The Aggregate Expenditure Model and its Components

The Aggregate Expenditure model is obtained by AE = C + I + G + (X – M); where c is the consumption by households, I is investment in the economy, G is government spending, X is exports, M is imports, and (X – M) is net exports (Sexton, 2015). Having identified the components of the AE model, the next step is to identify the various variables that is bringing impact to our case. Growing housing market represents an improvement in the investment component. A solid economic growth means that the aggregate expenditure will rise. Generally, when the economy is performing well, there is a rise in investment level such that many jobs are created and thus a fall in unemployment rate.

The economy always starts at a dissaving level where consumers are spending a certain amount of money even when their income is zero. This is represented by the origination of the AD0 curve at a point on the y-axis. The AD = Y curve represents the breakeven point of AD and real GDP. The equilibrium in the economy is obtained by the intersection of the AD and the AD = Y line. The initial position of this economy is at m where AD0 intersects with AD = Y; at this point, the output level is equal to Q0 (Mceachern, 2011). A rise in the demand for houses will raise the investment component of the AE; on the other side, a sound economic growth will raise the investment and consumption component of the economy. Since these components are increased, the AE curve will shift outward to reflect this increase; the shift will be from AD0 to AD1 (Be?nassy, 2011). A new equilibrium level n is reached at after this increment. At the new equilibrium level, Aggregate demand is high, and the real GDP is also higher; it has improved from Q0 to Q1.

The OECD has noted that the Australian housing market is on heat and there exist economical risks from this. An example is the US housing bubble which was the source of the Global recession which was experienced worldwide in 2008 -2009. What is making the housing market more attractive is the low interest rate where people have taken advantage of the low costs of borrowing (Duff, 2017). It’s the dream of each person to own a house and thus whenever that chance is presented to them, they usually seizing it. The ideal of raising the official interest rate in Australia is to ensure that the cost of lending goes up and that people will avoid borrowing and thus the demand for houses will fall (Ivan, 2017). However, this may not have a significant effect in the short run because most investors observe the state of the economy in order to determine the direction in which the interest rate is likely to move. The current Australian inflation rate is low and thus investors have no expectations of rate hikes, thus they may continue borrowing. However, after the raise of official interest rate, new investors will be discouraged and may decide to wait until the rate falls again (Johnston, 2017). This move to rate hikes will affect the investment and consumption function of Aggregate Demand since money borrowed is used for either consumption or for investing.

Identifying the Impacting Variables

There are implications that may emerge if the RBA fails to raise its official rate as advised by the OECD if there is a sound economic growth in the future. In the static model, price is plotted against the real GDP with an assumption that Q* is the potential for this economy and this potential is not expected to expand (Luke, 2011). Thus, the LRAS curve remains constant and does not shift. The equilibrium given by intersection of AD and SRAS initially is at e1. A positive shock in AD due to solid economic growth shifts it to the right from AD0 to AD1, forming a new equilibrium at e2; this is the impacts in the short run. At equilibrium e2, the price level is higher than at P* If the prices are flexible, a change in AD to AD1 would lead to price level rising from point e1 to b immediately, but since it’s not flexible, its assumed that price level in the short run will only rise narrowly to P1. Since there is an assumption that the LRAS cannot be expanded to reflect the expanded potential at e2, the workers will translate this growth in price as a benchmark for demanding higher wages. In return, the production costs will rise, causing a fall in SRAS as represented by a rightward shift from SRAS0 to SRAS1. In this case the economy has gone back to its initial level of LRAS but at a very high price level; PL is the new price level after there has an expansion in AD and a contraction response of negative supply shock from equilibrium e2 back to the economy’s long run potential level LRAS. Thus failure to heed the OECD advice will result in inflation for this economy based on static AD-AS model. If the RBA followed the OECD’s advice, the AD would have fallen initially causing a short run fall in price level, then the solid economic growth would only shift it back to its original position such that price would have remained unchanged at P.

In the case of dynamic AD-AS model, the changes in price level is plotted against the real GDP (Hubbard, Garnett, Lewis & O’Brien, 2014). The equilibrium level is also determined by the intersection of SRAS curve and the AD. However in this case, the LRAS curve is replaced by the Solow curve; this curve represents the potential real GDP growth rate. The Solow curve is based on real factors of production where Q* = f (A, K, L) where A is multifactor productivity, k is capital and l is labor. In this case, prices are assumed to be perfectly flexible (Evans, 2016). There are several factors that have been claimed to be responsible for shifting the Solow curve. These factors include; weather, strikes, wars, R&D, infrastructure, innovation, competitiveness, labor market flexibility, education and training. The AD curve represents (M + V) where M is money supply and V is velocity of money. It’s  assumed that M + V = P + Y. Velocity shocks are caused by; wealth which impacts households’ consumption level, confidence which impacts business investment, stimulus which impacts government spending, tax changes which impacts net exports, and money demand. The nominal shock are believed to only impact inflation level.

In the future, due to increments in population and advancement in technology, the potential for productivity in Australia will shift from Solow curve Solow0 to Solow1; the corresponding real GDP is Qn. The equilibrium point currently is at e1 where the SRAS0 curve intersects with the AD0 curve. Since Australia doesn’t raise the official rate today due to the existence of low inflation level, the aggregate demand will rise in the future. However, it’s noted that the change in aggregate demand does not reach the new potential level, thus the real GDP will be at Q0, which is higher that Q* but lower than Qn. The changes in SRAS will also be positive in the future and may exceed AD as shown above. Thus, a new equilibrium e2 is formed. This new equilibrium is at a lower price level. Now if the RBA decides it’s time to raise the official rate, the economy will be worse off since a leftward movement of the AD curve would lower the inflation rate further, the output level will fall, and more people will be unemployed. Thus, the long run recovery will still have hurdles and difficult to achieve. Thus as argued by Fry (2016), low interest rate is not good for the Australian economy.

References

Be?nassy, J. (2011). Macroeconomic theory. New York: Oxford University Press.

Duff, V. (2017). How Do Interest Rates Affect Businesses? [Online] Smallbusiness.chron.com. Available at: https://smallbusiness.chron.com/interest-rates-affect-businesses-67152.html [Accessed 13 Oct. 2018].

Evans, A. (2016). The Dynamic AD AS Model. [Online] Slideshare.net. Available at: https://www.slideshare.net/AnthonyEvans1/the-dynamic-ad-as-model [Accessed 15 Oct. 2018].

Fry, R. (2016). Low Interest Rates are Hurting Growth. [Online] Forbes.com. Available at: https://www.forbes.com/sites/realspin/2016/10/04/low-interest-rates-are-hurting-growth/#44adb12db605 [Accessed 13 Oct. 2018].

Hubbard, G., Garnett, A., Lewis, P. and O’Brien, A. (2014). Essentials of Economics. Pearson Australia Pty Ltd.

Ivan, I. (2017). Do lower interest rates increase investment spending? [Online] Investopedia.com. Available at: https://www.investopedia.com/ask/answers/101315/do-lower-interest-rates-increase-investment-spending.asp [Accessed 13 Oct. 2018].

Johnston, K. (2017). The Effect of Interest Rates on Business. [Online] Smallbusiness.chron.com. Available at: https://smallbusiness.chron.com/effect-interest-rates-business-69947.html [Accessed 13 Oct. 2018].

Luke, J. (2011). AD-AS Model Explained. [Online] EconProph. Available at: https://econproph.com/2011/03/02/ad-as-model-explained/ [Accessed 15 Oct. 2018].

Mceachern, A. (2011). Macroeconomics. Mason, Ohio, South-Western.

Sexton, R. (2015). Exploring Macroeconomics. 7th ed. Australia: Cengage Learning