure-Output/Expenditure-Income Approach

According to the expenditure-output/expenditure-income approach, the equilibrium national output/national income is the national output/national income where aggregate expenditure is equal to national output/national income. Recall that aggregate expenditure is the planned total expenditure on the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, planned investment expenditure, government expenditure on goods and services and net exports.

In the above diagram, the equilibrium national output/national income where aggregate expenditure (AE) is equal to national output/national income (Y) is Y0. At a national output/national income higher than Y0, such as Y1, aggregate expenditure is less than national output/national income. When this happens, the output produced by firms will be more than sufficient to meet the planned total expenditure on the goods and services produced in the economy and this will result in a surplus of goods. A surplus of goods in the economy will cause firms to experience an unplanned increase in their inventories and hence unplanned inventory investment as they add the surplus to their inventories. This will induce firms to decrease their inventories to achieve the desired or planned levels. To bring their inventories down to the planned levels, firms will decrease production which will lead to a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income. At a national output/national income lower than Y0, such as Y2, aggregate expenditure is greater than national output/national income. When this happens, the output produced by firms will be less than sufficient to meet the planned total expenditure on the goods and services produced in the economy and this will result in a shortage of goods. A shortage of goods in the economy will cause firms to experience an unplanned decrease in their inventories and hence unplanned inventory disinvestment as they draw on their inventories to meet the shortage. This will induce firms to increase their inventories to achieve the desired or planned levels. To bring their inventories up to the planned levels, firms will increase production which will lead to an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. At Y0 where aggregate expenditure is equal to national output/national income, the output produced by firms will be equal to the planned total expenditure on the goods and services produced in the economy which will not result in any surplus or shortage of goods. Therefore, firms will not experience any unplanned changes in their inventories and hence will not have any incentive to change output. When this happens, national output and hence national income will have no tendency to change.

Injections-Withdrawals Approach

According to the injections-withdrawals approach, the equilibrium national output/national income is the national output/national income where injections are equal to withdrawals. Recall that injections are the payments received by domestic firms that do not come from households and comprise government expenditure on goods and services, investment expenditure and exports, and withdrawals are the factor income received by households that does not return to domestic firms as revenue and comprise taxes, savings and imports.

In the above diagram, the equilibrium national output/national income where injections (J) are equal to withdrawals (W) is Y0. At a national output/national income higher than Y0, such as Y1, injections are less than withdrawals. When injections are less than withdrawals, aggregate demand will fall which will induce firms to decrease production resulting in a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income. When households’ income falls, they will decrease consumption expenditure on domestic goods and services which will lead to a further decrease in aggregate demand and this will induce firms to further decrease production. When this happens, firms will employ even less factor inputs from households and hence will pay them even less factor income. The further decrease in households’ income will induce them to further decrease consumption expenditure on domestic goods and services resulting in a further decrease in aggregate demand. However, each time households’ income falls, they will pay less taxes, decrease savings and buy less imports. In other words, withdrawals will decrease when households’ income falls. When withdrawals fall to the level of injections, equilibrium will be established and national output and hence national income will stop falling. At a national output/national income lower than Y0, such as Y2, injections are greater than withdrawals. When injections are greater than withdrawals, aggregate demand will rise which will induce firms to increase production resulting in an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. When households’ income rises, they will increase consumption expenditure on domestic goods and services which will lead to a further increase in aggregate demand and this will induce firms to further increase production. When this happens, firms will employ even more factor inputs from households and hence will pay them even more factor income. The further increase in households’ income will induce them to further increase consumption expenditure on domestic goods and services resulting in a further increase in aggregate demand. However, each time households’ income rises, they will pay more taxes, increase savings and buy more imports. In other words, withdrawals will increase when households’ income rises. When withdrawals rise to the level of injections, equilibrium will be established and national output and hence national income will stop rising. At Y0, injections are equal to withdrawals. When injections are equal to withdrawals, aggregate demand will remain constant. Therefore, firms will not have any incentive to change output. When this happens, national output and hence national income will have no tendency to change.

An Alternative Explanation of the Injections-Withdrawals Approach (Optional but good to know)

According to the injections-withdrawals approach, the equilibrium national output/national income is the national output/national income where planned injections are equal to withdrawals. Recall that injections are the payments received by domestic firms that do not come from households and comprise government expenditure on goods and services, investment expenditure and exports, and withdrawals are the factor income received by households that does not return to domestic firms as revenue and comprise taxes, savings and imports. Also recall that aggregate expenditure is the planned total expenditure on the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, planned investment expenditure, government expenditure on goods and services and net exports, and national income is the sum of consumption expenditure, savings and taxes. When aggregate expenditure is equal to national output/national income, the sum of consumption expenditure, planned investment expenditure, government expenditure on goods and services and net exports is equal to the sum of consumption expenditure, savings and taxes. Cancelling out the common term of consumption expenditure and rearranging the remaining terms, the sum of planned investment expenditure, government expenditure on goods and services and exports is equal to the sum of savings, taxes and imports, which means that planned injections are equal to withdrawals. Referring to the injections-withdrawals diagram, the equilibrium national output/national income where planned injections (J) are equal to withdrawals (W) and hence aggregate expenditure is equal to national output/national income is Y0. At a national output/national income higher than Y0, such as Y1, planned injections are less than withdrawals and hence aggregate expenditure is less than national output/national income. When this happens, the output produced by firms will be more than sufficient to meet the planned total expenditure on the goods and services produced in the economy and this will result in a surplus of goods. A surplus of goods in the economy will cause firms to experience an unplanned increase in their inventories and hence unplanned inventory investment as they add the surplus to their inventories. This will induce firms to decrease their inventories to achieve the desired or planned levels. To bring their inventories down to the planned levels, firms will decrease production which will lead to a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income. At a national output/national income lower than Y0, such as Y2, planned injections are greater than withdrawals and hence aggregate expenditure is greater than national output/national income. When this happens, the output produced by firms will be less than sufficient to meet the planned total expenditure on the goods and services produced in the economy and this will result in a shortage of goods. A shortage of goods in the economy will cause firms to experience an unplanned decrease in their inventories and hence unplanned inventory disinvestment as they draw on their inventories to meet the shortage. This will induce firms to increase their inventories to achieve the desired or planned levels. To bring their inventories up to the planned levels, firms will increase production which will lead to an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. At Y0 where planned injections are equal to withdrawals and hence aggregate expenditure is equal to national output/national income, the output produced by firms will be equal to the planned total expenditure on the goods and services produced in the economy which will not result in any surplus or shortage of goods. Therefore, firms will not experience any unplanned changes in their inventories and hence will not have any incentive to change output. When this happens, national output and hence national income will have no tendency to change.

Aggregate Demand-Aggregate Supply Approach

According to the aggregate demand-aggregate supply approach, the equilibrium national output/national income is the national output/national income where aggregate demand is equal to aggregate supply. Recall that aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports, and aggregate supply is the total supply of goods and services in the economy over a period of time and is determined by the production capacity and the cost of production in the economy.

Neoclassical                                                     Keynesian

In the above diagram, the equilibrium general price level and the equilibrium national output/national income where aggregate demand (AD) is equal to aggregate supply (AS) are P0 and Y0. At a general price level higher than P0, aggregate demand is less than aggregate supply. When this happens, the output produced by firms will be more than sufficient to meet the total demand for the goods and services produced in the economy and this will result in a surplus of goods. A surplus of goods in the economy will induce firms to lower prices to reduce their stocks which will lead to a fall in the general price level. When the general price level falls, firms will decrease production which will lead to a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income. In addition to a decrease in aggregate supply, a fall in the general price level will lead to an increase in aggregate demand through the substitution effect, the interest rate effect and the wealth effect. The general price level will continue falling until aggregate demand is equal to aggregate supply at Y0, at which point the surplus is eliminated and an equilibrium is established. At a general price level lower than P0, aggregate demand is greater than aggregate supply. When this happens, the output produced by firms will be less than sufficient to meet the total demand for the goods and services produced in the economy and this will result in a shortage of goods. A shortage of goods in the economy will induce firms to raise prices to increase their profits which will lead to a rise in the general price level. When the general price level rises, firms will increase production which will lead to an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. In addition to an increase in aggregate supply, a rise in the general price level will lead to a decrease in aggregate demand through the substitution effect, the interest rate effect and the wealth effect. The general price level will continue rising until aggregate demand is equal to aggregate supply at Y0, at which point the shortage is eliminated and an equilibrium is established. At P0 where aggregate demand is equal to aggregate supply at Y0, the output produced by firms will be equal to the total demand for the goods and services produced in the economy which will not result in any surplus or shortage of goods. Therefore, firms will not have any incentive to change output. When this happens, national output and hence national income will have no tendency to change.

Note:   Although the Neoclassical model is more realistic than the Keynesian model, students are allowed to use either model to illustrate the aggregate demand-aggregate supply approach to determining the equilibrium national output/national income in the examination. Neoclassical economics will be explained in greater detail in Section 4.

Equilibrium national output will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

3.4       The Multiplier Effect and the Multiplier

The multiplier effect is the effect of an increase in autonomous expenditure resulting in a larger increase in national output and hence national income. An increase in autonomous expenditure will lead to an increase in aggregate expenditure and hence aggregate demand which will induce firms to increase production resulting in an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income.

In the above diagram, an increase in aggregate expenditure (AE) from AE0 to AE1 leads to an increase in national output and hence national income (Y) from Y0 to Y1. Suppose that the marginal propensity to consume domestic goods and services (MPCD) is 0.8, the marginal propensity to withdraw (MPW) is 0.2 and the increase in autonomous expenditure (ΔAE) is $1000. When firms increase production by $1000 in response to an increase in aggregate demand due to an increase in aggregate expenditure as a result of an increase in autonomous expenditure of $1000, they will employ more factor inputs from households and hence will pay them more factor income. When households’ income rises by $1000, they will increase consumption expenditure on domestic goods and services by $800 (0.8 × $1000) which will lead to a further increase in aggregate demand and this will induce firms to further increase production by $800. When this happens, firms will employ even more factor inputs from households and hence will pay them even more factor income. The further increase in households’ income of $800 will induce them to further increase consumption expenditure on domestic goods and services by $640 (0.8 × $800) resulting in a further increase in aggregate demand. Therefore, the initial increase in aggregate demand due to the increase in aggregate expenditure as a result of the increase in autonomous expenditure will lead to increases in consumption expenditure and hence further increases in aggregate demand resulting in a larger increase in national output and hence national income. This is commonly known as the multiplier effect. However, each time households’ income rises, they will pay more taxes, increase savings and buy more imports. In other words, withdrawals will increase when households’ income rises. When withdrawals rise by $1000, which is equal to the increase in autonomous expenditure, injections will once again be equal to withdrawals. When this happens, equilibrium will be restored and national output and hence national income will stop rising.

Round ΔY ΔCD ΔW
1 $1000 $800 $200
2 $800 $640 $160
3 $640
Sum $5000 $4000 $1000

In the above table, ΔY = $1000 + $800 + $640 + ……….

Therefore, ΔY = $1000 + (0.8)($1000) + (0.8)2($1000) + ……….

Applying geometric progression, ΔY = $1000/(1 – 0.8) = $5000 > (ΔAE = $1000).

More generally, ΔY = ΔAE/(1 – MPCD).

Therefore, ΔY/ΔAE = 1/(1 – MPCD).

Since MPS + MPT + MPM + MPCD = 1, ΔY/ΔAE = 1/MPW.

    ΔY                1                      1

Multiplier = ——– = —————- = —————

           ΔAE       1 – MPCD            MPW

In the above analysis, a $1000 increase in aggregate expenditure will lead to a $5000 increase in real national output and hence real national income. The implicit assumption is that the increase in aggregate expenditure will not lead to a rise in the general price level. However, recall that using empirical evidence, economists have found out that an increase in aggregate expenditure and hence aggregate demand always leads to a rise in the general price level which proves that the horizontal portion of the Keynesian aggregate supply curve does not exist in reality. Therefore, when aggregate expenditure rises, real national output and hence real national income will not rise by the full multiplier effect as the general price level will rise.

The multiplier is the number of times by which national output and hence national income rises due to an increase in autonomous expenditure. The multiplier is the inverse of the marginal propensity to withdraw which is the sum of the marginal propensity to save, the marginal propensity to tax and the marginal propensity to import. The marginal propensities to save, tax and import are the proportions of an increase in national income that are saved, taxed and spent on imports. Therefore, the multiplier will be larger the lower the savings, the lower the income taxes and the lower the imports.

The multiplier in Singapore is small due to high savings and high imports. The savings rate in Singapore is high due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system. The level of imports in Singapore is high due to lack of factor endowments and the embracement of free trade.

In the examination, unless the multiplier effect is a major focus of the question, students need not provide the full explanation. In other words, they do not need to explain the multiplier effect with a set of numerical values. Nevertheless, they need to provide a brief explanation of the multiplier effect when there is an increase in aggregate demand, and for that matter, a brief explanation of the reverse multiplier effect when there is a decrease in aggregate demand. The following is a brief explanation of the multiplier effect which students can provide in the examination. Assume that consumption expenditure and investment expenditure increase which will lead to an increase in aggregate demand resulting in an increase in national output and hence national income. When firms increase production in response to an increase in aggregate demand due to an increase in consumption expenditure and investment expenditure, they will employ more factor inputs from households and hence will pay them more factor income. When households’ income rises, they will further increase consumption expenditure which will lead to a further increase in aggregate demand and this will induce firms to further increase production. When this happens, firms will employ even more factor inputs from households and hence will pay them even more factor income. The further increase in households’ income will induce them to further increase consumption expenditure resulting in a further increase in aggregate demand. Therefore, the initial increase in aggregate demand due to the increase in consumption expenditure and investment expenditure will lead to further increases in consumption expenditure and hence further increases in aggregate demand resulting in a larger increase in national output and hence national income. This is commonly known as the multiplier effect.

Note:   Although the explanation of the multiplier effect is required in the examination, the derivation of the multiplier is not. 

The marginal propensity to consume domestic goods and services out of national income (MPCD) is the proportion of an increase in national income that is spent on domestic goods and services. Therefore, MPCD = MPC – MPM.

The multiplier effect will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

4          THE NEOCLASSICAL THEORY

Classical economics and Keynesian economics are traditional schools of thought in macroeconomics. Today, no economist subscribes to these precise collections of economic views. Instead, what is taught to students today is Neoclassical economics which is the mainstream economics.

Neoclassical economists believe that although prices and wages are flexible in the long run, they are rigid in the short run. Therefore, although the economy will be at the full-employment equilibrium in the long run, it can stay at a below-full-employment equilibrium or an above-full-employment equilibrium in the short run.

In the above diagram, the equilibrium national output/national income (Y0) where aggregate demand (AD0) is equal to short-run aggregate supply (SRAS0) is below the full-employment national output/national income (Yf), creating a negative output gap (Y0 – Yf), which is also known as a deflationary gap. When national output is below the full employment level, unemployment is above the natural rate. In such a state of the economy, firms will find it easy to employ workers but workers will find it difficult to get jobs which will lead to a downward pressure on wages. However, as wages are rigid in the short run, in Neoclassical economists’ view and in reality, they will not fall and hence the economy will stay at a below-full-employment equilibrium in the short run. When wages and hence the cost of production in the economy fall in the long run, in Neoclassical economists’ view and in reality, short-run aggregate supply (SRAS) will rise from SRAS0 to SRAS1 and hence national output will rise from Y0 to Y1 which is equal to Yf. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income from Y0 to Y1 which is equal to Yf. Therefore, the long-run aggregate supply curve (LRAS) is vertical at the full-employment national output/national income (Yf). Long-run aggregate supply is the total supply of goods and services in the economy when all factor prices have fully adjusted in the long run and is determined by the production capacity in the economy.

In the above diagram, the equilibrium national output/national income (Y0) where aggregate demand (AD0) is equal to short-run aggregate supply (SRAS0) is above the full-employment national output/national income (Yf), creating a positive output gap (Y0 – Yf), which is also known as an inflationary gap. When national output is above the full employment level, unemployment is below the natural rate. In such a state of the economy, firms will find it difficult to employ workers but workers will find it easy to get jobs which will lead to an upward pressure on wages. However, as wages are rigid in the short run, in Neoclassical economists’ view and in reality, they will not rise and hence the economy will stay at an above-full-employment equilibrium in the short run. When wages and hence the cost of production in the economy rise in the long run, in Neoclassical economists’ view and in reality, short-run aggregate supply (SRAS) will fall from SRAS0 to SRAS1 and hence national output will fall from Y0 to Y1 which is equal to Yf. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income from Y0 to Y1 which is equal to Yf.

Note:   When using the Neoclassical model, it is not always necessary to include the long-run aggregate supply (LRAS). The long-run aggregate supply (LRAS) is only necessary for  certain analyses such as potential economic growth, which will be explained in greater detail in Chapter 11. When the long-run aggregate supply (LRAS) is not necessary, the short-run aggregate supply (SRAS) can simply be written as aggregate supply (AS).

In Keynesian economics, an inflationary gap is the excess of aggregate expenditure over national output/national income at the full-employment national output/national income. In other words, it is the decrease in aggregate expenditure which is needed to close a positive output gap. A deflationary gap is the shortfall of aggregate expenditure below national output/national income at the full-employment national output/national income. In other words, it is the increase in aggregate expenditure which is needed to close a negative output gap. In mainstream economics, an inflationary gap and a deflationary gap refer to a positive output gap and a negative output gap respectively. 

The concepts of full employment and natural unemployment will be explained in greater detail in Chapter 11.

Neoclassical economics will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

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