3.1 - Relevant Syllabus.
- Factors affecting each of the components of aggregate expenditure.
3.2 - Summary.
3.3 - Content.
3.3.1 - Factors affecting aggregate consumption expenditure.
Discretionary spending (durables) varies subject to many influences whereas necessities spending (non-durables) tends to remain stable over the business cycle.
Main factors affecting discretionary spending in consumption includes (DICAS):
- Disposable income (Yd) (Most significant).
- Interest rates (r).
- Consumer expectations.
- Availability of credit.
- Stock of wealth (property, shares).
Disposable income refers to household income available after tax. There is a positive relationship between disposable income and consumption expenditure. - The proportion of income spent declines as income rises. - For e.g., as income rises, absolute spending (total amount of money spent) increases but the proportion of income spent decreases (APC, APS). - The relationship called the consumption function explains the Keynesian AE model.
Interest rates or cost of credit refers to the price of household borrowing to finance spending such as discretionary consumption. There is a negative relationship between interest rates and consumption expenditure. - Decreased interest rates increases household spending because: - Periodic repayments takes up a smaller proportion of disposable income (cost of borrowing decreases / income increases over time if credit was used to fund consumption). - The opportunity cost of consumption falls as there are less incentives in savings in interest-bearing accounts with a lower rate of return.
Households’ perceived wealth of stock refers to the perceived prices of real assets (e.g., property and shares) that households own. There is a positive relationship between the perceived prices of real assets and household spending. - Households tend to spend more if they are more confident about the prices of their assets or their wealth. - For e.g., early 2020, the ASX index (value of public companies, price of shares) for the top 200 companies fell from 7144 in 18 February to 4735 in 23 March which saw an increased CAB as consumption for imports fell.
Consumer expectation refers to households’ perception of future trends regarding economic growth, interest rates, exchange rates, shares and property market, etc. If consumers have positive expectations about a decreasing interest rates, they will tend to spend more. - A decreasing interest rates means decreased cost of borrowing over time (assuming payback rate is not fixed).
There are other factors affecting consumption expenditure such as:
- Exchange rates (Positive).
- The distribution of income and wealth.
- Demographic facotrs (e.g., age).
- Exogenous events (e.g., COVID-19).
- Changes in community attitudes (e.g., views about climate change may impact spending patterns).
- Government economic policy (e.g., monetary policy and fiscal policy).
3.3.2 - Factors influencing aggregate private investment.
Investment rises or falls according to the perceived risk or the chance that the outcome of an investment will be different than the expected positive outcome. The probability of difference can be positive or negative.
Main factors affecting private (planned) investment include both economic and non-economic factors:
- Business expectations.
- Interest rates (r).
- Levels of past profits / business profitability.
- Government policies (e.g., taxation).
Real interest rates (interest rates factored in inflation) is more important to investment decisions than nominal rates:
There is a negative relationship between interest rates and private investment expenditure.
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Explanation 1: Increased interest rates -> increased periodic repayments or cost of borrowing -> decrease tendency to borrow to fund investment.
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Explanation 2: Increased interest rates -> increased opportunity cost of investment (retained profits can be used for other purposes) -> decreased the likelihood that the rate of return on new capital equipment exceeding its price.
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The elasticity of investment with respect to interest rates refers to the responsiveness of investment spending to changes in interest rates (the relationship is still negative, how much is the change).
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The elascity of investment with respect to interest rates is influenced by the business cycle and business expectations:
Cyclical upswing -> positive business expectations about future prospects -> continue to invest despite rising interest rates (investment declines at a lower rate than the increase in interest rates).
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For e.g., between September 2017 & April 2022, interest rates were historically low yet business investment spending was below average (in a contraction / trough).
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ID1 represents economic changes such as interest rates.
ID2 represents non-price changes such as business expectations.
Business profitability refers to the proportion of profit that businesses retain for investment spending. There is a positive relationship between business profitability and investment spending. - Low profits (contraction) -> firms tend to depreciate or run down their capital equipment with limited investment. - High profits (upswing) -> firms have increased fund to invest on new capital items. - Technological progress is embodied in investment on new capital items as firms take advantage of lowered cost of production and increased efficiency.
Business expectations refer to the economic outlook of businesses. If there is a positive expectations about future salws and profit levels, then the demand for investment will likely increase. - Business expectations are influened by current economic activity and trends (economic growth, exchange rates, interest rates, etc.).
Government policies refers to fiscal and monetary policies. Fiscal and monetary policies affect costs and expected sales revenue. - Increased tax on the earnings of an industry negatively affects its investment spending due to decreased fund for investment . - Tax incentives or decreasing taxation increases the level of investment spending in that industry. - A stable macroeconomic environment provided by the government is important for life-long private investment projects e.g., constuction, mining, and transport.
3.3.3 - Factors influencing government expenditure.
Economic factors are not central (but do affect) to government consumption and investment decisions.
Government spending are influenced by:
- Economic policy objectives.
- The business cycle.
Government current spending is governed by the need to fund essential services (e.g., health, defence, education) which is governed by the size of the population.
Government capital spending is governed by the need to provide appropriate levels of service across the country.
Government spending’s timing may be influenced by the state of the economy:
- For e.g., during a peak where the economy is operating at full capacity, capital spending would be inappropriate as it worsen supply bottleneck and inflationary pressure.
3.3.4 - Factors affecting net exports.
Net exports is reasonably volatile and is affected by:
- The level of domestic and overseas economic activity.
- Exchange rates.
- Terms of trade.
- Tariffs and quotas.
The volality of net exports is explanable by overseas demand fluctuating based on regional / world economic conditions and domestic supply fluctuating based on seasons and natural events.
Domestic economic activity influence Australians’ propensity to import. There is a negative relationship between domestic GDP and net exports (imports are debits). - Australian imports are relatively elastic in respect to GDP, meaning an increase in GDP is likely to be met with a similar increase in imports, reflecting Australia’s small manufacturing sector. - In periods of strong economic activity consumers purchase overseas goods and businesses purchase capital equipment not available in Australia.
Exchange rates refer to the price of one currency in terms of another currency. There is a negative relationship between exchange rate and net exports. - An appreciation of the AUD will see an increase in demand for imports as the AUD can purchase more G&S and a decrease of demand for Australian exports, decreasing net exports. - The impact of exchange rate is dependent on various price elasticities.
Terms of trade is an index which measures the relative movements in the price of a nation’s exports in comparison to its imports. ToT has a positive relationship with net exports. - An increase in ToT suggests for an increase in demand for Australian exports, which increases net exports. - 2012 - 2016, export price index fell relative to imports, decreasing net exports. - Recently, ToT risen due to the Ukraine War, reflecting an increase in demand for Australian agriculture commodities.