2014 A level H2 Economics Review: Macroeconomics Qn 46 min read

The following data relate to the Singapore economy in 2011

$ billion
Private Consumption Expenditure 129
Gross Fixed Capital Foundation 77
Government Consumption Expenditure 34
Exports of goods and services 531
Imports of goods and services 444
GDP 327

a. Economies consist of several key sectors such as households, firms, government and the rest of the world. Explain the relative importance of these key sectors of the circular flow of income in determining national income in Singapore. [10]

b. Discuss the likely effects on Singapore’s national income and its components when its exchange rate appreciates. [15]

Whip out your calculator! This type of question is the reason why you should always bring a calculator for an economics paper, unless you are some math god who can do mental sums quickly and accurately. This question tests you on the fundamental of macroeconomics – the circular flow of income in part (a) and how appreciation of currency can affect the components of AE in part (b).

Part (a) is relatively straightforward, so I will not be spending too much time on it. Singapore’s economy has 4 sectors namely households, firms, government, and the rest of the world as mentioned in the question. Here, you have to identify the injections and withdrawals made by each of these sectors, their significance and determine how the national income is calculated from them.

As the saying goes, “A picture speaks a thousand words.” I will prefer to draw a diagram to help me explain the circular flow of income. Alternatively, if you are good with words, you can explain the concepts without the diagram, but for those of you who are like me, you will have to come up with a diagram like this: Please just come up with an illustration. It is better than having only plain text. Period.

4 sector economy

Circular Flow of income of a 4 sector economy. Source Link: http://angrybearblog.com/wp-content/uploads/2013/08/flow-1.png

From the diagram above, you can see how the circular flow of income works. First you have a demand for goods and services in the terms of Domestic Consumption (Cd), Investment (I), Government Expenditure (G) and Export Expenditure(X). The firms will take this signal to hire factors of production in terms of Wages (W), Rent (R), Investments (I) and Profits (P) to increase production. This will translate into income for the individual household.

Not all the income that an individual earns will be spent on domestic goods and services, thus withdrawals will exist in the forms of Savings (S), Taxes (T), and Import Expenditures (M). The money will be saved in banks and will be channelled back into the economy as loans for investments; the government will have used the taxes collected to intervene in the market (for example, to correct market failures); if your economy is open there will be external demand from other countries for your goods and services.

Here’s the math part, you have to calculate the individual percentage of the following components of the national income and compare the values to determine which component is more significant in the Singapore economy.

By the definition of national income, it’s the total value of the goods and services an economy can produce annually; you should get a formula summing up all the injections and that will translate to the national income at equilibrium.

NY = AE = Cd + I + G + X

You are probably used to seeing NY = AE = C + I + G + X – M. The difference is that the formula that you normally see uses consumption in general (Domestic and imports), so you have to deduct the withdrawal of the import expenditure. This is rather important to know so I repeat: typically, C includes M. If you used domestic consumption, the import expenditure has already been accounted for.

Now, for part (b), some students may find it challenging as it will make you think more about exchange rate policy than what you normally do. Usually for macro essays, you will just say that appreciation will cause net export to fall if Marshall Lerner condition holds true blah blah blah… That’s insufficient here. You will have to think about the direct and indirect impacts of exchange rate policies on other components of the national income.

Appreciation of the currency will decrease domestic consumption. Why? Take some time to think about this, here’s a clue to help you with the thought process: substitutes. Get it? Imports are cheaper when the domestic currency appreciates. Thus, households will tend to substitute some domestic goods with imports. This will cause the domestic consumption to fall.

How do you evaluate the above argument? Since most of what Singapore imports — agricultural products and raw materials — are not produced locally, the magnitude of XED of domestic goods and foreign imports will be low. In other words, there is little substitution going on. Therefore, there will be little impact on the level of domestic consumption.

Even if there were some degree of substitutability between the goods, consumption will not fall significantly. Singapore imports most of its factors of production (crude oil, labour etc) so domestic firms will enjoy cost savings and can choose to pass it on to the consumers through lower prices as well. The lower prices can offset the fall in demand from substitution. Thus, in this case, there may not be any significant changes to the level of domestic consumption as well. If you can think of any counter arguments to what I said above, great! You are starting to get the hang of evaluation. If not, you can try referring to this post to get a better idea of what evaluation is like.

Here’s one possible structure for the body of your essay: The general impact of the policy on the individual components, followed by the evaluation — how significant will the change be. You can also discuss the impact of appreciation of currency on investments. It might be more challenging to discuss the impact on government expenditure as it is often decided through parliamentary debates and is likely to be autonomous.

Before you start on your conclusion, remember to include a paragraph about national income. Here I will prefer to use a Keynesian diagram as it will give you the nominal income which I believe is what the question is asking for.

AE diagram

Here’s a diagram you should be able to come up with. It will also be good if you can include a brief explanation of the multiplier effect, which can be shown by the “staircase” between the 2 equilibrium points and how the new equilibrium Y2 is achieved.

Now that you have met all the requirements of the question, you can wrap up the essay. Here are 2 key takeaways from this question. Firstly, when numbers are given, you usually have to do some calculations. Secondly, sometimes the question may require you to explore more in depth than what you normally do. As I personally do not believe in memorising and spotting essays, be prepared to think of points that are not among the standard few.

Till next time, dream economics.

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5 Comments

  1. Hi, I don’t understand what u mean by “since most of what sg import is not produced locally, so XED btn imports and local products is low.”…can u explain?
    Is it right to say that injection always equal to withdrawals because govt budget, BOP must balance?
    Also, for this qn, how do we talk abt leakages (do we even need to talk abt S and T) to show the significance without making them sound terrible? Thank u!

    Reply

    1. Hi,

      Thanks for leaving a comment!

      To answer your first question, Singapore imports mostly agricultural products, crude oil and natural gases. These are products that Singapore are not and can’t produce. Thus the substitutability of imports and exports will be small and thus magnitude of XED will be small.

      Secondly, no you can’t say that injection always equal to withdrawals. Government budgets don’t have to balance; they can always borrow and spend and incur a deficit — Keynesian economics 101. BOP on the other hand does have to be balanced, and that really shouldn’t be surprising because it’s just an accounting trick (surpluses get accrued to reserves and deficits get financed by private investors or drawing down reserves so that everything nets to zero.)

      Finally, if I’m not wrong leakages and withdrawals are used interchangeably (i.e. they refer to the same thing) in most contexts.

      Hope that answers your questions.

      Reply

    2. Here are some more suggestions for commenting on the significance of the different sectors:

      1. Explain why Imports and Exports are so large relative to the rest. What are the implications of this?
      2. Government spending is at about 10% of GDP. Is that large or small relative to other countries? Why? What does this imply about taxes given that SG usually runs a budget surplus or balanced budget?
      3. (more advanced) X – M > 0 implies Net Savings = (S – I) > 0 (simplifying assumption that current account = trade balance). Calculate the magnitude and what does this imply about Singapore’s preferences over time or our competitiveness?

      Reply

  2. hi,

    you said that the C in AD= C + I + G + (X-M) includes consumption for both domestic and imported goods? then what does the M in the formula account for? Plus, I was taught in school that C only accounts for consumption of locally produced goods while M accounts for goods consumed that are imported? :/

    Reply

    1. C in that formula includes consumption of both domestic goods/svs and imports.

      That’s why we have to subtract M.

      We can also write AD = Cd + I + G + X, where Cd = domestic consumption.

      This is a common mistake in some schools’ notes.

      Reply

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