In this video we’ll take our first look at the aggregate expenditure function, examine
its components and their determinants.
We’ll conclude with an introduction to the diagram which will be explored in further
detail in the following video.
The aggregate expenditure approach to equilibrium is based on the theory that an economy will
be in equilibrium if expenditure quals income.
We reference the circular flow model to better understand what’s meant by that.
If expenditure equals income it means that planned spending is equal to the income earned
by the factors of production.
If that is the case then the economy is in equilibrium.
However, if spending is less than income, then firms will cut production.
If spending exceeds income then firms will increase production.
Let’s start off with the aggregate expenditure function and we’ll return to the idea of
equilibrium towards the end of the video.
Aggregate expenditure (AE) is the total level of spending that takes place within an economy
for a given time period, usually a year.
In the short-run we hold the price level constant.
This is different to our aggregate demand and aggregate supply model where we view real
GDP against the price level.
In the aggregate expenditure model, also called the Keynesian aggregate expenditure model,
we plot expenditure against income.
Aggregate expenditure is equal to consumption spending plus investment plus government spending
plus the value of net exports.
Let’s look at each of these components and the determinants that influence them.
The first one we’ll look at is consumption.
Simply put, consumption spending is household spending and includes expenditure on final
goods and services.
Consumption is the only component that we do not hold fixed.
Individual consumption alters with income.
The formula for the consumption function is as listed c equals a plus b Y.
'a’ represents autonomous spending.
This is consumption spending that would take place irrespective of income.
If an individual had no income they would still need to spend money to afford basic
needs like food, shelter and clothing.
They would fund this either through spending their existing savings, borrowing money or
other sources.
To that autonomous spending we add some amount that changes as income rises.
‘b’ represents the marginal propensity to consume.
This is the additional amount of consumption that occurs when disposable income rises.
And ‘Y’ represents disposable, or after-tax income.
To clarify, ‘a’ is spending irrespective of income whereas ‘bY’ is spending dependent
on income.
The consumption function expresses the relationship between aggregate expenditure and income,
or real GDP.
If we plot it graphically, the Y-intercept would be at the positive value of a.
The slope of the consumption function is determined by the marginal propensity to consume or variable
‘b’.
Now that we have established our consumption function we should also take a look at the
savings function.
The savings function looks at how savings changes with income and expressed as the formula
s equals negative a plus s Y.
'a’ here also represents autonomous spending.
If income were zero, this would be dissavings, hence the negative sign.
's’ represents the marginal propensity to save.
This is the additional amount of savings that occurs when disposable income rises.
‘Y’ here represents disposable, or after-tax income.
The saving function has a negative y-intercept because of the dissavings element at zero
income.
The money spent when income is zero is either dissavings or borrowing, which results in
a negative level of savings when no income is earned.
The slope of the savings function is determined by the marginal propensity to save or the
variable ‘s’.
Beyond income, there are several other factors that would influence the level of consumption.
First up is household.
If households feel wealthier they are more likely to spend.
When house prices appreciate, homeowners may feel wealthier and make more purchases as
opposed to if their home value had not appreciated.
Interest rates are the cost of borrowing and the reward for saving.
If interest rates fall, consumption is likely to increase as borrowing becomes cheaper,
saving less attractive and repaying debt with an adjustable rate of interest becomes easier.
Third, if consumer expectations are quite positive, consumption is likely to be higher.
If consumers fear a recession or experience a pandemic, their spending habits are likely
to be more conservative as they plan for uncertainty.
The more credit that is available, the more opportunities there are to borrow and spend.
If there is an increase in the availability of credit, spending should increase.
And finally, when wealth is redistributed from higher income earners to lower income
earners, consumption is likely to increase.
This is because people on lower incomes tend to have a higher marginal propensity to consume
than those with higher incomes.
The second component of aggregate expenditure is investment, which is planned business spending
for the year.
We assume that businesses forecast their spending for the year and that it is a fixed amount
of spending for the year.
There are several factors that influence the level of investment in an economy.
First up is the level of consumer demand.
The higher it is, the greater likelihood of increased investment.
Similarly to consumers, a low interest rate will encourage firms to borrow and expand
production.
Low interest rate environments mean cheaper borrowing costs and lower debt repayments
as well as a level of consumption that will be higher than in an high interest rate environment.
If business expectations are positive, businesses will spend more than they would have in uncertain
economic times.
Government policy can encourage or discourage investment.
If policy is favourable to firms, such as the deregulation of industry, it is likely
that investment will increase.
If government policy is not favourable to firms, such as increased corporation tax,
they may reduce investment.
If technology helps firms become more profitable, it will drive investment.
Similarly, the cost of capital goods impacts the profitability of firms, so a lower cost
for capital goods will also result in greater investment.
Since we assume planned investment is fixed and not responsive to changes in income, we
represent investment as a straight line.
The assumption that investment is not responsive to income is a BIG simplification, but an
essential assumption of the model.
Third is government spending, which includes spending by all levels of government (local,
regional and national).
Government spending is influenced by the tax revenues they collect, what their political
priorities are, government policy and changing demographics.
Government spending can be higher with more tax revenues collected.
Lower levels of tax revenue will constrain government spending.
If the country’s priorities are to expand the military or improve schools, increased
spending may result.
However, if the government is concerned about the rising national debt, then austerity measures
may be taken and spending cut.
Also, if government policy results in greater need for spending then government expenditure
will rise.
If a country experiences a high birthrate or has an ageing population, there will be
necessary increases in spending to address the various needs that would result.
A country with a high birthrate will have to provide adequate schooling for the growing
generation.
An ageing population will strain the healthcare and pension system which may result in greater
government spending.
Here we also assume that government spending is fixed for the time period and not responsive
to changes in national income.
Therefore, G is also represented on this diagram by a straight line.
Finally, we come to net exports.
The value of net exports is determined by subtracting the spending on imports from the
revenue earned from the sale of exports.
Net exports are determined by several key factors.
If the domestic economy is performing well, it may result in greater imports and thus
reduce the value of net exports.
When trading partners are performing well economically, our exports to their countries
may rise which would cause net exports to rise in value.
A depreciation in the domestic currency’s exchange rate will make imports more expensive
and exports cheaper.
A currency appreciation will cause imports to be relatively cheaper and exports relatively
more expensive to foreign buyers.
If the quality of exported goods and services improves, then the quantity of exported goods
and services should rise as well.
Additionally, an increase in global price competitiveness will result in greater exports
when foreign buyers find our exports to be better value.
Finally, protectionist trade policy would cause imports to fall.
If trade is opened up, it may result in greater imports and a lower value of net exports.
It may however, have the opposite effect if an opening of trade is matched by countries
abroad.
This is the final piece of the puzzle and again we simplify and set net exports fixed,
explaining the straight line here for NX.
Now we’ll put all four pieces together.
The y-intercept of the aggregate expenditure function is the sum of all its components
when income is zero.
The line is upward sloping and with a slope of less than 1.
It takes its slope from the consumption function’s marginal propensity to consume.
The 45 degree line represents all points along which aggregate expenditure and real GDP would
be equal.
The intersection point of the aggregate expenditure function and the 45 degree line represents
equilibrium, which in this example occurs at Y1.
This does not necessarily correspond to full-employment equilibrium.
We’ll explore the diagram in much greater detail in the next video on income determination.
By now you should have a better understanding of the key points listed.
If you have any questions or comments on this topic, leave them below and let’s try and
answer them together.
That’s us done for now and I will see you in the next one!