Note: the keynesian cross diagram in this essay is more relevant for JC2 students. The new 2017 H2 paper de-emphasises this.
- Explain how the equilibrium level of national income is reached. (8)
- To what extent do different savings rates between countries affect changes in national income given an increase in autonomous expenditure? (17)
def The equilibrium level of national income is the level at which there is no tendency for it to change. It is consistent with planned aggregate demand equalling planned aggregate supply.
Using the income expenditure approach, an economy (assumed to be open to trade with a government sector) where national income (Y) is equal to aggregate expenditure is said to be at equilibrium. Aggregate expenditure is made up of domestic consumption, investment, government expenditure, and net exports.
In the graph, when national income is $300m, planned aggregate expenditure exceeds planned output. This leads to a fall in unplanned inventories of $100m. When firms see this depletion in their inventories, they will expand output, hiring workers and other factor inputs. This leads to an increase in income, output and employment. National income will rise until planned AE equals planned output.
Conversely, when national income is $800m, planned aggregate expenditure is less than planned output. This leads to an increase in unplanned inventories of $200m. When firms see this increase in their inventories, they will decrease output, hiring fewer workers and other factor inputs. This leads to a fall in income, output and employment. National income will fall until planned AE equals planned output.
- To what extent do different savings rates affect changes in national income given an increase in autonomous expenditure? (17)
def Autonomous expenditure refers to any component of aggregate expenditure which does not change with changes in national income. For instance, government expenditures typically depend on a government's fiscal position and economic policies, while investment spending may increas due to improved business sentiments or lower interest rates.
def The savings rate in a country can be modelled as a percentage of the national income. This percentage is known as the marginal propensity to save, and defined as the proportion of each additional dollar of household income that is used for saving.
When autonomous expenditures increase, it leads to a multiplied increase in the national income. The multiplier is lower when the savings rate is lower.
thesis Different savings rates will lead to different changes in the national income given an increase in autonomous expenditure.
The marginal propensity to save in different countries is affected by 1) cultural atttitudes towards thrift and 2) government policies among other factors.
An Asian country like China, or Singapore tends to have higher rates of savings, while western countries such as the US typically have a less prudent attitude when spending.
Government policies also play a role in influencing the MPS. For instance, in Singapore, compulsory savings under the CPF scheme lead to a high saving rate, while in the countries with welfare schemes such as the US, citizens may feel less need to save since they can expect government payouts when they no longer have an income.
A higher savings rate will lead to increased withdrawals from the circular flow of income, which will dampen the multiplier effect of any increase in autonomous expenditure.
For example, given an autonomous increase in government expenditure due to expansionary fiscal policy, households employed by firms which contract for the government will earn higher income. These households will in turn spend a proportion of this higher income in consumption, which further increases the factor income of those in consumer facing industries, who then go on to spend so on and so forth until withdrawals equals injections.
In the picture below,
AE_1 increases to
AE_2, showing an increase in autonomous expenditure. National income increase from
Y1. However, if the multiplier is lower due to a higher savings rate, the
AE_1a increases to
AE_2a, and the increase in national income is smaller (
anti-thesis Other factors also affect the national income given an increase in autonomous expenditure.
Apart from withdrawals from the economy via savings, imports and taxes are also important factors.
def The marginal propensity to import is defined as the change in import expenditure that occurs with a change in disposable income. The higher the MPM, the lower the multiplier.
The MPM is affected by 1) the openness to trade of an economy, and 2) the trade policies of an economy.
Singapore is a good example of a country which is highly open to trade. As the country lacks natural resources , it has to import many goods for domestic consumption. Singapore also has a very liberal trade policy, and has signed countless free trade agreements with many countries and trading blocs.
The marginal propensity to tax is determined by government policy, and a higher MPT would also lead to a lower multiplier.
Singapore has pretty low taxes relative to other countries both at the individual level and at the firm level. As the government operates on the principle that citizens should strive to pay for most of their expenses, there is minimal welfare tax burden on the state, unlike other western countries where government spending can be much higher as they have to support welfare.
eval The multiplier effect due to an increase in autonomous expenditure will lead to an increase in nominal national income. However, real national income will only increase if there is spare capacity in the economy. In an economy without spare capacity to grow, the multiplier effect on real growth will be weak and inflation will be more likely.
conclusion A higher savings rate implies a higher marginal propensity to withdraw, which will reduce the extent to which an autonomous increase in expenditure would lead to an increase in national income. However, other factors such as the tax rate and the marginal propensity to import are also important.
In the long run, a higher savings rate allows a country to investment in productive capacity, which would lead to a higher growth path of the economy.