The Aggregate Expenditre Model

Question 1

What is aggregate expenditure?

Answer 1

Aggregate expenditure is the cum of all spending on final goods and services produced in the economy.

Question 2

What does AE consist of? What is the formula?

Answer 2

AE consists of consumption (household expenditure on final goods and services), investment (spending on capital equipment), government spending and net exports (exports - imports).

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

Question 3

Describe what the consumption component of aggregate expenditure consists of.

Answer 3

Consumption consist of:

• Expenditure on non-durable goods.
• Expenditure on durable goods.
• Expenditure on services.

Goods are tangible (can be seen and touched).

• Non-durable goods are consumed shortly (up to three years) after purchase.
• Much of this spending could be regarded as essential, because it satisfies regular needs.
• As a result, non-durable consumption spending is fairly stable over time.
• Durable goods last of a longer period of time (three of more years)
• Spending on durable goods is usually discressionary, so it can be postponed or brought forward, depending on the individual household’s cirumstances.
• Services are intangible and usually provide transitory satisfaction of wants.
• Spending on servies makes up the largest slice of the consumption cake, accounting for 50% of all household expenditure.

Question 4

Why is non-durable consumption spending fairly stable?

Answer 4

• Non-durable goods are consumed shortly (up to three years) after purchase.
• Much of this spending could be regarded as essential, because it satisfies regular needs.
• As a result, non-durable consumption spending is fairly stable over time.

Question 5

What makes up the largest component of consumption?

Answer 5

Services! They account for 50% of all household expenditure.

Question 6

Describe what the investment component of aggregate expenditure consists of.

Answer 6

• The second type of aggregate expenditure is private sector investment.
• Investment is defined as spending on new capital goods and additions to inventories.
• A capital goods is any item of machinery that is used to assist labour in the production process.
• The three categories of investment are: Business investment, housing investment, and inventories.

Question 7

Define investment.

Answer 7

Investment is defined as spending on new capital goods and additions to inventories.

Question 8

Describe the three categories of investment.

Answer 8

Business Investment
-Privately funded business spending on capital goods using in production (equipment, machinery, and buildings).
Housing Investment
-Private expenditure on new housing.
Inventories
-Unsold goods, sometimes described as ‘stock’.
-Inventories rise when all current production is not sold.
-Inventories are excluded from investment spending in the aggregate expenditure equation.

Question 9

Distinguish between planned and actual investment.

Answer 9

• The term planned investment includes the planned spending by firms on business investment and residential investment by households.
• Actual investment comprises planned investment plus inventories.

Question 10

Why is investment the most volatile component of aggregate expenditure?

Answer 10

Investment spending is the most volatile component of AE. Over the last 50 years, private investment has accounted for between 16 and 26% of Australia’s GDP. Fluctuations in private investment spending are thought to be a key factor in explaining changes in economic activity over the course of the business cycle.

Question 11

Describe the government expenditure component of AE.

Answer 11

Government expenditure is the third component of aggregate expenditure.
Government spending is often divided into current spending and capital spending.

Current spending= expenditure on day-to-day business of government in its core functions like health, education, social welfare and defence.
Capital spending= spending on productive machinery and public infrastructure such as power and water supply, roads, railways and communications networks

Question 12

Describe the Net Exports component of AE.

Answer 12

• Exports occur when overseas residents purchase goods and services produced in Australia.
• Spending on exports adds to aggregate expenditure on goods and services produced in Australia.
• Imports are a withdrawal from the circular flow of income, and thus reduce the aggregate amount of expenditure on Australia goods and services.
• In 2015-16, net exports were $22 billion, representing 0.45 of GDP.
• In most years, however, the aggregate value of imports exceeds the value of exports.

Question 13

List the factors affecting consumption spending.

Give an overview.

Answer 13

Aggregate consumption includes household spending on non-durable goods, services, and durable goods.
Expenditure on household necessities is generally stable over the course of the business cycle.
Discretionary expenditure is more likely to vary- is influenced by changes in households’ income, wealth, willingness to borrow and expectations about future job security.

FACTORS AFFECTING CONSUMPTION SPENDING

• Level of disposable income
• The cost of credit
• Current stock of wealth
• Consumer expectations
• Government economic policy

Question 14

Describe how the level of disposable income effects consumption spending.

Answer 14

The level of disposable income is the MOST IMPORTANT factor effecting consumption spending.
Disposable income is the income that households receive after tax.
There is a positive relationship between the amount households spend on consumption and their disposable income.
However, the proportion of income spent on consumption declines as income rises.

Question 15

Describe how the cost of credit effects consumption spending.

Answer 15

The cost of credit is also known as the interest rate.
Interest rates represent the price of borrowed money/the cost of borrowing.

We would expect low interest rates to have a positive effect on household spending for two reasons:

1) Interest payment on borrowed money represent a smaller slice of disposable income when interest rates are low.
2) The opportunity cost of consumption falls.

Rising interest rates, however, may cause households to postpone consumption decisions. Higher rates mean repayment take up a larger proportion of disposable income, and that the opportunity cost of consumption increases, giving households more incentive to save.

Question 16

Describe how the current stock of wealth effects consumption spending.

Answer 16

Households that hold real assets such as property or shares tend to feel ‘wealthier’ or more confident when share process or property process are rising.
Discretionary spending rose during the boom in share and house process during the early 2000’s.
A decline in the stock of wealth causes a significant change in saving and spending patterns in the economy because it changes people’s perception of their wealth.

Question 17

Describe how consumer expectations effect consumption spending.

Answer 17

Expectations are the positive or negative sentiments that people hold about the state of the economy.
Reports concerning economic growth, changes in interest rates, changes in exchange rates and movements in the share and property market effect household confidence, and thus their willingness to purchase goods and services.
The impact of changing expectations on essentials is small.
Has a greater impact on household intentions to purchase discretionary items e.g. holidays.

Question 18

Describe how government economic policy effects consumption spending.

Answer 18

Government economic policy is designed to influence household consumption.
The Reserve Bank of Australia administers monetary policy using the official cash rate.
If the cash rate rises, higher interest rates generally flow through other financial markets -e.g. Banks will lift interest rates on personal loans and housing morgages -> meaning households have less spending power.
The Commonwealth Government (Treasury) is responsible for fiscal policy- using the government’s spending and taxing powers to influence household spending decisions.
Increasing the tax rate would also impact on consumption spending.

Question 19

List and summarise the factors affecting investment expenditure.

Answer 19

Investment is expenditure on capital goods that will be used to produce final goods and services in the future.
Aggregate private investment is the most volatile element of aggregate expenditure, ranging between 16 and 26% of AE over the past 50 years.
When businesses invest, they are expecting to get a positive return in the future. As the future is unknown, it involves risk.
Investment rises and falls according to the perceived risk

• Rate of interest
• Elasticity of investment
• Profitability in business sector
• Business expectations
• Government policies

Question 20

Describe how the rate of interest effects investment expenditure.

Answer 20

The rate of interest plays a key role in business investment decisions.
Interest rates and the level of investment expenditure are negatively related, this is illustrated by the investment demand curve.
Lower rates of interest tend to induce higher investment expenditure.
Why:
1) Interest rates represent the price of borrowed money, so when rates rise, so do the periodic repayments for capital items purchased with borrowed funds.
2) Interest rates represent the opportunity cost of money. The opportunity cost of investment increases when interest rates are high.

Question 21

What are real interest rates?

Answer 21

Real interest rates take into account the rate of inflation.

Question 22

Describe how the elasticity of investment effects investment expenditure.

Answer 22

The responsiveness of investment to changes in interest rates is less certain.
This is known as the ‘elasticity of investment with respect to interest rates’.
The interest rate elasticity of investment is influenced by the current stage of the business cycle and producer expectations.
-> E.g. In a cyclical upswing, producers are likely to be upbeat about the future and continue to invest despite rising interest rates.
-> On the other hand, during a contraction or trough phase, expectations of lower levels of economic activity and profits are likely to reduce investment spending even though interest rates may be very low.

Question 23

Describe how the profitability in the business sector effects investment expenditure.

Answer 23

Many firms retain a portion of their profits for expansion.
When economic conditions are challenging and profits low, firms tend to run down their capital equipment over a longer period of time (depreciation).
On the other hand, a booming economy increases profits and the pool of funds to spend on new capital equipment.
Also, technological progress is embodies in new capital equipment. This means that firms invest to take advantage of the lower average costs of production and increased efficiency that the capital equipment can deliver.
Investment in more efficient equipment is an important business strategy to lower unit costs, even when economic activity is low.

Question 24

Describe how business expectations effect investment.

Answer 24

Business expectations refer to what businesses think about the current level of economic activity and forecasts for the future.
Business perceptions are formed as a result of sales and enquiries form 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.
However, a downturn in the level of business confidence could result in a reduction in planned investment.

Question 25

Describe how government policies effect investment.

Answer 25

Fiscal and monetary policies affect investment decisions because they affect costs and expected returns.
Taxing the earning of an industry can change the risk/reward relationship in that sector.
On the other hand, tax incentives may attract investment funds to an industry.
The record of the government in achieving key macroeconomic objectives (growth, price stability, and full employment) also helps to foster a positive business environment.
A stable macroeconomic environment is important for large private sector investment projects, such as construction, mining and transport.
Stability means there is a level of certainty.
Responsible and stable government is an important element in providing certainty for decision makers.
The government’s regulatory framework can also affect market structures and the level of competition in the economy.

Question 26

Describe the factors influencing government expenditure.

Answer 26

• The majority of government spending is on current items- the goods and services consumed by government industries and the wages and salaries paid to employees.
• This spending is governed by the need to provide a service to the public who fund the public service through their taxes.

-Economic factors influencing private businesses apply to the government, most governments are requited to make decisions as if they are part of the normal corporate landscape.

• However, much government activity is not specifically directed at making a profit- governments often provide essential services such as health, education, law and order, social security and defence.
• The government also undertakes considerable long term investment in essential infrastructure- public utilities, such as power and water supply, roads, railways and communication networks.
• These decisions are also governed by the need to provide appropriate levels of service across all communities.

-Sometimes, their timing might be influenced by the state of the economy.
E.g. it would be inappropriate to undertake a major new infrastructure project when the economy was operating at full capacity as this may worsen bottlenecks in supply and build inflationary pressure.

-In general, economic factors are not considered central to government consumption and investment decisions. They do, of course, effect government policy decisions, however.

Question 27

List and summarise the factors affecting net exports.

Answer 27

Exports and imports are a reasonably volatile component of aggregate expenditure, particularly in Australia, because of the nature of its traded goods and services.

• Overseas demand for commodity exports
• Domestic supply
• Domestic levels of economic activity
• The exchange rate
• Terms of trade

Question 28

Describe how overseas demand for commodity exports effects net exports.

Answer 28

Overseas demand for commodity exports fluctuates according to regional and world economic conditions.
E.g. strong demand for Australia’s resources associated with the development of the Chinese and Indian economies.

Question 29

Describe how domestic supply effects net exports.

Answer 29

Domestic supply also contributes to volatility, as agricultural and pastoral commodities are influenced by the vagaries of seasons and events such as drought.

Question 30

Describe how the domestic levels of economic activity effects net exports.

Answer 30

Domestic levels of economic activity influence Australia’s propensity/willingness to import.
Australian imports are relatively inelastic with respect to GDP (small changes in GDP with have a large effect on imports).
This has to do with 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 that may not be produced in Australia.

Question 31

Describe how the exchange rate effects net exports.

Answer 31

When the Australian dollar rises in value, domestic residents can buy more units of other currencies, and overseas residents can buy less units of AUD.
Australian exports become less attractive and less competitive in overseas markets.
Buyers of imports find they are cheaper, and this makes them more competitive against domestically produced items.
Appreciation of the currency has a contractionary effect on aggregate expenditure because net exports fall.
A depreciation has an expansionary effect on the economy as net exports will increase, as the price of exports falls for overseas buyers, but import prices increase.

Question 32

Describe how the terms of trade effects net exports.

Answer 32

Movements in the ToT play a significant role in determining spending on exports and imports.
Australia’s exports are dominated by resources such as coal, iron ore, gold and bauxite.
The recent growth of the Chinese and Indian economies meant that the demand for those commodities rose and their prices reached record levels, boosting Australia’s export price index.
Other things being equal, this means that Australia’s export income rises.
At the same time, Australia’s import price index has fallen.
This increase in the ToT index is referred to as being ‘favourable’.
Alternatively, a falling ToT index sees the price received for exports fall relative tot he prices paid for imports, in which case net export receipts are likely to fall.

Question 33

What relationship is the Keynesian expenditure model based on?

Answer 33

The Keynesian expenditure model is based on the relationship between the level of disposable income received by households, and the level of consumption and saving. This is known as the consumption function.

Question 34

Describe the consumption function:

c= a+bY

Answer 34

‘a’ represents the autonomous component of consumption.

‘b’ represents the marginal propensity to consume (MPC). The MPC is the slope of the C line.

Question 35

When will savings and dissaving occur?

Answer 35

When consumption is less then income it means that saving is positive.
When consumption is greater than income (which occurs at a lower income level), it means that savings is negative, referred to as ‘dissaving’.

Question 36

What is shown on the vertical and horizontal axis?

Answer 36

The level of spending is shown on the vertical axis, and disposable income is shown on the horizontal axis.

Question 37

What does the 45 degree line show?

Answer 37

The 45 degree line shows all points where planned expenditure equals total income.

Question 38

Where is consumption function equilibrium and what does it mean?

Answer 38

When the consumption function intersects the 45 degree line, the economy is in equilibrium.
Equilibrium means that the level of income, output and spending in the economy is in balance- the level of economic activity is stable.

Question 39

What is the Keynesian Aggregate Expenditure Model used for and what does it show?

Answer 39

It is used to analyse the impact of changes in aggregate expenditure on economic activity.
Keynes showed that fluctuations in spending could have significant short term effects on output and employment, and that it was appropriate for the government to take a more active role in economic management.

The size of cyclical fluctuations are generally smaller than could be expected prior to the use of Keynesian ‘pump-priming’.

Question 40

What is the consumption function equation?

Answer 40

C=a+bY

Question 41

What is ‘a’? (in C=a+bY)

Answer 41

‘a’ is the vertical intercept- the place where the consumption function meets the y-axis. This is described as autonomous consumption- there would be some level of aggregate spending even if consumers had no income (presumably households would draw on savings or claim capital transfers).

Question 42

What is ‘b’?

Answer 42

‘b’ is the rate at which consumption changes when income rises- the slope of the line. It is the MPC.

Question 43

What is the MPC?

Answer 43

The marginal propensity to consumer (MPC) is the fraction of any change in income that is spent on consumption.

MPC= change in consumption/change in income.

Question 44

What is the MPS?

Answer 44

The fraction of any change in income that is saved is known as the marginal propensity to save (MPS). It is the change in savings divided by the change in income.

MPS= change in savings/change in income.

Question 45

What do MPS and MPC add to?

Answer 45

1

Question 46

What does the size of the MPC depend on?

Answer 46

The size of the MPC depends on the attitude of consumers to spending and saving. If the MPC increases, then the consumption function will be a steeper line.
A steeper consumption function means that households spend a greater proportion of any increase in income.

Question 47

What is the is the APC and APS?

Answer 47

The overall proportion of income that is spent or saved at any level of income is known as the average propensity to consume (APC) and the average propensity to save (APS).

The APC is defined as the proportion of total income which is spent on consumption.
The ASP is the proportion of total income which is saved.
APC+APS=1

Question 48

What is macroeconomic equilibrium?

Answer 48

It is useful to recap the meaning of macroeconomic equilibrium. Equilibrium occurs when total planned spending equals total output- this is the point where the AE function crosses the 45 degree line, corresponding with the level of income, Ye.
At a lower level of income planned spending is greater than output and there is a decrease in inventories. Firms will increase aggregate output, so income and employment will rise.
At an income level about Ye, planned spending is now less than output so there is an increase in inventories. Again, this will automatically lead to a decrease in production and the level of output and income will fall back to equilibrium.

The equilibrium level of income simply means that the level of income is stable.

**Use AE model to assist answer.

Question 49

What determines the MPC?

Answer 49

The mpc is determined by the attitudes to spending and savings, and may change over time.

Question 50

Give three examples of events that would result in a higher level of AE (the AE line in the model would shift upwards at all levels of disposable income).

Answer 50

• A rise in retail spending due to an increase in consumer confidence.
• An increase in coal exports to supply steel producers in India.
• An increase in business investment associated with new oil and gas projects in WA.

Question 51

Define the multiplier.

Answer 51

The multiplier refers to the proportion by which income will rise following the initial change in spending.

Question 52

How is the value of the multiplier determined?

Answer 52

k= 1 / (1-MPC)

or

k= 1 / MPS

*If the MPC increased, this would increase the ‘responding’ effect from a given change in investment and so the value of the multiplier must rise.

Question 53

What would be the multiplier if an increase in investment by $10 billion caused the level of income to rise by $25 billion?

Answer 53

If an increase in investment of $10 billion caused the level of income to rise by $25 billion, the value of the multiplier would be 2.5- that is, the final impact on income is 2.5 times the value of the new expenditure.

Question 54

What are some instances in which the multiplier process would have an impact on the Australian economy?

Answer 54

• New resource projects in the Pilbra.
• An increase in mining exports from the resource boom.
• An increase in government spending on new roads.
• The increase in apartment construction in capital cities.

Question 55

Does the multiplier process also apply to a decrease in spending?

Answer 55

Yes.
The multiplier process also applies for any decrease in autonomous spending.
If investment falls, the level of income in the economy will fall by a greater amount.

Question 56

What determines the size of the multiplier?

Answer 56

The size of the multiplier is determined by factors that affect the marginal propensity to consume.
There are a number of factors which restrict the value of the MPC and therefore reduce the size of the multiplier.

The most important influences on the multiplier process are the size of leakages associated with savings, taxation, and imports.
Each of these leakages reduces the size of the multiplier.

(k=1 / MPC)