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Week 6: Ch 9- Aggregate expenditure (AE) & output in the SR - Coggle…
Week 6: Ch 9- Aggregate expenditure (AE) & output in the SR
LO#1: AE Model
1.1 Fundementals of AE model
Definition:
Focuses on the SR relationship between total spending & real GDP
Key Idea: In any yr, the level of GDP is determined mainly by the level of AE
4 Components of AE
Planned Investment (I)
spending by firms on capital goods
EG: Factories, office buildings, machinery, by households on new dewellings
Gov Purchases (G)
spending by federal, state & local Govs
EG: Infrastructure, salaries
Consumption (C)
Spending by household on g&s
EG: Food, shopping, cars
Net Exports (NX)
Spending by firms & households on g&s produced in AUS minus spending by AUS firms & household on g&s produced in other countries
AE= C+I+G+NX
Distinction between planned investment & actual investment
Actual Investment
=planned investment only when there is no unplanned change in inventories
EG: Person may print 20,000 books
If Person sells all 20,000 books, the its inventories will be unchanged
However, if they sell 15,000, then it will be an unplanned increase in inventories of 5000 books
Changes in inventories depend on sales of goods which firms cannot forecast accurately
1.2 Macroeconomic equilibrium
Equilibrium occurs:
AE= total production (or GDP)
firms will sell what they expected to sell
inventories wil be unchanged & they will not have an incentive to increase/decrease production
Doesn't hold at all times
AE > GDP
AE < GDP
Summary
AE = GDP
Inventories unchanged
in macro equilibrium
AE < GDP
Inventories rise
GDP & employment decrease
AE > GDP
Inventories fall
GDP & employment increase
LO#2: Determinants of AE
2.1 Factors related to the 4 components of AE
2.2.2 Planned Investment Factors
The Interest Rate
Business investment is financed by borrowing (issuing corporate bonds or borrowing from banks
Higher IR's results in less investment spending (since business investment is financed by borrowing
Expectations of Future Profitability
A firm will not invest in cap goods unless its optimistic that demand will be strong in SR
Optimism/pessimism of firms is critical to investment spening
Taxes
Lower company tax encourages investment spending
A higher company tax decrease after-tax profitability of investment spending
Cash Flow
Firms also use their own funds to finance investment spending
The more profit, the greater the cash flow & the greater the ability to finance investment
2.2.3 Gov Purchases Factors
Spending by all levels of governments on g&s
Does not include transfer payments --> b/c the gov does not receive a g&s in return
Gov purchases have been stable & grown for most of the 1960-2016 period
2.2.1 Consumption (C) Factors
Current Disposable Income
Income house receive (minus taxes paid/or gov transfer payment received
The higher their disposable income the more they spend on g&s
Household Wealth
Value of its assets (home, shares, etc.) minus the value of its liabilities (loans that it owns)
When the wealth of households increase, consumption increases
Expected Future Income
Promotions in jobs & bonuses
The Price Level
Price level affect consumption through household wealth
The Interest Rate
When Its are high, reward for saving is high, & households are likely to save more
However, spending on durable goods will be affected by changes in the IR
Curent Disposable Income most important of the 5: Why?
consumption & disposable income are (almost) perfectly related
consumption function
line of best fit shows a positive relationship
This tells us:
Change in disposable income depends on changes in C
It looks almost perfectly related
Thus, we say that consumption is a function of disposable income; hence the consumption function
Slope of consumption function is the 'Marginal Propensity to Consume' (MPC)
MPC is the proportion of change in disposable income that is spent on C
MPC = change in C / change in disposable income
EG: change in C= $20b & Change in disposable income= $22b Then MPC= $20b / $22b = 0.9
This tells us that households spent 90% of the increase un their disposable income
Change in C = change in disposable income X MPC
EG: MPC= 0.9, a $10b increase in disposable income will increase C by: $10b X 0.9= $9b
Relations between Consumption & GDP
National income differs from disposable income
National Income (GDP)= disposal income + net taxes
Disposable income income= national income - net taxes
graph consumption function using national income rather than disposable income
MPS= Change in savings / change in national income
1= MPC + MPS
2.2.4 Net Export Factors
Relative Economic Growth Rates
When incomes in other countries rise, AUS NX rise. (demand for our commodities, closely related to world eco growth
When incomes rise faster in AUS (rel to other countries), AUS IMP increase faster than EXP, thus NX falls
Exchange Rate
A decrease in the value of the AUD will increase EXP-income & reduce IMP, so NX rises
An increase in the value of the AUD will reduce EXP-income & increase IMP, so NX falls
Relative Price Levels
AUS EXP increase & AUS IMP decrease, which increases NX
If inflation in AUS is lower (relative to other countries), demand for AUS g&s increases
LO#3: Macroeconomic Equilibrium
3.1 Graphing macroeconomic equilibrium
Lie on the 45 line
Quantity produced = Quantity sold
Lie above the 45 line
Quantity sold > Quantity produced
planned AE > GDP
Unplanned decrease in inventories, leading to an increase in production
Lie below the 45 line
Quantity sold < Quantity produced
Planned AE < GDP
Unplanned increase in inventories, leading to a decrease in production
LO#4: The Multiplier Effect
4.1 Impact of the multiplier
Start at equilibrium point A: real GDP = $960 billion
Q: Suppose firms become more optimistic about their future profitability and increase spending on capital by $10 billion. What will happen?
This will increase investment (I) (C, G, NX are ceteris paribus)
Increase in investment spending shifts the AE line up by $10 billion: AE_1 to AE_2 at point B
Note, $10 billion increase in investment spending results in a $40 billion increase in equilibrium real GDP
The initial increase in I will set off a series of increases (i.e., autonomous expenditure) in real GDP.
4.2 The multiplier equation
The multiplier effect occurs when autonomous expenditure increases or decreases.
Multiplier= Change in equilib. real GDP / Change in autonomous expenditure = 1 / 1-MPC
EG: If MPC=0.75, then Multiplier= 1 / 1- 0.75 = 4
This means that for each additional $1 of autonomous spending, equilibrium GDP will increase by $4
A $10 billion increase in I results in a $40 billion increase in equilibrium GDP
re-arranging above equation: ∆ in equilibrium GDP = $10 × MPC = $10 × 4 = $40 billion.
Each round of increase results in a smaller increase, and eventually come to an end and settle at a new macroeconomic equilibrium
LO#5: The link between AE and AD
5.1 Deriving the AD curve
Increases or decreases in expenditure would affect not just real GDP but also the price level.
Increases (decreases) in the price level will cause AE to fall (rise) – indicating an inverse relationship.
3 factor explain this inverse relationship
Changes in the price level affects consumption
Rising prices reduces consumption by decreasing the real value of household wealth (vice-versa)
Relative Price Levels
If Australia price level rises (relative to the price levels in other countries) then:
Foreign imports will become relatively less expensive, causing net exports to fall.
A falling price level in Australia has the reverse effect.
Australian export income will fall making exports less attractive to produce
Changes in Interest Rates
Higher real IR’s increases the cost of borrowing and reduces investment spending
Consumption may also fall as households borrow less to spend on durable goods.
However, people with savings enjoy a wealth increased (when IR’s are higher) and will thus increase their consumption.
The Effect of a Higher Price Level
An increase in the price level results in declining consumption (C), planned investment (I) and net exports (NX).
This causes the AE line to shift down from AE_1 to AE_2.
As a result, equilibrium real GDP declines from $1000 billion to $980 billion
The Effect of a Lower Price Level
This causes the AE line to shift up from AE_1 to AE_2.
As a result, equilibrium real GDP increases from $1000 billion to $1020 billion.
A decrease in the price level results in a rising consumption (C), planned investment (I) and net exports (NX).
