H1 Economics 8843

INTRODUCTION TO MACROECONOMIC ANALYSIS

To analyse macroeconomic issues and government decisions at the national level, there is an
important framework that we will utilize, that is, aggregate demand and aggregate supply
(AD-AS) model. Under this theme, we will examine domestic and external factors that
influence economic growth, price stability and employment, with a focus on how these
factors affect a country’s standard of living.

3.1.1 Aggregate Demand and Aggregate Supply Model

The aggregate demand and aggregate supply model can be used to explain how equilibrium
national income and general price level is determined.

1. Aggregate Demand (AD)

Aggregate demand (or aggregate expenditure) refers to the total amount of domestically
produced goods and services that is desired to purchase at each general price level by
households, firms, foreigners and the government. AD is made up of the following components:
consumption (C), investment (I), government expenditure (G) and net exports (X-M).

Table 1: Components Share of AD by Expenditure in Singapore, China, USA, UK in 2020

Component % Share of GDP (2020)

Singapore China USA UK

Private Consumption Expenditure C 32.6 37.8 67.2 58.0

Gross Fixed Capital Formation & I 22.0 43.0 21.0 17.0
Changes in Inventories
Government Consumption G 12.3 17.1 14.7 22.2
Expenditure
Net Exports of goods & services (X-M) 31.7 2.5 -3.1 0.3
Exports of goods and services X 181.7 18.5 10.2 28.4
Imports of goods and services M 150.0 16.0 13.3 28.1
Statistical discrepancy 1.4 -0.4 0.2 2.5
Gross Domestic Product GDP 100 100 100 100

Source: https://data.worldbank.org/
https://www.theglobaleconomy.com/

Consumption expenditure refers to the expenditure on all goods and services by households.
Investment expenditure refers to the expenditure by firms on capital goods. Government
expenditure refers to the expenditure on non-marketed services such as education but does
not include transfer payments. Exports refers to the expenditure from foreigners on domestic
goods and services. As expenditure by locals include spending on imports (M) as well, net
exports (NX) refers to the expenditure from foreigners on domestic goods and services minus
the expenditure by locals on foreign goods and services.

Similar to the demand curve, the AD curve is also downwards sloping. When the general price
level is lower, the real national income is higher and the aggregate quantity of goods and
services that can be purchased will also be higher. A movement along the AD curve is caused

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by a change in general price level. A change in any of the components of C, I, G or X-M will
result in a shift of the AD curve.

General Price Level

P1

P2

AD

Y1 Y2 Real National Income

Fig. 1

As shown above, when the general price level falls from P1 to P2, the real national income
levels increase from Y1 to Y2, thus showing that output has increased with a fall in average
prices.

Shifts in the AD curve

The AD curve shifts due to changes in factors that are not related to the changes in general
price level. An increase in AD results in the AD curve shifting to the right, as shown below from
AD1 to AD2. This can be due to an increase in any of the components of the AD curve which
are C + I + G + (X-M). An increase in AD would result in a greater output being produced at
Y2 for the same average prices P2.

General Price Level

P1

AD2
AD1

Y1 Y2 Real National Income

Fig. 2

The determinants of AD (or factors that result in a shift in the AD) are factors that will influence
the components such as consumption, investment, government expenditure and net exports.

Determinants of consumption

1. Wealth
▪ Wealth of an individual is given by the difference between the total asset value and
total liabilities. Households that are wealthier are likely to spend more and save less at
each possible income level. For example, when there is a sudden windfall gains, one

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may be tempted to splurge. On the other hand, following the burst of the property
market bubble, one may feel poorer and cut back on consumption.

2. Expectation of future income and inflation

▪ Consumers might expect real income level to rise in the future. This can raise
consumer confidence and lead to an increase in consumption spending. However, if
consumers expect the income to stagnant due to bleak economic conditions, they will
likely cut back on consumption and save more.

3. Consumer credit
▪ Credit is an important source of purchasing power. Money lenders such as banks and
financial institutions are the main source of credit. If the interest rate is low, the cost of
borrowing is low and it can encourage household to borrow to finance the purchase of
big ticket items such as cars and housing.

4. Tax rate on income

▪ The higher the income tax (T), the lower the disposable income (Yd) of an individual.
(Yd = Y – T). This results in a lower purchasing power and lead to a fall in consumption
spending.

Determinants of investment

1. Interest rate
▪ Interest rate is considered as the cost of borrowing. If interest rate decreases, the cost
of borrowing is cheaper and more investment projects will be profitable.

2. Economic outlook
▪ If business sentiment is optimistic, the expected rate of returns will increase. This will
cause firms to increase in investment. However if economic outlook is bleak,
entrepreneurs would expect investment to be unprofitable and may cancel investment
projects, resulting in a decrease in investment level.

3. Cost of capital goods

▪ Capital goods are goods that can be used to produce more goods and services in the
future. The cost of purchasing capital goods can be considered from an absolute and
relative perspective.

▪ If the absolute cost of purchasing capital goods such as new plant or equipment
increases, this results in lower profit margins assuming the price at which the output
can be sold remains the same. Investment will decrease.

▪ If the relative cost of capital goods decrease, assuming flexible production

technologies where inputs are substitutable, more capital goods will be utilized in the
production process and less of the other factors of production will be used. For
example, this could be due to higher cost of labour, prompting firms to use more labour-
saving capital goods to mitigate the increase in the cost of production. Hence
investment will increase.

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4.Tax rate on business profit

▪ The tax rate on profit is also known as corporate tax. A higher corporate tax translates
into lower after-tax profits and hence will lead to lower expected rates of return on
investment. Consequently, when the corporate tax rate increases, there will be a
reduction in investment for each possible rate of interest.

Think
(a) Is foreign direct investment included in the investment component of aggregate
demand?

(b) Are the determinants of FDI same as above?

Determinants of net exports

1. National income of trading partners

▪ If national incomes of trading partners increase, their citizens would have higher
disposable income and hence are able to consume more imported goods. This causes
the export of the domestic country to increase.

2. Relative inflation rates

▪ If the domestic inflation rate is higher than the inflation rates in foreign countries,
domestic goods will become relatively more expensive compared with foreign goods.
This results in higher imports as domestic citizens substitute the relatively cheaper
foreign goods for domestic goods while foreigners decrease their demand for the
domestic country’s exports. Net exports of the domestic country decreases.

3. Exchange rate
▪ Exchange rate is the price of one currency in terms of other currencies. If the domestic
currency appreciates against a foreign currency, more units of foreign currency can be
purchased with the same number of units of domestic currency. This means imports
will become cheaper in terms of domestic currency. Conversely, foreigners will find the
domestic country exports more expensive in terms of their currencies and this will lower
the quantity of export demanded. This results a rise in imports in the domestic country
while its exports decrease.

4. Trade policies
▪ A country’s trade policies will influence its export level. For example, the government
could place a heavy emphasis on exports for economic growth. Hence it implemented
policies to attract multinational corporations (MNC) that are dealing with tradable
goods to set up production facilities in the country. When this happens, the exports of
the country will increase.

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2. Aggregate Supply (AS)

Aggregate Supply (AS) refers to the total amount of goods and services produced and
supplied by an economy over a period of time. The AS curve consists of 3 segments. They
are the Keynesian range, the Intermediate range and the Classical range as shown in the
graph below.

Fig. 3

The Keynesian range is the horizontal portion of AS where the real national income levels
are much lower than that of the full employment level (Yf).
▪ This full employment level refers to the case when all resources are used to their full
potential, producing at maximum capacity. At Yf, unemployment equals the natural rate
of unemployment. When production is much lower than the full employment level, there
is an abundance of idle and unemployed resources available for use. Increasing
production, with the use of a greater quantity of resources, will not lead to an increase
in factor prices because there is insufficient aggregate demand for factors.
Consequently, prices in both the input and the output markets remain constant and as
such the general price level remains unchanged.

The Intermediate range is the upward sloping portion of the AS where the real national
income levels approaching Yf.
▪ When producers attempt to increase production, they encounter supply bottlenecks
due to the increasingly scarce idle resources. Thus, competition for resources lead to
higher factor prices and the higher costs of production translate into higher output
prices to ensure the firms can still cover their production costs Thus, the general price
level increases when national output increases.

The Classical range is the vertical portion of the AS where full employed as been achieved.
▪ Attempt to increase production to meet higher AD will only drive up factor prices and
output prices as the output level cannot rise any further as all the resources necessary
for production have been used to maximum capacity and can no longer be used to
increase output. Thus, when AD increases, only the general price level would increase
with national output remaining constant.

As the input and the output markets need time to clear to result in full employment of resources,
in the short run, the economy will most likely operate along the Keynesian or the intermediate
range of the AS. In the long run, when all market clears, the economy would then enter the
classical range of the AS.

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Shifts in the AS curve

General Price Level

AS1

AS2

Real National Income

Yf

Fig. 4

The AS curve shifts up and down from AS1 to AS2 depending on the non-price supply factors
that affect the costs of production.

Determinants of the costs of production

Changes in wages
▪ The wage rate refers to the amount of wage paid to the worker per unit of time (e.g.
per hour or day). Labour productivity refers to the amount of goods produced per unit
time (usually an hour). If the growth in labour productivity is lower than the growth in
the wage rate, unit labour cost will increase. Ceteris paribus, the costs of production
will increase which cause the SRAS to decrease. Wages can increase for many
reasons. For example, due to the imposition of a minimum wage law or because of
stronger trade union bargaining with employers.

Changes in non-labour resource prices

▪ When the prices of non-labour resource such as crude oil increase, this means that
the unit factor cost will increase. Ceteris paribus, this leads to an increase in the overall
costs of production resulting in a decrease in SRAS.

Changes in indirect taxes on producers (e.g VAT/GST)

▪ An increase in indirect tax on goods and services has the effect of increasing the costs
of production. Hence SRAS would decrease if the indirect tax increases as the
producers would need to be compensated with higher prices in order to be willing to
supply the same quantity.

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Factors that cause the LRAS curve to shift

The classical range of the AS curve will shift to the right when there is an increase in the
productive capacity of the economy, increasing Yf. Conversely, when there is a fall in the
productive capacity of the economy, the classical range of the AS curve will shift to the left,
lowering Yf in the process.

General Price Level

AS1 AS2

Real National Income

Yf1 Yf2

Fig. 5

Changes in the quantity of factor inputs

▪ An increase in the quantity of resources means more resources can be put into the
production process to increase national output. Consequently, the productive capacity
of the economy increases and the full employment national output increases. For
example, in Singapore, to increase the labour force, the government has allowed
domestic firms to employ foreign workers as long as they do not discriminate against
local workers.

Changes in the quality of factor inputs

▪ An increase in education levels will make the labour force more skillful and this
increases the economy’s ability to produce more goods and services as the workers
are more productive, increasing the full employment national output level. Increase in
the quality of other factor inputs has the same result. For example, the government of
Singapore placed great emphasis in developing human capital. Education is heavily
subsidized and strict regulations are in placed to ensure high quality. This has enabled
Singapore to develop quickly from a labour intensive to a capital intensive economy,
increasing national income to a level comparable to most of the developed nations in
the world.

Changes in technology
▪ An improvement in technology will affect the productivity levels as better machinery
will be able to produce a larger output from a given amount of resources. This will
increase the productive capacity of the economy.

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Impact of the shifts in AS

General Price Level

AS1
P1
P2

AS2 AD

Real National Income

Y1 Y2 Yf

Fig. 6

An increase in the AS due to a fall in production costs (i.e. AS curve shifts downwards)
results in an increase in real national income as general price level falls from P1 to P2.
Aggregate spending increases as consumers can now purchase more goods and services
with the same disposable income, thus increasing consumption levels and thus national output
increases from Y1 to Y2. Thus, actual economic growth is achieved. As real national output
has increased, this implies more resources have been utilized. Employment level in the
economy would therefore increase correspondingly.

General Price Level

AD AS1 AS2

P1
P2

Real National Income

Y1 Y2 Yf1 Yf2

Fig. 7

An increase in the AS due to an increase in the productive capacity of the economy (i.e.
vertical portion of the AS curve shifts right) results in an outcome similar to the case presented
in Fig. 8. However, on top of actual economic growth, the increase in the productive capacity
of the economy from Yf1 to Yf2 ensures that growth is sustained due to the increase in potential
growth.

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3. Interaction of AD and AS to determine equilibrium level of national output and

general price level

The equilibrium level of the general price level and national output is determined at the point
of intersection between AD and AS when planned spending equals planned production.
However, when AD is not equal to AS, say when there is a shift in AS or a shift in AD, how
does the economy return to the state of equilibrium?

Consider the case when AD increases. Due to the increase in AD, aggregate spending in the
economy rises. This excess spending on domestic goods and services will lead to a fall in
inventories. Firms will then raise production in the next production period to meet the higher
spending as well as to replenish stocks. The increase in production will lead to an increase in
national output which requires the use of more factor inputs. The firms then employ more
workers and other factor inputs to produce the higher output and the national income will
increase correspondingly. This adjustment process will continue until planned production is
again equal to planned expenditure where AS=AD.