Y6 H2 Economics 2013 Term 1 Essay Test 2 How the Macroeconomy Works (Part 1) Income Determination (a) Explain the

he determinants of consumption in an economy. [8] (b) Analyse the impact of an increase in consumption on the economic growth of different countries. [17] Approach Question requires students to understand the concept of consumption and explain the main factors affecting consumption in an economy. Introduction: - Define consumption: the use of income by households to purchase goods and services to satisfy current wants. - Highlight different types of consumption: Consumption has both an autonomous component (independent of Y) and an induced component (dependent on Y). - Consumption can be represented the consumption function: C = a + bY Body: - Explain the determinants of autonomous consumption. o Interest rates As interest rate falls, the level of consumption increase. And vice versa. The lower the i/r, the lower the cost of borrowing. The lower the cost of borrowing, the more likely households will borrow to consume especially on big ticket items as the total cost of consuming the good falls. Hence, the level of consumption will rise. The reverse is true when interest rates increases. Examples: Cars and furniture o Expectations of future income If households expect an increase in future income, they would be more willing to spend now (may even borrow to spend now) as they believe they will have the means to finance their current expenditure. This positive consumer sentiment will lead to an increase in consumption. The reverse is true for expectations of a fall in future income. o Government policy If government raises income tax rates, disposable incomes (aftertax incomes) would fall at each income level and households have less purchasing power. This will lead to a fall in consumption. o Other factors include expectations of future prices and wealth. Explain the determinant of induced consumption o Level of income The higher the level of income, the more households are willing and able to consume given the higher purchasing power the higher the level of consumption.

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Marginal propensity to consume For a given level of income (and autonomous consumption), the higher the MPC, the more households consume out of additional income, the higher will be the level of induced consumption for given change in NY.

Conclusion: - There are many determinants of consumption in an economy. - The relative importance of the factors differs from country to country and may also depend on the prevailing state of the economy.

Common Mistakes: Did not establish what is meant by consumption. Insufficient scope of explanation: o Did not explain both induced and autonomous consumption o Lack of factors explained (must explain 3 factors to gain Level 3 marks). o Poor choice of factors chosen. A worrying number of students looked solely at the change in GPL using the wealth effect, interest rate effect and foreign substitution effect, in affecting C. But students should know GPL is only one factor that affects consumption and those effects are mainly used to explain the inverse relationship between level of AD and GPL, not Consumption and GPL. Insufficient depth of elaboration o Students tend to state the factors rather than explain the factors. E.g. students stated that an increase in interest rate will reduce the level of consumption, but did not explain the mechanism through cost of borrowing. Likewise for those students who stated wealth as a determinant - they did not mention what constitutes wealth and how it may change. Lack of application o Students must be aware that even for a part (a) question, there is a need illustrate points with use of examples. Students can gain a maximum of Level 2 marks without examples. Others: o Suggestion that a switch of consumption from domestically produced goods to imports leads to a fall in consumption. That is incorrect as households consumption includes both consumption of domestically produced goods and imports. The statement is only true if consumption is defined as just domestic consumption. o Many students stated that savings as a factor that affects consumption, without explaining what factors may cause savings to change. Savings is an indirect determinant of consumption, and students should go straight into factors affecting consumption instead.

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(b) Approach Students are required to explain the impact of an increase in consumption on national income (actual growth) and analyse the extent of impact on different economies. Students are also required to look at changes in potential growth as a result of increase in consumption. Introduction: Define economic growth Sustained increase in real NY. (For a sustained increase in real NY, there must be both actual and potential growth) Clarify different economies Small open economies (SOE) vs large economies; Developing vs developed; Different policies (welfare state vs non-welfare states); Different economic conditions

Body: Explain how increase in C leads to increase in real NY via multiplier process (Refer to lecture notes for a detailed explanation of k-process) o Increase C Increase AE or AD more than proportionate increase in real NY (actual growth) via multiplier process. o The k-effect is based on the principle that expenditure creates income and income generates greater expenditure. o Multiplier process: > Increase in (autonomous) C increase in NY > Increase in NY induces spending, which then becomes income for someone else > In each round, induced C < increase in NY as some of the increase in Y is leaked out (S, T, M) > Process ends when all the original increase in C is leaked out > Total increase in NY is a multiple of original increase in C

Explain the extent of impact of increase in consumption in different economies. o Explain how MPW affects size of multiplier. A higher MPW means more leakages in each round of the multiplier process and hence less induced consumption and income generation in each round. Also, they will be fewer rounds of income generation in the multiplier process. Hence, higher MPW means smaller multiplier. Factors that cause MPW to differ across countries: Different MPS May be due to policies (e.g. compulsory savings in Sg vs no compulsory savings in Hong Kong), prevailing i/r on deposits (higher i/r induces

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people to save more of additional income), developing economies tend to have lower MPS as many needs and wants of households not met yet, etc. Different MPM SOE that lack natural resources (e.g. Singapore) will need to import most things (hence high MPM) vs large, resource abundant economies (e.g. Australia) Different MTR Welfare states or states that adopt the tax-and-spend model will tend to have higher marginal tax rates (MTR) than countries where governments are leaner or countries that adopt low tax rates to attract high-skilled migrants.

Explain the impact of increase consumption on potential growth o Increase in current consumption is at the expense of savings as savings fall, this will lead to a fall in investments due to less funds for investment and rising interest rates fall in productive capacity fall in potential growth economic growth will be hindered in the long run. o Increase in C through the k-process triggers the accelerator effect due to an increase in the rate of change in NY increase in I increase in AD and productive capacity (Note: the accelerator principle is out of the syllabus dont worry if you do not know what it is). Other factors that determine the magnitude of the economic growth when consumption increases. o o Presence of spare capacity (no spare capacity limited increase in real NY for given increase in C). Original amount of increase in domestic C >Larger increase in C larger increase in real NY for given size of multiplier) >Increase in total C may not necessarily be due to increase in domestic C (if increase in total consumption was all due to increased consumption of M, then no change in national income). [Note: point only valid if student makes clear that consumption in the question is interpreted as total consumption].

Overall evaluation and Conclusion: Impact of increase in consumption will lead to actual growth in most countries. The extent of growth depends on the extent of increase in C, the size of k and the state of the economy (whether the full k-effect can be experienced) As to whether growth can be sustained depends on the impact on productive capacity.

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Common mistakes: Did not establish what is meant by economic growth. Irrelevancies in analysis: o Some students were answering a different question. The answer addressed inflation rate and unemployment rate, which is not part of the question. Insufficient scope of analysis: o Did not address the impact on potential growth. Students must be aware that whenever a question is on economic growth, they must pay attention to BOTH actual and potential growth. o Did not address the different factors affecting the size of multiplier. Weak depth of elaboration: o Insufficient elaboration on the concept of the multiplier. When a question is specifically on economic growth (17 marks), it is important that students gives a detailed explanation of the k-effect, the k-principle and the k-process (when it starts, how it continues, and when it stops), since economic growth is about a rise in real national income. o Superficially explaining why the size of multiplier affects the impact of consumption on economic growth with explaining why the size of multiplier differs across countries. o Many students also did not explain HOW the size of the multiplier will change effect the economic growth rate. They are expected to show that with a smaller k, every round of induced consumption is lower than with a larger k, thus affecting the rate of growth. Poor application to the question: o Did not look at different economies just different size of k. o Lack of use of examples in the essay. o Superficial use of examples such as country A and Country B. Surely you know the names of some countries, such as Singapore, China, the US etc. No evaluation and judgement o Students are still very weak in evaluation. In this question, a judgement must be made on the different impacts on countries. Poor time management o No conclusion and evaluation

Overall criticism on stylistics: Need to ensure that diagrams are not text-wrapped One sentence is not equivalent to one paragraph

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