Aggregate expenditure Flashcards
What is aggregate expenditure?
The sum of all spending on goods and services produced in the economy. It consists of consumption, investment, government spending and net exports.
What is the equation for AE?
AE = C + I + G + (X-M)
What was Australia’s GDP in 2013-14?
Australia’s Gross Domestic Product in 2013-14 was $1.6 trillion dollars
Consumption expenditure
Accounts for 55.7% of AE Consists of: - Expenditure on non-durable goods - Expenditure of durable goods - Expenditure on services
Non-durable goods
- Consumed shortly after purchase
- Eg. Food, drink and packaged products, clothing and footwear
- Regarded as essential
- 35% of consumption expenditure
Durable goods
- Last longer
- Include white goods, brown goods, toys, sporting equipment and motor vehicles
- Usually discretionary, so it can be postponed or brought forward
- 15% of consumption expenditure
Services
- Intangible and usually provide transitory satisfaction of wants
- Include items such as education, transport, health and recreation
- Largest component and accounts for 50% of consumption expenditure
What is private investment?
Spending on new capital goods and additions to inventories
22.5% of AE
What does a capital good refer to?
Any item of machinery that is used to assist labour in the productive process
What does private investment consist of?
- Business investment – privately funded expenditure on capital goods such as equipment, machinery and buildings used in production
- Housing investment – private expenditure on new housing
- Inventories – unsold goods or stock (inventories rise when all current production is not sold). Inventories are excluded from investment spending in the aggregate expenditure equation
What is planned investment?
The planned spending by firms on business investment and residential investment by households
What does actual investment comprise of?
Planned investment plus inventories
Investment spending
- Most volatile component of AE
- Private investment has accounted for between 16% and 26% of GDP
- Fluctuations in private investment spending are through to be a key factor in explaining changes in economic activity over the course of the business cycle
Government expenditure
22.3% of AE and is divided into current spending (G1) and capital spending (G2)
Current spending
- Expenditure on the day-to-day business of government in its core functions like health, education, social welfare and defence.
- This includes wages and salaries, and the purchase of goods and services
Capital spending
- Spending on productive machinery and essential public infrastructure
- Such as power and water supply, roads, railways and communications networks
Net exports
Exports - imports
Make up -0.4% of GDP
What are the main factors affecting consumption?
- Level of disposable income
- Cost of credit (interest rates)
- Current stock of wealth
- Consumer expectations
- Government economic policy
- Other influences
The level of disposable income (affecting consumption)
- Most important factor
- It is the level of income households receive after taxation
- Consumption function model
o There is a positive relationship between the amount households spend on consumption and their disposable income
o Although, the proportion of income spent on consumption declines as income rises
Interest rates (affecting consumption)
- Interest rates represent the price of money – the cost of borrowing
- Low interest rates have a positive effect on household spending
o Interest rates represent a smaller slice of disposable income when interest rates are low
o The opportunity cost of consumption also falls as households are faced with two choices, to spend or save their income.
o Saving is less attractive when interest rates are low because they won’t get as much of a return on their saved funds - When interest rates rise, the opportunity cost of consumption increases and repayments take up a larger proportion of disposable income, therefore giving households a greater incentive to save
Current stock of wealth (affecting consumption)
- Households that hold real assets such as property or shares tend to feel wealthier when prices in those markets are high
- Even though the values are only on paper, a decline in the stock of wealth may cause significant changes in saving and spending patterns in the economy because it changes people perceptions of their wealth
Consumer expectations (affecting consumption)
- They are the positive or negative sentiments that people hold about the state of the economy
- Consumer sentiment has a greater impact on households’ intentions to purchase discretionary items such as holidays, computers, televisions and motor vehicles
Government economic policy (affecting consumption)
- The Reserve Bank of Australia administers monetary policy, for example increasing interest rates will discourage spending in the economy resulting in a contraction effect
- The Commonwealth Government is responsible for fiscal policy and uses the government’s spending and taxing powers to influence household spending decisions
Other influences affecting consumption
- Exchange rates
- Distribution of income and wealth
- Demographic factors
What is investment?
Expenditure on producer or capital goods that will be used to produce final goods and services in the future.
Investment rises and falls according to the perceived level of risk which the future entails
What are the main factors that influence investment expenditure?
- Rate of interest
- The elasticity of investment
- Profitability in the business sector
- Business expectations
- Government policies
- Stability of the macroeconomic environment
Rate of interest (investment expenditure)
- Interest rates and the level of investment expenditure are negatively related
- Interest rates represent the price of borrowed money, so when rates rise, so do the periodic payments for capital items purchased with borrowed money
- Firms have a choice of using retained profit for new investment or some alternative purpose
- The opportunity cost of investment increases when interest rates are high
Elasticity of investment with respect to interest rates (investment expenditure)
- Influenced by the current stage of the business cycle and producer expectation
- During an upswing
o Producers are likely to be upbeat about future prospects and continue to invest despite rising interest rates - During a contraction phase
o Expectations of lower levels of economic activity and profits are likely to reduce investment spending even though interest rates may be relatively low
Profitability in the business sector (investment expenditure)
- Many firms retain a portion of their profits for expansion such as building new premises or buying new equipment
- Challenging economic conditions: firms may tend to run down capital equipment over a long period of time
- Technological progress is embodied in new capital items
- Firms invest to take advantage of the lower average costs of production and increased efficiency that capital equipment can deliver
- This is an important strategy to lower unit costs, even when the level of economic activity is low
Business expectations (investment expenditure)
- What businesses think about the current level of economic activity and forecasts for the future
- Formed as a result of current economic events: levels of sales and enquires from buyers
Government policies (investment expenditure)
- Significant impact on private investment
- Fiscal and monetary policies affect cost and expected returns
- Taxing an industry can change the risk/reward in that sector
- Tax incentives may also attract funds to an industry
What is government expenditure mainly influenced by?
The state of the economy
What makes up the majority of government spending?
- On current items
- The goods and services consumed by government institutions and the wages and salaries paid to employees
- Government institutions also provide essential services such as health, education; law and order; social security and defence
Long term investment in essential infrastructure
- Public utilities such as power and water supply
- Roads
- Railways
- Communication networks
Main factors affecting net exports
- Domestic economic activity
- Exchange rates
- Terms of trade movements
How are net exports one of the most volatile components?
- Overseas demand for Australian commodity exports fluctuates according to regional and world economic conditions
- For example, there was strong demand for Australian resources due to the development of the Chinese and Indian economies
- Agricultural and pastoral commodities are influenced by the vagaries of seasons and events such as drought
Domestic levels of economic activity (affecting net exports)
- Influence Australia’s propensity to import
- Imports are relatively elastic due to the small size of Australia’s manufacturing sector
- In periods of strong economic activity, consumers import goods that cannot be sourced from local manufacturers and businesses buy capital equipment not produced domestically
Exchange rates (affecting net exports)
- When the Australian dollar appreciates, our exports become less competitive in overseas markets and imports become cheaper and therefore more competitive against domestically produced items
- An appreciation will therefore have a contractionary effect on AE – decreasing net exports
- If the Australian dollar depreciates, this will have an expansionary effect on the economy because exports become cheaper in the overseas market, therefore becoming more competitive. Imports also become more competitive, decreasing net exports.
What did Keynes show?
That fluctuations in government spending could have significant effects on output and employment, and that it was appropriate for government to spend more in times of recession to boost economic activity.
What does the consumption function represent?
The relationship between the level of disposable income received by households, and the level of consumption and savings
Assumptions of the consumption function?
- No government sector
- No overseas sector
- There are only two ways for people to use their disposable income: spend it or save it
What is income equal to?
Y = C + S
consumption + savings
What does the 45 degree line represent?
Shows all points where planned expenditure equals total income
When the consumption function intersects the 45-degree line, the economy is in equilibrium
What does point A represent?
- The level of consumption expenditure (C) equals the level of income
- Referred to as the ‘breakeven’ point
What is the equation for consumption?
C = a +bY
C = a +bY
What does variable A represent?
- Where the consumption function meets the y-axis
- Known as autonomous consumption
- Refers to the level of aggregate spending even if consumers had no income (presumably they would draw from savings)
C = a +bY
What does variable B represent?
- The rate at which consumption changes when income rises
- The slope of the line
- Known as the marginal propensity to consume (MPC)
What is the marginal propensity to consume (MPC)?
The fraction of any change in income that is spent on consumption
Equation for the MPC
MPC = (∆C )/(∆Y)
What is the marginal propensity to save (MPS)
The fraction of any change in income that is saved
Equation for MPS
MPS = (∆S )/(∆Y)
MPC + MPS =?
1 (this assumes that all income is either spent or saved)
Size of the MPC
- Depends on the attitude of consumers to spending and saving
- If the MPC increases, then the consumption function will be steeper
- A steeper function means that households spend a greater proportion of income
What is the average propensity to consume? (APC)
The proportion of total income which is spent on consumption
What is the average propensity to save? (APS)
The proportion of total income which is saved
What happens as income rises?
APC falls and the APS rises, even though marginal rates stay the same
What is the role of the financial sector?
To act as an intermediary to channel the savings of households to firms who can draw on these funds to finance investment
Assumptions of adding the financial sector
- Investment spending is a fixed amount
- Investment is independent of the level of income
What does investment spending refer to?
Planned spending on capital equipment (it does not include changes to inventories
What does aggregate expenditure now equal?
The sum of consumption and investment
AE = C + I
When does the new equilibrium occur?
Occurs where total planned spending (C+I) equals output or income
- This is where the C+I function intersects the 45® line
What happens if the level of income is either above or below the equilibrium level?
Then planned spending will not equal output and firm’s inventories will change. The economy will automatically move towards equilibrium.
When the C+I line lies below the 45® line
- The level of savings is greater than the level of planned investment
- Inventories rise and firms cut production
- Income levels starts to fall
- Occurs during a downturn
When the C+I line lies above the 45® line
- Investment is greater than savings
- Inventories fall and firms increase production
- They may have to employ more people, creating more income.
- This may occur during an upturn
Government expenditure (G) and exports (X) in the full AE model
Assumed to be a fixed amount and independent of the level of real GDP
Imports in the full AE model
Assumed to increase with the level of disposable income. This is referred to as the marginal propensity to import
Changes to inventories at equilibrium
There are no changes to inventories at equilibrium
Equilibrium
- no tendency for change in the levels of income or output at that point in time
- total planned spending equals output
- The income level where planned saving by households equals planned investment by firms
At lower levels of income (Y1)
- planned spending is greater than output
- there is a decrease in inventories
- firms will increase aggregate output, so income and employment will rise
At higher levels of income (Y2)
- planned spending is less than output
- there is an increase in inventories
- leads to a decrease in production and the level of output and income will fall back to the equilibrium level
