Explain the possible impact of a world-wide recession on the components of the circular flow of income for a small and open economy such as Singapore
The circular flow of income for an open economy is a model that shows the flows of goods and services and factors of productions between firms and households and in the process injections and withdrawals are made by the government and the rest of the world. This model shows that household provides the factors of production for firms who produce goods and services. In return, the factors of production receive the factor payments (such as wages, dividends, and profits) which are in turn spent on the firm’s output. The circular flow of income can be expanded by injections (addition to the circular flow which does not come from the domestic expenditure of the household in the form of investment, government expenditure, export revenue) and reduced by withdrawals (any part of income not passed on within circular flow of income in the form of savings, taxes, imports).
Being a small and open economy, Singapore has placed a strong emphasis on export-orientated growth due to our small domestic market, thus resulting in a strong dependence on export revenue to sustain our economic growth. Moreover, with limited domestic investment and the openness to international capital flow, we are more dependent on foreign direct investment (FDI). Therefore, these two components account for a large proportion of the total injections in our economy. As for withdrawals, due to the lack of natural resources and the policy of free trade, we have high import expenditure. Therefore, the impact of a worldwide recession would adversely affect these components in Singapore.
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In a worldwide economic recession, Singapore’s export revenue would drop significantly. This is due to the fall in the aggregate demand for our domestically produced goods due to a lower income earned compared to previously. During a recession, household demand falls, firms experience difficulties in selling all their current output. As a result, they cut back on production and subsequently reduced the number of workers employed. This deficiency in aggregate demand results in cyclical unemployment causing the unemployment rate to rise globally, resulting in a general decrease in the income levels of households. With the reduction in income levels and a rise in the unemployment rate, the purchasing power of households globally would decrease significantly.
Therefore resulting in a significant fall in our export revenue, due to the high-income elasticity of our exporting goods such as electronics, there would be a more than proportional fall in our export revenue earned as the purchasing power of household globally decrease. With export revenue accounting for 236.4% (Q4/2010) of our GDP, this decline would cause a great shock to our economy. Despite, the significant effect on exports, imports are also affected but to a relatively small extend.
During a recession, imports expenditure on goods and services is generally perceived to decrease significantly. This is due to the decrease in aggregate demand due to the decrease in purchasing power as mentioned above. However, for Singapore, this is not the case. Due to the lack of natural resources and the inability to satisfy our domestic market with our limited level of production, we are highly dependent on foreign imports (182.8% (Q4/2010) of GDP).
Thus, we are very income inelastic toward foreign imported goods resulting in a less than proportional fall in the demand for foreign imported goods with the reduction in household’s purchasing power as a result of the inflation. This results in a slight decrease in import revenue hence have a minimal effect on withdrawal. Whilst for savings, the effect on withdrawals is also minimal. As more people are unemployed or have a general decrease in their income levels, it is difficult to save at the same amount as before with a lower income. Thus, the overall effect on withdrawals would only be a slight decline.
Despite the mild effect on withdrawals, this effect on injections is adverse. With the great decline in export revenue, the significant decrease in FDI has made the number of injections decrease further.
With a global economic recession, the level of investment being made would decrease. This is due to the decline in revenue that the firms earned from the reduction in the sales of their product due to a decrease in the demand for their good and services as households now have a lower purchasing power. This cause the firm’s profits to drop as compared to previously resulting in a reduction in the demand to invest as they now have fewer profits, hence fewer funds available for investment purpose and therefore less willing to invest.
Furthermore, with an economic recession, the future expected returns are not stable and the investment takes time to see the result, therefore firms might find it risky to invest during that period of time and hence decide not to do so. Moreover, most firms would focus on surviving in the market in the short run by operating at the level where marginal revenue equals marginal cost or above. Therefore, this results in a significant decrease in the level of FDI injected into our economy affecting our economic growth as we are heavily dependent on it.
In conclusion, Singapore’s injections would decrease significantly as compared to the mild decrease in withdrawals and this would adversely affect its internal economy.
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