Explain factors affecting Aggregate Demand, given the context of Singapore. [10]
Aggregate demand (AD) refers to an economy’s total demand for domestically produced goods and services for a given price level. In a 4-sector economy, AD is made up of components which include consumption (C), investment (I), government expenditure (G), exports(X) and imports (M). As the demand resulting from C, I, G, and X consists of demand for both domestic as well as imported goods and services, the spending on imports has to subtracted in order to determine the demand for domestically produced goods and services. Thus AD = C + I + G + X – M. However, economists typically combine exports and imports together as (X-M), which is known as net exports. Thus aggregate demand is commonly represented as AD = C + I + G + (X-M).
Consumption refers to household’s expenditure for goods and services, and it is mainly affected by their income. When the economy is booming, rising wages, rentals, profits and interests raise households’ incomes and stimulate consumption. Conversely, higher personal income taxes and social security contributions lower disposable income, which is the income of a household that is available for immediate consumption (usually after the deduction of direct taxes and social security contributions and the addition of direct transfers), and hence dampen consumption. In Singapore, disposable incomes are lower because households have to save a part of their wages in a state managed retirement fund called the Central Provident Fund (CPF), another part of their income for future healthcare epenses under the Medisave scheme and also have to contribute to Medishield, a compulsory healthcare insurance scheme.
Consumption is also affected by wealth, the value of accumulated savings and assets. The 2 main assets that experience fluctuation in its values are property and shares. A booming stock or property market pushes up the value of such assets, making households feel wealthier, thus stimulating consupmtion. A downturn in stocks and assets, however, decreases consumption. In addition, wealth is also affected by wealth taxes such as property taces and capital gains taxes, where lower tax rates increase consumption and vice versa.
The availability and cost of credit also affects consumption as households would borrow from banks to finance their spending on costly items such as property. Lower interest rates and easier access to credit, for example less strict conditions for loan and credit card applications stimulate borrwoing and raise consumption levels. Lower interest rates also reduce the incentive for households to save because the returns to savings are lower, hence there would be increased consumption.
Investment refers to firms’ spending on capital goods, which include purchasing new machinery and equipment. It is mainly affected by business expectations. If a firm expects the demand for its products to rise, it is likely to invest more now to boost future capacity. If business outlook is poor, then investment are likely to be postponed or decreased. Business expectations are largely dependant on the current state of the economy. If the economy is facing a recesssion then business outlook will be poor. Conversely if the economy is booming, business outlook will be optimistic.
Investments are also influenced by direct taxes on firms like corporate taxes, where firms are taxed on their profits. Reducing corporate taxes raises the post-tax profits and raises the incentive to invest because the returns to investment are higher while increasing corporate taxes hinders investments. In addition, the cost and availability of credit affects investments. Lower interest rates and easier credit conditions would translate to cheaper and easier finance investments. The cost and productivity of capital goods can also affect investments. Cheaper and more productive capital equipment increases the returns on investment thus increasing investment.
Government expenditure refers to the government’s spending on publicly provided goods and services. Government spending falls during an economic downturn, assuming that it only spends what it collects. During an economic downturn, lower tax collections arise as a result of declining income, profits and consumption levels, hence revenues from income, corporate and sales taxes fall. Thus the government’s ability to spend is limited by a lower tax revenue. With a fall in government spending, there will be a fall in aggregate demand because it is a component of aggregate demand.
Exports refer to foreign purchases of domestically produced goods and services while imports refer to domestic purchases of foreign produced goods and services. A country’s exports may increase as a result of increased foreign preference for its exports, which could be due to better marketing, improved product quality or having new products being produced. On the other hand, if other countries advertise their products more, the home country is expected to face rising demand for imports.
Rising income and wealth of foreign countries would lead to an increase in demand for the home country’s exports whereas rising income in the home country raises the demand for imports. Hence it can be seen that the key factor affecting income is the economic performance of a country. A booming economy results in rising imports while a recession brings about falling imports.
Exchange rates affect the prices of a country’s products relative to the products produced by other countries. An appreciating currency makes a country’s exports relatively more expensive and less competitive while imports become relatively cheaper and more competitive, thus reducing export demand and increasing import demand. A depreciation in the currency on the other hand helps boosts exports and curb imports.
A country’s inflation rate also affects its exports and imports. Rapidly rising wages, land prices and raw material costs will siginificantly push up a country’s cost of production, thus making its exports more expensive and less competitive. Higher domestic inflation also makes imports seem increasingly cheaper compared to domestically produced goods hence raising import demand. On the other hand, relatively higher inflation rates in other countries tend to increase the home country’s exports and reduce its exports.
Out of all the components that affect AD, (X-M) would be the largest component of Singapore’s economy, the reason being that Singapore has a small and open economy. Being a very small economy, Singapore cannot influence world prices and is forced to be a price taker due to our lack of resources. Thus, (X-M) is the largest component of Singapore’s economy.
GY (Gary)