RI H1 Economics Lecture Notes 5 Introduction to Macroeconomics

RAFFLES INSTITUTION YEAR 6 H1 ECONOMICS 2019 ECONOMICS CONTENTS: Introduction to Macroeconomic •AD-AS MODEL •FACTORS CAUSING CHANGES •The Multiplier Effect Factors Affecting the Standard of Living 1.Economic Growth 2.Price Stability 3.Employment 4.Other Factors Macroeconomic Policies to Improve the Standard of Living 1.Fiscal Policy 2.Monetary Policy (Interest rate & Exchange Rate) 3.Supply-side Polices Students will understand the concept of standard of living and its significance for countries. Students will examine domestic and external factors that affect a country’s standard of living. Students will examine how governments make policy choices at the national level in order to improve living standards. MACROECONOMICS LECTURE NOTES @dream

2019 Y6 H1 Economics Macroeconomics 1 RAFFLES INSTITUTION YEAR 6 H1 ECONOMICS 2019 Outline of Contents 1 AN INTRODUCTION 1.1 What is Macroeconomics? 2. AGGREGATE DEMAND (AD) / AGGREGATE SUPPLY (AS) MODEL 2.1 Aggregate Demand 2.2 Aggregate Supply 2.3 AD-AS MODEL AND EQUILIBRIUM LEVEL OF NATIONAL OUTPUT AND GENERAL PRICE LEVEL 3. CHANGES IN EQUILIBRIUM LEVEL OF NATIONAL OUTPUT CAUSED BY NON- GENERAL PRICE LEVEL FACTORS 3.1 Factors That Affect Aggregate Demand 3.2. Factors That Affect Aggregate Supply 4 CHANGE IN EQUILIBRIUM LEVEL OF NATIONAL INCOME 5 THE MULTIPLIER EFFECT Reference Mankiw, Gregory N., Quah, Euston, & Wilson, Peter, Principles of Economics: An Asian Edition, Chapter 33, Cengage Learning. At the end of this lecture series, you should be able to: 1. Explain what is meant by macroeconomics. 2. Explain the key determinants of AD and AS. 3. Explain how equilibrium output and price are determined using the AD/AS model. 4. An awareness of an increase in AD having a multiplied effect on national income INTRODUCTION TO MACROECONOMIC @dream

2019 Y6 H1 Economics Macroeconomics 2 1 A QUICK RECAP 1.1 What is Macroeconomics? Economics is traditionally divided into 2 parts: Microeconomics and Macroeconomics. Macroeconomics is on the aggregate economy as it considers the economy as a whole. Macroeconomics also studies relationships and connections between one country and another for example, how a slowdown in the Chinese economy can affect Singaporean businesses or how Brexit will affect Singaporean based firms exporting to UK and also other countries around the world. The scope of macroeconomics includes looking at the success or failure of government policies – for example does the government have effective and fair policies for cutting unemployment? Or has the government succeeded in creating the conditions for a durable and balanced recovery? In macroeconomics we look at things ‘in the whole’ and, in doing so, we use these terms regarding the different stakeholders of every economy: Households: Receive income through wages and salaries from their jobs and then buy the output of firms (this is known as consumer spending and is labelled as C) Firms: Businesses hire land, labour and capital inputs when making products for which they pay wages and rent. Firms receive payment from consumers and profitable businesses may invest (Investment is given the label ‘I’) a percentage of their profits into new producer goods such as equipment and technology Government: Collect taxes (T) to fund spending on public services such as education, healthcare and defence. Government spending is given the label (G) International/Foreign sector: Singapore buys imports (M) from other countries, and overseas businesses/consumers buy Singapore’s products – known as exports (X). International trade is important for Singapore. Thousands of jobs depend directly or indirectly on Singapore remaining competitive in overseas markets. It is common to analyse net exports (X-M) rather than look at imports and exports separately. 2. AGGREGATE DEMAND (AD) / AGGREGATE SUPPLY (AS) MODEL The aggregate demand and aggregate supply (AD/AS) framework is used to provide a more complete picture of how the economy works, in particular the causes behind economic growth, unemployment and inflation. The AD/AS framework helps us to understand how the equilibrium level of national income and the general price level in an economy are determined. 2.1 AGGREGATE DEMAND (AD) What goes on in the aggregate goods and services market is central to the health of an economy. Fluctuations in economic activity occur in all countries and in all times throughout history. Fluctuations in the economy are often called the business cycle. Economists use the model of aggregate demand (AD) and aggregate supply (AS) to analyse economic fluctuations. AD and AS interact and determine the equilibrium level of national income or output as well as the general price level. The vertical axis of the diagram reflects the general price level while the horizontal axis could refer to real national output or income. Definition: Aggregate demand refers to the total level of spending in an economy at various price levels. It shows the amount of domestically produced goods and services which households, firms, government and foreigners desire to buy at each price level. @dream

2019 Y6 H1 Economics Macroeconomics 3 AD = C + I + G + (X−M) In a 4-sector economy (households/firms/government/international), total expenditure on domestically produced goods and services consists of consumer spending by households (C), investment expenditure by firms (I), government spending (G) and expenditure by foreign buyers (X). Other factors remaining constant, the higher the price level, the lower the quantity demanded of goods and services. Referring to Figure 1, when the general price level falls from P1 to P2, the quantity demanded for goods and services increases from Q1 to Q2. In short, there is an inverse relationship between the general price level and level of national output (or income). 2.1.1 Why does the AD curve slope downwards? a. The general price level (GPL) and consumption (C): the wealth effect When the general price level falls, the purchasing power of households rises since their nominal incomes now can buy more goods and services. Thus, a fall in the general price level makes consumers feel wealthier, which in turn encourages them to spend more. The increase in consumption means a larger quantity of goods and services demanded and thus a larger output. b. The general price level (GPL) and Investment (I): the interest rate effect The lower the general price level, the less money households need to hold to buy the goods and services they want. When the general price level falls, households try to reduce the amount of money they hold by lending some of it out, driving down the prevailing interest rate. Lower interest rates, in turn, encourage borrowing by firms that want to invest in new plants and equipment and by households who want to invest in new housing since the interest rate is the price one pays to borrow money. Thus, a lower general price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded. c. The GPL and Net Exports (X-M): the international substitution effect When the domestic general price level falls while foreign prices remain constant, domestic goods have become relatively cheaper compared to the price of foreign substitutes. This is called a fall in the relative price level of domestic and foreign goods. Ceteris paribus, residents are likely to buy less foreign goods leading to a fall in import expenditure. At the same time, foreign demand for the country’s goods and services rises. Thus, export expenditure increases. Net export earnings (i.e. the value of exports minus value of imports) will tend to rise. Therefore, a fall in the domestic general price level stimulates the hom