MJC H2 ECONS EQ5

JC2 H2 Prelims Question 5 (a) Explain the process whereby an increase in government expenditure can lead to a bigger change in national income. [10] (b) In view of rising government debts, discuss whether governments’ subsidies to increase its global competitiveness is justified. [15] Suggested Answer to Part A Introduction Identify the process as Multiplier process and state the multiplier and its formula: This is the multiplier process, where any increases in injection, e.g. government spending, will cause national income to increase by a multiplied amount of the rise in G. This is determined by the size of the multiplier, k, where k = 1/ 1- Marginal Propensity to Consume (MPCd) = 1/ Marginal Propensity to Withdraw (MPW) A small MPW will mean that a small proportion of additional income is allocated to withdrawals such as savings, taxes and import expenditure in the economy, theref ore the size of the multiplier will be large, resulting in a large multiplied increase in national income. Explain the underpinning of the multiplier process: For instance, a country like U.S. will have relatively higher rate of consumption due to well- developed social security systems hence less incentive to save. This means that given an amount of injection, lesser income is leaked away as withdrawals while a larger proportion of additional income is spent on domestic consumption in each round of spending. This means that every round of the i nner flow results in larger rounds of induced consumption. This results in a larger multiplied increase in national income. Development Explain the multiplier process: Let us assume a four-sector economy with an MPC of 0.9. It is assumed to be initially in equilibrium and spare capacity is available in the economy. Briefly Explain the CFo I, role of HHs and Firms : In the inner flow there are 2 key sectors, the households and the firms. The role of the households is to supply factors of production e.g. Inner flow of income Outer flow of income

land, labour, capital and entrepreneurship to the firm s in return for factor income. This income is then used to purchase goods and services or be withdrawn from the inner flow as savings, taxes and import expenditure. The role of the fi rms is to produce goods and services which households will exchange for consumption expenditure. Explain trigger(s): An injection is an addition to the circular fl ow of income which does not come from the expenditure from domestic households. In this case, the Increased spending by the government could be spent to improve public infrastructure. Explain multiplier effect: [Round 1] When $10bn of government spending is spent on infrastructure upgrading  construction firms will have to increase their output by a value of $10bn. This means that they will have to hire FOP such as skilled workers and machinery. HHs that supply factor inputs to these industries will hence receive $10bn worth of income. Given the MPCd is 0.9, they will spend 90% of it on goods and services such as food. Domestic consumption will increase by $9bn. $1bn is withdrawn from through savings, taxes and imports. [Round 2] Firms in the food industry will thus to increase their output by a value of $9bn. This means that they will have to hire FOP such as labour and machin ery to manufacture food. As the HHs working in the food industries receive $9bn worth of income, they will spend 90% of it on goods and services such as clothing. Domestic consumption will increase by $8.1bn. $0.9bn is withdrawn from through savings, taxes and imports. [Conclude] The process continues with each round of consumption expenditure being 90% of the previous rounds income. This process does not go on indefinitely and it stops when the value of the initial injections (or total injections) is equal to the sum of the withdrawals. As k=1/MPW, k=1/0.1 = 10 Change in NI = change in injection x k = S10bn x 10 = $100bn National income would have increased by a multiplied amount of $100bn. Level Knowledge, Application, Understanding and Analysis Marks L3 Detailed and analytical explanat ion of the impact of increased government spending on a country's national income with a clear understanding of the working of the ‘k’ process 8-10 L2 Some analysis of the impact of increased government spending on a country's national income. 5-7 L1 Unexplained statements of the mult iplier process, largely lacking in analysis. 1-4

(b) In view of rising government debts, discuss whether governments’ subsidies to increase its global competitiveness is justified. [15] Suggested Answer to Part B Introduction In this essay, we will define global competitiveness in terms of • increasing price competitiv eness of a country’s exports • increasing non-price competitiv eness of a country’s exports (Students may also define global competitiveness in terms of the ability to attract FDI) Thesis: Governments’ subsidies to increase its global competitiveness is justified Development 1: Governments’ subsidies to increase its glo bal competitiveness can be implemented through supply side policies to: 1. increase non-price competitiveness With the use of better technology and machinery to harness better designs and quality of exports produced  this can help to increase non-price competitiveness demand of exports will increase and at the same time, become more price inelastic due to the reduced substitutability to other competitors’ goods 2. increase price competitiveness Policies directed at SMEs and capital enhancement through funding of research and incentives to innovate. E.g. Productivity and Innovation Credit Scheme resulted in capital accumulation which takes the form of capital broadening & capital deepening. E.g. Through the Productive Innovation credit, firms enjoy tax deduction or cash reimbursement for the retraining of workers, investing in automation or acquiring intellectual property. Economic analysis version 1: firm analysis By encouraging automation, if export-related firms are likely to increase their investment spending on capital goods such as automated equipment and this might be used to replace labour as machine might be able to increase the output per hour especially for repetitive task. On the other hand, use of retraining to equip workers with new skills can increase labour productivity as workers are more able to work with more efficient technol ogy etc. this helps to further increase output per manhour. The above will help to lower unit cost of production, lowering average and marginal cost of the firm, resulting in lower prices charged at PN. Price competitivene ss of exports produced increases. Assuming PEDx>1, a fall in price w ill lead to a more than proportionate increase in quantity demanded, hence, increasing export revenue.

OR Economic analysis version 2: macro. level analysis if these policies are conducted across all industries, the increase in productivity will lead to lower unit cost of production, increases in aggregate supply from AS1 to AS2, hence, GPL falls from P1 to P2. Price competitiveness of goods including exports will increase. Assuming PEDx>1, a fall in price will lead to a more than proportionate increase in quantity demanded, hence, increasing export revenue. Development 2: Use of subsidies is justified as there are positive impacts of increased competitiveness on the macroeconomy • Increase X  increase AD  increase actual growth and hence, increase material standard of living, given that consumers will have higher incomes and hence greater ability to consume more goods and services • On the other hand, with increases in real output produced this will increase the aggregate demand for labour  decreasing demand-deficient unE which can also improve non- material standard of living  with more individuals being able to f