Week 7 - Aggregate Expenditure Model

Question 1

What is aggregate expenditure?

Answer 1

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/

Question 2

What does the AE model do?

Answer 2

Macroeconomic model focusing on the short-run relationship between total spending and real GDP.

Question 3

Is the price level assumed to be constant in the AE model

Answer 3

yes

Question 4

What are the 5 key variables impacting consumption

Answer 4

1) current disposable income
2) expected future income
3) household wealth
4) price level
5) interest rate

Question 5

What are the assumptions about people in the AE model?

Answer 5

assumes people are rational, maxamising and self interested.

Question 6

What is the permanent income hypothesis?

Answer 6

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

Question 7

Define wealth

Answer 7

refers to the accumulation of income in the form of assets.

Question 8

What is the wealth effect?

Answer 8

Wealth can be drawn on to fund spending and make consumers more comfortable with spending, depending on the liquidity

Question 9

Why is inflation important in the AE model?

Answer 9

inflation:

• decreases the real value of wealth
• leads to increasing demand for cash
• causes changes in exchange rates and relative world prices

Question 10

Impact of higher interest rates on consumption

Answer 10

Higher interest rates make money more costly and lowers consumption (particularly that financed by debt)

Question 11

Formula for consumption

Answer 11

C = A + MPC + DI

Question 12

What is the MP

Answer 12

marginal propensity to consume.
= slope of consumption function
= change in consumption / change in disposable income

Question 13

What is autonomous consumption

Answer 13

autonomous consumption is spent regardless of disposable income (e.g. food and water)

Question 14

Formula for disposable income

Answer 14

DI = national income (GDP) - net taxes

Question 15

Formula for investment in AE model?

Answer 15

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)

Question 16

How are savings treated in the AE model?

Answer 16

All savings are converted into some form of business asset but some may sit idle for a period.

Question 17

What is planned I reliant on?

Answer 17

1) expectations of future profitability
2) interest rates
3) taxes
4) cash flows (profit = tr - tc)

Question 18

What are gov purchases?

Answer 18

includes net spending at a federal, state and local level

Question 19

What impacts net exports in AE model?

Answer 19

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

Question 20

What is the equilibrium condition in AE model?

Answer 20

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.

Question 21

What happens in the AE model if AE is more than GDP

Answer 21

inventories are rising, gdp and employment are falling.

Question 22

What is the multiplier effect?

Answer 22

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

Question 23

What is the multiplier formula in AE model?

Answer 23

multiplier = change in equilibrium real GDP / change in autonomouts expenditure

= 1/ 1- MPC

Question 24

What happens if a firm is in a high inventory situation when a recession hits?

Answer 24

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)

Question 25

What does a higher MPC mean for consumpton

Answer 25

= larger multiplier and higher change in consumption (positive relationship)