# Aggregate Expenditure Model to Explain the Impact Term Paper

#### Excerpt from Term Paper :

aggregate expenditure model to explain the impact of the housing boom on investment and consumption spending.

In order to determine the relation between the housing boom and the rise of prices, which are probably caused by greater demand in the housing sector, all factors which may produce shifts in the production function must be analyzed. The model proposed by Keynes suggests that each monetary unit spent on something must be somebody's income. Therefore, the housing boom, which creates new jobs, not only in the construction industry, but also in related areas, such as the production of wood or steel, is bound to produce a corresponding rise in consumption demand, as a result of increased spending. A similar effect is incurred upon investment demand.

Consumption demand goes up and down with peoples' income. The relation is simple to grasp: the more money people have, the more they'll be spending. Should income increase, consumer demand shall also increase, although proportionately not as much as the income since there will also be an increase in savings and taxes. Should the income fall, consumption demand shall also be reduced, although by less than the income. Saving and payment of taxes shall also be reduced. This is what Keynes referred to as the "psychological law" of behavior. "Any increases in income would result in an increase in consumption, but the increase in consumption would be in less than a one-to-one relationship. In other words, if income increases by a dollar, consumption would increase by a fraction of a dollar. This fraction is called the marginal propensity to consume. "

The Marginal Propensity to Consume (MPC) is that particular fraction of the monetary unit that is spent on consumption, which also leaves something to be saved. MPC is calculated as dC/dDI A similar formula applies to the Marginal Propensity to Save: dS/dDI. The two propensities must always add up to 1, because of the DI = C + S identity. Consumption = a+ bY, where b = MPC, Y = Income and a = consumption spending when income is null. The curve of consumption shifts up and down, as the value of MPC changes. Should the MPC rise, the slope of the consumption function moves up and vice-versa.

There are also other factors, beside changes in the MPC, which can trigger modifications in the consumption function, such as age, demographic composition and others. Since houses are usually bought by young people, it may be possible that the housing boom generate increased spending for a certain age category (i.e., relatively young people, who earn enough to afford a house). Also, companies in need of offices may decide to invest in new headquarters.

Other things may also shift the consumption function, aside from age and demographic composition of the population:

Net wealth -- Although explanations about the net wealth effect are notably different between economists, who pretend, on one hand, that there isn't actually any such effect, and on the other that a lag between a market decline or raise and the impact on consumption exists, although the importance of this lag is not very clear. Some economists make a connection between consumption levels and the stock-market level. They state that "the real wealth effect is actually the sum of the stock-market level, consumer confidence, perceptions of income stability and gains in housing values. In other words, it isn't how consumers' balance sheets look that it is important, it is how consumers feel. "

In our case, there is a slight gap between the moment houses are being built and the moment money begin to be spent by consumers. This period is necessary in order for people to build some wealth and to get comfortable spending it.

2. Changes in expectations - The housing boom may indicate an economic boom, therefore increasing consumer confidence.

Also, changes in real rates of interest, changes in the price level and the rate of formation of new households, may have an effect on consumption demand.

Investment demand is pushed forward by expectations of future profits. The whole point behind investment demand is that changes in expectations regarding profit make the entire investment demand curve go to the left or right, depending on whether profit expectation went down or up. Since house prices in Australia are on the rise, investors' income should go up and a growth of investment demand may be expected. Therefore, Aggregate expenditure should grow even more.

2. Use the multiplier analysis to explain the increase in GDP consequent upon the rise in spending outlined in (1) above.

YNominal = C + I + G + NX

The variables on the right represent the four expenditure categories which add up to form the GDP. An important aspect is that expenditure decisions must be made so that should a proportion must be kept between the income level and aggregate expenditure. As aggregate income increases, so should expenditure increase by a fraction of the income modification. This situation represents an equilibrium (Ye): for each unique income level, expenditure is equal to that certain income level:

Ye: Aggregate Income = Aggregate Expenditure

Price level should be considered constant and the Nominal GDP equal to Real GDP:

(Ye = YN = YR).

Consumption expenditure ('C') is a function of the disposable income (i.e., gross income minus paid taxes). The proportional relationship is defined by the marginal propensity to consume 'b':

C = Co + b (Y-T), 0 < b < 1

For simplicity, Tax revenue 'T' is considered standard, as a fraction of the income, so that the total taxes paid are computed as follows: 't': T = tY, 0 < t < 1

Also, for similar reasons concerning simplicity, the other expenditure categories, investment, government, and net exports, are considered autonomous in relation to income, which means that spending decisions do not depend on the national income level). By adding autonomous consumption ('Co') to these values, a single variable ('Ao') known as the autonomous expenditure is obtained, which represents total expenditure independent from the national income level.

Ao = Co + Io + Go + NXo

Therefore, the expenditure equation looks like this: AE = Ao + b (1 - t) Y

Ye: Y = Ao + b (1 - t) Y

The solution for this equation is 'Ye', the equilibrium income value, as follows: Ye = a'[Ao], where a' = [1 - b (1 - t)]-1, what is commonly referred to as the simple spending multiplier.

The Multiplier Process

GDP, just as the other measures of the national income, suffers modifications whenever new spending makes its presence felt into the economy. The same thing happens if spending declines. GDP changes by a multiple of the spending shock. The value of this multiple depends on several factors. This process takes place in aggregate spending mainly by way of modifications in consumption expenditure The triggering modification in autonomous spending (for example, in our case, a shock in the form of an increase in spending in the real estate business) is received as an income by another person (the construction company or the workers in the aggregate economy). This spending is synonymous with an increase of the income of that particular person who, taking into account a certain propensity to spend, shall increase his/her expenses by, let's say, half. This amount additionally spent is received by another person as an income, who may spend various percentages of that sum.

This flow of expenditure and income runs through the economy in such a manner that, when totaling up the increases in income, the conclusion is that the aggregate income has increased several times the initial spending shock. This chain of events, known as the multiplier process, works similarly in the case of the housing boom in Australia. Consumer spending translates into income for the construction company, which pays more wages, which allows the workers to buy additional goods and services, which means a general growth of the industry, including the construction sector.

3. Assume that the housing boom has created an inflationary gap. Use the aggregate expenditure model to explain this gap and then explain how fiscal policy could be used to eliminate this gap.

The income-expenditure model does not have a mechanism which could ensure that the economy reaches an equilibrium at full-employment. As a consequence, macroeconomic policy has a role to play in the stabilization of the aggregate economy. This role is attributed to fiscal policy, as by adjusting taxation the government can manipulate aggregate expenditure in order to obtain full employment equilibrium. Government spending is also an important method in the process of reaching the desired equilibrium

Although there is a simple connection to be made between expansionary fiscal policies and increased government budget deficits, there is no actual need for the implementation of fiscal policies to be done at the expense of larger deficits.

A controversy exists between classical and Keynesian economists regarding the cause of the passage of the economy from the short run to the long run equilibrium.…

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