Aggregate Expenditure

Aggregate Expenditure is the sum of all expenditure on final goods and services undertaken in the economy during a specific time period.

• Consumption - (household expenditure on final goods and services)
• Investment - (spending on capital equipment (intermediate goods, raw materials))
• Government spending - G1 (Day to Day expenses which are always the same) G2 (Capital Expenditure that can fluctuate depending on the day)
• Net exports - (export revenue minus import expenditure)
• AE = C + I + G + (X-M)

Australia’s Gross Domestic Product (GDP) in 2021-2022 amounted to nearly 2.1 trillion dollars (2,091 billion dollars).

Any AE or AD/AS model requiring questions: mention inventories.

Consumption

The largest component of aggregate expenditure was CONSUMPTION expenditure – household expenditure on goods and services.

• Consumption (C) accounted for 53.0 percent of the total (1,103 billion dollars)
• Consumption consists of:
  • Expenditure on non–durable goods;
  • Expenditure on durable goods; and
  • Expenditure on services

Goods are tangible (they can be seen and touched).

• Non-durable goods are consumed shortly after purchase (technically, up to three years) and tend to be necessary (non-discretionary)
  • This includes food, drinks, fuel, cosmetics, cleaning products, textiles, clothing and footwear. Much of this spending could be regarded as essential, as it satisfies the regular needs of most households.
  • As a result, non – durable consumption spending is fairly stable over time, typically accounting for about 35 percent of total consumption expenditure
• Durable goods last for a longer period of time – by definition three or more years.
  • Durable goods include white goods (large items such as washing machines, fridges, ovens); brown goods (light household items such as computers audio equipment and televisions); furniture; sporting equipment; and motor vehicles.
  • Spending on durable goods is usually ‘discretionary’ (meaning it can be postponed or brought forward, depending on the individual household’s circumstances).
  • Expenditure on durable goods is thought to account for about 15 percent of aggregate consumption
• Services are intangible and usually provide transitory satisfaction of wants - examples include education, transport, health, and household utilities.
  • In modern economies, spending on services makes up the largest of the three slices of the consumption cake, accounting for 50 percent of all household expenditure (C).
  • Some services are regarded as essential, such as education, health services and transport, while others are discretionary, such as spending on entertainment and leisure.

Factors affecting Consumption Spending (C)

These normally affect discretionary spending.

Factors affecting Consumption Spending

• Disposable Income (Yd) (Movement along the curve)
• Interest rates
• Current stock of wealth
• Consumer Expectations
• Government Economic policy

Disposable Income (Yd) – the income households receive after tax.

• As we would expect, there is a positive relationship between the amount households spend on consumption and their disposable income. - But that proportion declines as income rises.

Cost of Credit (The Interest Rates)

• Households borrow to finance discretionary spending, so the cost of credit (interest rate)is relevant in their decisions
• Interest rates represent the price of money - the cost of borrowing - we would expect low interest rates to have a positive effect on household spending.
• Because:
  • If credit has been used to fund consumption the periodic repayments are a smaller portion of disposable income. (Borrowing Rise)
  • The opportunity cost of consumption falls - saving is less attractive when interest rates are low, because funds in interest bearing accounts would earn a lower rate of return. (Savings Falls)
• On the other hand, rising rates cause households to postpone discretionary consumption
  • Higher rates mean loan repayments take up a larger proportion of disposable income and increase the opportunity cost of consumption spending.

Current Stock of Wealth (Households’ perceived stock of wealth)

• Households that hold real assets such as property or shares tend to feel ‘wealthier’ or more confident when share prices or property prices are rising.
• The ‘wealth effect’ was a considerable drag on consumption in the first half of 2020, when the value of public companies fell on worlds markets
• In Australia, the ASX index for the top 200 companies fell from 7144 on 18 February to 4735 on 23 March, although half of those losses were restored by the end of the financial year.
• Although this fall in value may have only been ‘on paper’ the decline in the stock of wealth brought, influenced many households to change their spending and saving patterns.

Consumer Sentiment and Expectations

• Expectations are the positive or negative sentiments that people hold about the state of the economy and they play an important role in spending decisions.
• News concerning economic growth, changes in interest rates, changes in exchange rates, and movements in the share and property markets affect household confidence, and thus their willingness to purchase goods and services.
• The impact of changing expectations on spending on essentials such as food, clothing and transport, is probably small.
• Consumer sentiment has a greater impact on household intentions to purchase discretionary items such as holidays, computers, televisions and motor vehicles.

Government Economic Policy (Affects Consumption as well as investment, government spending)

• Monetary Policy
  • The Reserve Bank of Australia (RBA) administers monetary policy using the ‘cash rate’ – the official interest rate.
  • If the cash rate rises higher, interest rates generally flow through other financial markets.
  • Banks for example are likely to lift their interest rates on personal loans and housing mortgages, meaning households have less spending power.
• Fiscal Policy
  • The Commonwealth Government (treasury) is responsible for fiscal policy – using the governments spending and taxing powers to influence household spending decisions.

Investment

The second component of aggregate expenditure is private sector investment

• Economists DEFINE INVESTMENT as spending on new capital goods and additions to inventories.
• A capital good is any item of machinery that is used to assist labour in the production process
• Investment Spending in the national accounts (gross private investment) is divided into three categories:
  • Business investment – privately funded business spending on capital goods used in production – equipment, machinery and buildings;
  • Housing Investment – private expenditure on new housing; and
  • Inventories – unsold goods, sometimes described as ‘stock’

Investment

• Private Investment
  • In 2021-2022, private investment accounted for 18 percent of aggregate expenditure in the Australian economy.
  • Investment spending is the most volatile component of aggregate expenditure.
• Inventories rise when all current production is not sold
  • An important point to note is that inventories are excluded from investment spending in the aggregate expenditure equation.
  • The term planned investment (Ip) refers to the planned spending by firms on business investment and residential investment by households.
  • Actual investment comprises planned investment plus inventories
  • If there is no change to inventories, then actual and planned investment are equal.

Factors affecting Investment (I)

Factors affecting Investment:

• Rising levels of profitability
• Profitability in the business sector
  • If you are profiting lots -> you will invest more with that profit
• Business expectations
  • What business thinks about the current level of economic activity and future trends
  • Business sentiment is influenced by perceptions of current economic events such as levels of sales and inquiries from buyers.
• Government policies
  • Fiscal and monetary policy affect investment decisions because they affect costs and expected sales revenue.
  • Taxing the earnings 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

Investment is expenditure by firms on new 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 23 percent of AE over the last 50 years
• Firms will spend money if it is justified by rate of return. They won’t spend if the rate of return is none.
• If interest rates are low, no point saving because they perceive the gains from interest rates to be not enough compared to taking the risk to invest.
• The opportunity cost of investment increases when interest rates are high.
• For example, if business interest rates were 8 percent p.a. the prospective rate of return on capital equipment must exceed 8 percent before a rational firm would consider the investment to be a prudent business decision.

Nominal Interest Rate - Inflation Rates = Real Interest Rates

• If nominal rates of interest are 8 percent and expected inflation is 4 percent then the real rate of interest is 4 percent

ALL FACTORS SHIFT INVESTMENT CURVE EXCEPT INTEREST RATES

Government Expenditure

Government expenditure is the third component of aggregate expenditure

• In 2021 – 2022, total government spending in Australia amounted to $580 billion, which represented 27 percent of aggregate spending.
• G1 Current spending is expenditure on the day to day businesses of government such as wages and salaries and purchases of goods and services
• G2 Capital expenditure is spending on public infrastructure such as power and water supply, public buildings, schools, roads, railways and communications networks

Factors Affecting Government Expenditure (G)

The majority of government spending is on current items (G1) - the goods and services consumed by government institutions and the wages and salaries paid to employees.

• This size of spending is governed by the need to fund essential services such as health education and social security.
• The government also undertakes investment in essential infrastructure (G2) – public utilities such as power and water supply, roads railways and communications networks.
• Sometimes their timing might be influenced by the state of the economy.
• It would be inappropriate for example to undertake a major new infrastructure project when the economy was operating at full capacity as this may worsen supply bottlenecks (all factors of production utilized, shortage is created) an build inflationary pressure.

Net Exports

Net Exports

• Overseas purchases of goods and services produced in Australia is an export in Australia’s National Accounts, and adds to aggregate expenditure.
• Imports occur when Australian households, firms, and governments purchase goods and services from overseas.

Factors Affecting Net Exports (X-M)

Factors affecting Net Exports:

• Seasons (Minimal Effect)
• Domestic Economic Activity
• Foreign Economic Activity (Larger effect than domestic)
• Exchange Rates
• Movements in ToT

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

Overseas demand for Australian commodity exports fluctuates according to regional and world economic conditions

• Domestic supply can also contribute to volatility as agricultural and pastoral commodities are influenced by the vagaries of seasons an events such as drought.

Domestic levels of economic activity influence Australian’s propensity (willingness) to import.

• 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.

The exchange rate is an important determinant of expenditure on exports and imports

• When the Australian dollar appreciates domestic residents can buy more units of other currencies, so imports are cheaper and more competitive against domestically produced items.
• Appreciation also means Australian exports become less competitive in overseas markets because overseas residents can buy less units of AUD.
• Appreciation of the currency has a contractionary effect on aggregate expenditure because net exports fall.

Movements in the terms of trade play a significant role in determining spending on exports and imports

• Australia’s exports are dominated by mineral and agricultural commodities such as iron ore, coal, wheat and barley
• Increase exports, increase value of export income, increase in AE