JC Economics Essay Investment Expenditure & FDI Model Answers
Every single A-level Economics students understand that investments are very important for any economy, including North Korea (from China and Russia)! In particular, foreign direct investments (aka FDI) can help to jump start most economies.
(See case for Vietnam’s FDI and Sierra Leone’s FDI here.)
Most JC Econs learners also know the events happening in Singapore and what is causing the increase in investment. However, most exam candidates are not able to consistently use appropriate economic analysis to explain economic issues in Macroeconomics properly. The following essay question shoes that many were happy to list all the events which went on in Singapore in recent years and make a statement to link all these to increasing investment. This approach clearly did not demonstrate any form of application of economic analysis.
Answers to part b again demonstrated students do know the benefits and costs investment brings to the economy but often lacked sufficient scope to score L3 marks.
(a) Explain the main causes of increase in the level of investment by firms in the Singapore economy in recent years. (10)
(b) How far do you agree that the Singapore government should continue to encourage this increase in investment?
Investment Component Expenditure and Determinants of Autonomous Investment
Investment spending is expenditure over a given period on the production of capital goods (factories, machinery etc) and on net additions to stocks of goods (raw materials, semi-finished goods). Essentially these are expenditure by firms in the economy. In this essay we will explain the main causes of increase in investment in Singapore.
Investment decisions are assumed to be made on the basis of how the capital good can contribute to the firm’s profitability. As such, in considering whether to buy a capital asset such as a machine or tool, the firm would have to consider:
Marginal Efficiency of Investment (MEI)
Marginal Efficiency of Investment (MEI) is a concept used to measure the expected profitability or rate of returns from an additional unit of investment. Thus, for every additional dollar spent on buying capital asset businesses need to know how much yield / returns can be expected from the money spent.
The MEI shows an inverse relationship between investment and current interest rates (cost of borrowing for the firm). Firms will invest up to the point where MEI = r. The profit maximizing position is illustrated in Fig. 1. As long as the rate of return is greater than the interest rate, the firm should invest more. It should stop when the investment level reaches I₁.
(Note: for new 9757 syllabus, MEI is no longer required. explain the determinants immediately.)
Since the MEI is based on expected profitability and not actual/realized profits from an additional unit of investment business expectations naturally play a key role in determining its value. The position of the MEI curve is determined by businessmen’s expectations of an unknown and possibly uncertain future. The business sentiments / confidence of businessmen are perhaps the key determinant of the level of aggregate demand in the economy. If business sentiment improves, entrepreneurs will immediately revise upwards their expectations of future profits and income streams yielded by the investments they are considering.
Given that the performance of the Singapore economy has surpassed some of the most developed countries in the recent years, producers are more confident in our economy and choose to invest in Singapore. Firms estimate rates of returns on investments on the basis of expected after-tax profits. If there is a decrease in tax rates, we expect a rightward shift of the MEI. This is an important factor which affects investment decisions considering that it is one of the tool used to attract investments (Singapore has one of the lowest corporate tax rates in the region)
(Note: MEI explains the factor of business confidence and business outlook in relation to the level of investments.)
Low inflation in Singapore which allows firms to better predict their profits
Lower interest rates
Lower tax rates / competitive tax structure
skilled labour force
5G islandwide capability
intellectual property protection, etc, etc
Choose your preferred 3-4 factors.
Singapore Government and Efforts to Increase Investments
Thesis Singapore government should encourage increase in investments
Benefits of an increase in investments have on Singapore economy
1. Growth and employment Explain using AD/AS model how increase in I helps to increase national income and employment.
An autonomous increase in investment, it will increase the level of AD and leads to an unplanned decrease in stocks. As the firms increase production to increase their stock levels back to desired levels, they hire more workers (as well as other factors of production), employment. This will generate income for households employed by firms in the capital goods industry. The household will tend to spend a proportion of the additional income on consumption, depending on their marginal propensity to consume (MPC). This further creates income for households employed in the consumer goods industry who will further spend their additional income on consumption. This cycle of spending and re-spending on consumption will continue until the increase in income becomes negligible. The eventual increase in national income is several times the initial increase in investment. The multiplier, K, represents how many times the national income increases with respect to the initial change in investment.
With econ growth and lower unemployment rates, there is more efficient use of resources which results in a gain in actual output (higher material standard of living). There will also be less drain on government revenues for unN benefits (do we have this in SG?), and the government revenue can be used for other purposes such as improving infrastructure development and enhancing the education system.
2. Improve Balance of payment (not expected)
With the increase in foreign direct investments, this inflow improves the financial account of the balance of payment, ceteris paribus, balance payment will also improve
Anti-thesis Should not encourage. increase in investment because …
1. SR inflationary pressure.
Too fast an increase in investment leading to increase in AD faster than the growth of the economy’s capacity will result in overheating of the economy. With the increase in AD, firms increase their production to meet the rising demands, but to do that they will need to acquire more resources (factors of production) which may involve competing with others uses of these resources. Thus, factor prices will be driven up, driving up costs of production (shown by the upward sloping nature of AS), leading to demand-pull inflation.
2. Employment may not increase
Although with the increase in AD and firms will need to hire more workers, this does not necessarily mean that Singaporeans will be employed. It will depend on whether Singaporeans have the necessary skills to take on these jobs and very often these jobs may be filled up by foreign workers instead. Also, opportunity cost of current consumption If more resources are allocated to capital goods less will be available for consumer goods affecting current SOL. (Note: However in the future, more goods and service can be produced with the increase in the productive capacity due to the accumulation of capital goods.)
3. Possible negative impact on environment (not expected); Worsen Balance of payment (not expected)
Profits of FDI brought back may lead to worsening of current account on balance of payments.
1. However, LR LRAS shift rightwards due to increase in productive capacity. Hence will be able to achieve non-inflationary growth and low unemployment.
2. There must be supply-side policies in place to complement the increase in I eg. Appropriate training or reskilling programme to help workers meet the skills requirement and fill up the jobs created by the influx of investments.
Investment is an important contribution to growth (especially potential growth) and especially in Singapore’s case where our economy is highly dependent on investment given our small domestic market. Thus it is only right that the government should encourage investments given the positive impact on growth and employment. As to the extent to which the government should encourage the increase, the government should balance the rate of increase with other policies to minimise the negative impact too fast an increase in investment might have on the economy.
JC Econs Tutor’s Comments:
1. Did not use economic analysis to explain the impact of increase I on growth and employment. Explanation is wrong because some students mistaken I for consumption and government expenditure. Some went off track by evaluating the policies which helps to increase investment.
2. Did not explain why price level increases with increase in AD when economy is near full capacity. Quite a handful did not know that I will have positive effect on LRAS.
3. Some students argue that trade is more important to Singapore than Investment hence government should not encourage I and encourage X instead. But doesn’t investment helps to improve competitiveness of goods produced by local firms and hence exports?
4. Many also argued that increase in I will not help NI because of small multiplier effect and hence we should not encourage the increase in I. Going by this argument then there is nothing the government can do then?