Flashcards in Week 7 - Aggregate Expenditure Model Deck (25):
What is aggregate expenditure?
Refers to the total amount of spending in the economy (consumption, investment , gov purchases and net exports). Description of specific flows in a macro economy for a time period/
What does the AE model do?
Macroeconomic model focusing on the short-run relationship between total spending and real GDP.
Is the price level assumed to be constant in the AE model
What are the 5 key variables impacting consumption
1) current disposable income
2) expected future income
3) household wealth
4) price level
5) interest rate
What are the assumptions about people in the AE model?
assumes people are rational, maxamising and self interested.
What is the permanent income hypothesis?
Asserts people spend at a level consistent with their expected long-term average income which would significantly weaken the impact of disposable income and expected income on consumption
refers to the accumulation of income in the form of assets.
What is the wealth effect?
Wealth can be drawn on to fund spending and make consumers more comfortable with spending, depending on the liquidity
Why is inflation important in the AE model?
-decreases the real value of wealth
- leads to increasing demand for cash
- causes changes in exchange rates and relative world prices
Impact of higher interest rates on consumption
Higher interest rates make money more costly and lowers consumption (particularly that financed by debt)
Formula for consumption
C = A + MPC + DI
What is the MP
marginal propensity to consume.
= slope of consumption function
= change in consumption / change in disposable income
What is autonomous consumption
autonomous consumption is spent regardless of disposable income (e.g. food and water)
Formula for disposable income
DI = national income (GDP) - net taxes
Formula for investment in AE model?
Depends on the level on actual investment, although, planned investment may be different due to expectations (inventories are goods that have been produced but not yet sold)
How are savings treated in the AE model?
All savings are converted into some form of business asset but some may sit idle for a period.
What is planned I reliant on?
1) expectations of future profitability
2) interest rates
4) cash flows (profit = tr - tc)
What are gov purchases?
includes net spending at a federal, state and local level
What impacts net exports in AE model?
relative price levels - if inflation is lower than elsewhere, relative prices fall leading to falling imports and rising exports
relative growth rates - if our GDP rises faster, so does income. Some of this will be used on imports and nx falls.
Exchange rate - a depreciating dollar makes exports more competitive and nx rises
What is the equilibrium condition in AE model?
Total output = total expenditure
45 degree line illustrates equilibrium and measures real national income against planned real aggregate expenditure. All point of macroeconomic equilibrium lie on this line.
What happens in the AE model if AE is more than GDP
inventories are rising, gdp and employment are falling.
What is the multiplier effect?
autonomous expenditure created a leveraging effect in which an incremental increase in spending yields a proportionately greater effect on GDP than the amount of spending
What is the multiplier formula in AE model?
multiplier = change in equilibrium real GDP / change in autonomouts expenditure
= 1/ 1- MPC
What happens if a firm is in a high inventory situation when a recession hits?
This is bad as inventory is not liquid and inventories will be increasing more are AE falls. The firm may reduce prices if its not perfectly competitive, reduce/stop production or dump (in extreme cases like GD)