Aggregate Expenditure Model

Question 1

What is aggregate expenditure?

Answer 1

definition: sum of all spending on goods and services produced in the economy

AE = C + I + G + (X-M)

Question 2

What is the consumption component of AE?

Answer 2

• largest component of AE
• consists of
  
  • goods: tangible (can be seen and touched)
    
    • non-durable goods: consumed shortly after purchase (up to 3 years) i.e. food, drink, clothing and footwear (35%)
    • durable goods: last for 3 or more years i.e. white goods (washing machines, fridges), brown goods (furniture), toys, motor vehicles. Spending is usually discretionary (can be postponed/brought forward (makes up about (15%)
  • services: intangible and usually provide transitory satisfaction of wants i.e. education, health, recreation (50% of consumption)

Question 3

Describe the investment (planned) component of AE

Answer 3

definition: spending on new capital goods and additions to inventories, a capital good is any item of machinery that is used to assist labour in production process

• gross private income categories (planned investment + inventories)
  
  • business investment: privately funded expenditure on capital goods – equipment, machinery and buildings used in production
  • housing investment: private expenditure on new housing
  • inventories: unsold goods aka stock, they rise when all current production is not sold. Excluded from investment spending
• planned investment components (Ip – most volatile)
  
  • planned business expenditure on new capital equipment – machines, factories, buildings, tools
  • expenditure on new housing

Question 4

Describe the government component of AE

Answer 4

• accounts for 22.3% of aggregate spending
• components
  
  • G1: current spending/consumption – refers to expenditure on the day-to-day government in its core functions i.e. health, education, social welfare
  • G2: capital/investment spending – spending to provide for future needs i.e. schools roads, power, communication

Question 5

Describe the net exports component of AE

Answer 5

• exports minus imports
• exports adds to aggregate expenditure on goods and services produced in Aus. while imports are a withdrawal from the circular flow of income

Question 6

What are the factors affecting consumption expenditure

Answer 6

• disposable income (Yd) level: there is a positive relationship between the amount households spend on consumption and their disposable income but proportion of income spent on consumption declines as income rises
• interest rates (r)/cost of credit: interest rate represent the price of money (cost of borrowing). Low interest rates have a positive effect on household spending because
  
  • interest payments represent a smaller slice of disposable income when interest rates are low
  • opportunity cost of consumption falls: savings is less attractive hen interest rates are low, because holding surplus funds in interest-bearing deposits offers a lower rate of return. Rising interest rates may postpone consumption decisions as it means repayments take up a larger proportion of disposable income and the oc of consumption increases
• stock of wealth: changes in people’s perceptions of their wealth affect their spending i.e. durable consumer spending in the early 2000s along with the boom in share and house prices
• expectations: consumer sentiment (influenced by reports on changing economic growth, interest rates, exchange rates and movements in the share and property markets) have a greater impact on households’ intentions to purchase discretionary items
• availability of credit: govt. economic policy influences consumer spending, via monetary policy – RBA using ‘cash rate’ (increase in cash rate leads to an increase in interest rates) and fiscal policy – responsibility of Treasury

Question 7

What are the factors affecting investment expenditure?

Answer 7

• business expectations: what business think about the current level of economic activity and forecasts for the future (perceived risk which the future entails) – formed as a result of current economic events (incl. political decisions, international events, consumer sentiment) i.e. level of sales and enquiries from buyers. If expectations about future sales and profit levels are positive, then it is likely that the investment demand curve will shift to the right
• interest rates: ceteris paribus, interest rates and investment are negatively linked. This is due to
  
  • interest rates represent the price of borrowed money, so when rates rise, so the periodic repayments for capital items purchased with borrowed funds, and
  • interest rates represent the opportunity cost of money – firms can retain profit for new investment or an alternative purpose, oc increases when interest rates are high. Responsiveness of investment varies however, interest rate elasticity of investment is influenced by the current stage of the business cycle and producer expectations i.e. after the GFC interest rate were very low yet investment spending in 2009-10 in Aus. (apart from the mining sector) due to expectations of lower levels of economic activity and profits
• profitability: many firms retain a proportion of profits for expansion (embodied in new capital items) which means firms invest to take advantage of lower ave. cost of production and increased efficiency it can deliver i.e. when economic conditions are challenging and profits are low, firms tend to run down capital equipment over a longer period of time (depreciation)
• technology
• government policies: fiscal and monetary policies affect investment because they can affect cost and expected values i.e. taxing the earnings of an industry can change the risk/reward relationship

Question 8

What are the factors affecting government expenditure?

Answer 8

• discretionary changes in accordance with govt. policy objectives i.e. social policy, health, education
• automatic changes due to the business cycle
  
  • economic factors influencing private business apply to some extent
  • affected by current need (to match provision of essential services)
  • long term investment in essential utilities i.e. power and water supply governed by need and state of economy
  • can be used to stabilise macroeconomic fluctuations

Question 9

What are the factors affecting net export expenditure?

Answer 9

• level of domestic and overseas economic activity i.e. development of Chinese and Indian economies is associated with the strong demand for Aus. resources, domestic levels of economic activity influence Australians’ propensity to import
• exchange rates: when the AUD increases – contractionary effects on AE (decreasing net exports) as Aus. exports become less competitive in overseas markets and imports are cheaper and more competitive
• terms of trade: increase in terms of trade is favourable (mainly due to increase in commodity prices with increase in growth in China and India) as leads to export income rise, import price index fall (as labor is cheaper in Asia) and hence an increase in AE
• presence of tariffs of quotas

Question 10

What is the multiplier effect and how is it calculated?

Answer 10

refers to proportion by which income will rise following the initial change in spending (shows how one person’s spending creates another person’s income)

k = 1/(1-MPC)

OR

k = 1/(MPS)

Question 11

How is the size of the multiplier determined?

Answer 11

• determined by factors that affect the marginal propensity to consume – most important influences on the multiplier process are the sizes of leakages associated with savings, taxation and imports – each reducing the size of the multiplier

Question 12

How is the business cycle and AE linked?

Answer 12

• any autonomous increase in one of the components of AE will be multiplied to result in a higher level of real GDP
• any autonomous decrease in a component of AE will be multiplied to result in a lower level of real GDP