Ch 8 - The Aggregate Expenditure Model

What is aggregate expenditure (AE)?

Aggregate expenditure is the spending on all final goods and services in the economy during a given period

Formula:

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

Consumption Expenditure (C)

Consumption expenditure is household expenditure on goods and services and is the largest component of AE.

Types include:

Non - Durable Goods: consumed immediately / within 3 years, e.g.:

• food

• fuel,

• clothing

• footwear

Durable Goods: last for a long period of time / over 3 years, e.g.:

• washing machines

• fridges

• microwaves

• motor vehicles

Services, e.g:

• Education

• Transport

• Healthcare

Factors Affecting Consumption

1. Disposable Income: higher levels of disposable income → higher consumption expenditure.

2. Cost of Credit: higher interest rates → borrowing money becomes more expensive → lower consumption expenditure.

3. Stock of Household Wealth: An increase in household wealth (assets - liabilities) → households feel wealthier → higher consumption expenditure

4. Consumer Expectations: If consumers are optimistic about the future of the economy (future economic growth, increase in shares, increase in property value) → increases household confidence → higher consumption expenditure

Private Investment Expenditure (I)

Private Investment is expenditure on new capital goods and new construction. E.g:

• New Capital Equipment

• Machinery

• Factories

Factors Affecting Private Investment

1. Rate of Interest: Higher interest rates → cost of business borrowing money increases → investment expenditure decreases'

2. Profitability: Higher profits → provides firms with funds to spend on new capital items → investment expenditure increases

3. Business Expectations: If firms expect a positive future economy → investment expenditure increases

4. Government Policies: Government introduces a policy such as a decrease in tax or a subsidy → investment expenditure increases

Government Expenditure (G)

Spending on goods and services by the government. Includes:

Current Purchases (G1):

• Wages

• Salaries

Capital Purchases (G2):

• Schools

• Roads

Factors Affecting Government Expenditure (G)

1. Population Size: Governments need fund essential services such as heath, defence and education, which are themselves governed by the size of the population.

2. Infrastructure: Infrastructure are said to be the ‘bricks and mortar’ that allow an economy to function. It includes expenditure on public buildings like hospitals and schools, roads and bridges, and also the ‘poles and wires’ that deliver essential electricity

Net Exports (X - M)

Exports (Australian goods and services sold overseas) - Imports (Foreign goods and services purchased into Australia)

Factors Affecting Net Exports (X - M)

1. Overseas Demand: If overseas demand for Australian goods and services increase → exports increase → net exports increase

2. Domestic Levels of Economic Activity: If Australian economy is experiencing economic growth → increase in imports of foreign g + s and capital equipment → net exports decrease

3. Commodity Prices: If prices of Australian commodity increases → value of exports will increase → net exports increase

Macroeconomic Equilibrium

Occurs when:

AE = Real GDP

When total planned spending = total production

What happens when AE < GDP

• Inventories will increase

• GDP and employment will decrease

What happens when AE > GDP

• Inventories will decrease

• GDP and employment will increase

What happens when AE = GDP

• Inventories do not change

• The economy is in macroeconomic equilibrium

The Consumption Function

• Shows the relationship between the level of disposable income and level of consumption

• We assume that there is no government sector or overseas sector

Y = C + S

Y = Income

C = Consumption

S = Saving

The Consumption Function Formula + Graph Explanation