Economics Model Essay 18

(a)   Explain the factors which may lead to a recession. [10]
(b)   Discuss whether the savings rate is the most important factor that affects the extent of the increase in national income given any increase in autonomous expenditure. [15]

Introduction

(a)   A recession is a fall in national output and hence national income for at least two consecutive quarters. A recession may occur due to a decrease in aggregate demand or aggregate supply.

Body

A recession may occur due to a decrease in aggregate demand. 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. 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.

In the above diagram, a decrease in aggregate demand (AD) from AD0 to AD1 leads to a decrease in national output and hence national income (Y) from Y0 to Y1. Furthermore, due to the reverse multiplier effect, the initial decrease in aggregate demand will lead to a larger decrease in national output and hence national income. Aggregate demand may decrease due to a decrease in any of its components. Consumption expenditure is determined by several factors such as consumer sentiment, the wealth of households, interest rates, expectations of price changes, the availability of credit and the distribution of income. For example, a fall in the wealth of households will induce them to decrease consumption expenditure. In the 2008-2009 Subprime Mortgage Crisis in the United States, the stock market crash led to a fall in the wealth of households resulting in a decrease in consumption expenditure and hence aggregate demand. Exports are determined by several factors such as the exchange rate, domestic inflation relative to foreign inflation, domestic income and foreign income. For example, a decrease in foreign income will lead to a decrease in exports. In the 2008-2009 Global Financial Crisis caused by the Subprime Mortgage Crisis in the United States, the decrease in foreign income in Singapore led to a fall in exports and hence aggregate demand. Government expenditure on goods and services is largely determined by the objective of the government. For example, the government may decrease expenditure on goods and services to reduce a budget deficit which is commonly known as austerity measures. The Greek government implemented austerity measures in 2010 which led to a decrease in government expenditure on goods and services and hence aggregate demand.

A recession may occur due to a decrease in aggregate supply. 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. As the production capacity in the economy is generally increasing, a decrease in aggregate supply typically occurs due to a rise in the cost of production in the economy. When the cost of production in the economy rises independently of demand, firms will increase prices at the same output levels to maintain profitability. In other words, they will decrease output at the same prices which will lead to a decrease in aggregate supply resulting in a decrease in national output and hence national income.

In the above diagram, a decrease in aggregate supply (AS) from AS0 to AS1 leads to a decrease in national output and hence national income (Y) from Y0 to Y1. The cost of production in the economy may rise independently of demand due to several reasons. Oil prices may rise due to man-made factors or natural factors. For example, the sharp rise in oil prices from October 1973 to March 1974 due to the oil embargo imposed by the Organisation of Arab Petroleum Exporting Countries (OAPEC) against the United States, the United Kingdom, the Netherlands, Japan and Canada, led to a substantial rise in the cost of production in the economy resulting in a substantial decrease in aggregate supply. The government may raise goods and services tax to reduce a budget deficit. For example, the Japanese government increased the consumption tax from 5 per cent to 8 per cent in 2014 to reduce the budget deficit which led to a rise in the cost of production in the economy resulting in a decrease in aggregate supply.

Conclusion

In conclusion, the standard of living is positively related to the amount of goods and services available for consumption and hence national output. Therefore, in times of recession, the government should use policies to steer the economy back onto the path of expansion to prevent a fall in the standard of living.

Introduction

(b)   National income is the total income earned by the nation over a period of time. Autonomous expenditure refers to expenditure that is independent of national income. The question on whether the savings rate is the most important factor that affects the extent of the increase in national income given any increase in autonomous expenditure can be discussed with reference to the multiplier effect, the multiplier, the savings rate, the tax rate, the level of imports and the state of the economy.

An increase in autonomous expenditure will lead to an increase in aggregate demand resulting in an increase in national income. An increase in autonomous expenditure will lead to an increase in 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. For example, the increase in exports in Singapore due to the global economic recovery in 2010 led to an increase in aggregate demand resulting in an increase in national output and hence national income.

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. 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 is $1000. When firms increase production by $1000 in response to an increase in aggregate demand due to 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 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 income 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

ΔYΔCDΔW

1

$1000$800

$200

2

$800$640

$160

3

$640

Sum$5000$4000

$1000

In the above table, the increase in national income of $5000 is greater than the increase in autonomous expenditure of $1000. The multiplier is the number of times by which national output and hence national income rises due to an increase in autonomous expenditure. It 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.

Since the multiplier is inversely related to the savings rate, given any increase in autonomous expenditure, the higher the savings rate, the smaller the increase in national income. The savings rate is dependent on several factors such as the attitude towards thrift, government policies and the welfare system. For example, 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. In contrast, the savings rates in some countries are low, such as the United States, due to the culture of extravagance, the generous welfare system and the absence of a compulsory savings scheme.

Apart from the savings rate, the extent of the increase in national income given any increase in autonomous expenditure is also influenced by a host of other factors.

The higher the income tax rates and the level of imports, the smaller the multiplier and hence the smaller the increase in national income given any increase in autonomous expenditure. The income tax rates are dependent on several factors such as the welfare system and the dependence on foreign direct investments and foreign talents. For example, the income tax rates in Australia are high as the government needs to collect a large amount of tax revenue to finance the generous welfare system. In contrast, the income tax rates in some countries are low, such as Singapore, due to the absence of a generous welfare system and the high dependence on foreign direct investments and foreign talents. The level of imports is dependent on several factors such as the amount of factor endowments and the trade policy. For example, the level of imports in Singapore is high due to lack of factor endowments and the embracement of free trade. In contrast, the levels of imports in some countries are lower, such as the United States, as they have more factor endowments and engage in protectionism.

The further the economy is from the full-employment equilibrium, the larger is the increase in national income given any increase in autonomous expenditure. For example, the Greek economy has been in recession for six consecutive years and hence is far from the full-employment equilibrium. With substantial excess production capacity in the economy, an increase in the autonomous expenditure is likely to have a small effect on the general price level and hence is likely to lead to a large realisation of the full multiplier effect resulting in a large increase in national income. In contrast, unemployment in Singapore is near the natural rate and hence the economy is near the full-employment equilibrium. With little excess production capacity in the economy, an increase in the autonomous expenditure is likely to have a large effect on the general price level and hence is likely to lead to a small realisation of the full multiplier effect resulting in a small increase in national income.

Conclusion

In the final analysis, high savings lead to a high supply of loanable funds and hence low interest rates resulting in high investment expenditure. When investment expenditure is high, the production capacity in the economy and hence aggregate supply will rise rapidly which will lead to high economic growth resulting in a rapid rise in the standard of living. For example, the high savings rate in Japan was one of the major factors that led to the high economic growth from the 1950s to the 1980s. However, an increase in savings, particularly one which occurs in a weak economic environment, is likely to be detrimental to the economy. In a weak economic environment, the growth of consumption is likely to be low and hence an increase in savings is likely to lead to a decrease in consumption expenditure resulting in a recession. For example, the increase in the savings rate in the United States in the first half of 2009 was one of the major contributing factors to the falling national output and hence national income. A small multiplier limits the effectiveness of demand-side policies which may make it difficult for the government to achieve the four macroeconomic goals of high economic growth, low unemployment, low inflation and a balance of payments equilibrium. However, if the economy is at or near the full-employment equilibrium, a small multiplier may prevent a decrease in autonomous expenditure from causing a substantial decrease in aggregate demand and hence national output and therefore national income from falling substantially from the full-employment level. Similarly, it may prevent an increase in autonomous expenditure from causing a substantial increase in aggregate demand and hence the general price level from rising substantially.

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