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Deriving the Aggregate Expenditures Model

AE Model: Components


Components of Aggregate Expenditure

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Alright, let's go into a little more detail about each of the components of aggregate expenditure, consumption, investment, government purchases and net exports. So what determines the level of each of these, let's start here with consumption. So the first thing we talked about already was disposable income. Right? As there's more disposable income, there's more consumption, Right? And that we learned in the consumption function videos, We saw that here with aggregate expenditures. So that one is going to be one of the determinants. The more disposable income, we'll write it here, the more disposable income, the more consumption, Right? How about household wealth? When I talk about wealth, it's not just income money you're making now, but more like owned assets. So you can think of maybe a family that owns a big house, they own a boat, They have a bunch of financial investments, right? Compare that to someone who maybe just, you know, owns their car, is making payments on their car, but renting their places and that, well, that family that has a lot of assets, well, they're gonna more likely have higher consumption because they have this wealth that can back up that consumption right? They could always sell some financial assets, maybe sell some stock to, uh, to pay off some of that consumption. So as wealth goes up with wealth goes up, we're gonna see consumption increasing as well. How about expected future income if you're expecting to make more money in the future? Well, you think, and you said, hey, I've got that raise coming next year. I've got a bonus coming? Well, maybe I can go ahead and put the down payment on that car. Right? So future income increases and we can expect and increasing consumption as well. Right? Because you're expecting more money in the future you might start spending now. How about the price level? What if we see higher prices? Think about you go to the store and everything costs a little more higher prices? Well, you'd probably spend a little less money, right? You wouldn't consume as many things. You everything costs a little more. You'd probably cut back on the amount of consumption you do. So higher prices lead to less consumption and finally the interest rate. Well, how does the interest rate reflect upon consumption? Well, we gotta think about savings. Think about savings in this case. So when there's a higher interest rate you're more likely to save, Right, savings go up. So what happens with our income? We either save it or we consume it. Right. So if our savings are going up because we're we see higher interest rate, we're gonna consume less now. Right? Our income, we're either gonna spend it now on consumption or spend it later by saving it now. Cool. So higher interest rates lead to less consumption. So what I have here is um a graph showing us consumption over the past say 50 or so years and we've got, starting from 1960 and notice what we've got, this is our consumption function. We've got disposable income here and as disposable income increases, notice what happens to consumption, it increases as well, right? So what we have here is a consumption function kind of showing what we've been talking about so far and that slope of the consumption function being our marginal propensity to consume right for each extra dollar of disposable income. How much more are we going to consume? Cool. So there we go. That's the consumption function in action there. Let's go on to investment. So investment has to do with firms, right? The spending of firms. So if the firms think that there's gonna be more profitability in the future, they're thinking, hey, there's gonna, we see the economic, the economy booming. We expect, uh, the, the future profits to go up. So I'm gonna put future profits up. Well, they're going to invest now, right, they're going to increase their investment now to be ready to meet that demand in the future. So future expectations of future profit increase, our investment is going to increase about the interest rate. We'll think about for a firm. If they're gonna make an investment, they usually need a loan, right? They're gonna need a loan because these investments are big time purchases, they're buying equipment, they're buying machinery, buildings, right, these big building a factory, they're gonna need a lot of money. So they generally take out a loan. So if the interest rate goes up. Well, how do you think that affects investment? These higher interest rates means they're gonna be paying more interest and it would be less likely that they take out the loan because they don't see as much profit out of it, right, firms are going to be very profit centered. So if there their expectations of profit in this case, they see higher expenses from higher interest rates, they're not going to invest as much. Same thing with taxes, taxes is another expense, right? As the business taxes go up. Well, the investment's gonna go down, they see less profit because they're gonna have to be paying more taxes. The last one here is cash flow. So business operations are generating cash flows right as they buy and sell, uh buy and sell their product, whatever it is, they're gonna be generating cash flows and they don't want that cash to be sitting on hand. So as the cash flows go up, they're gonna want to invest it right as they have higher invest cash flows, they want to invest in their business to increase those in the future as well. Now for government purchases, we're gonna kind of skip that for now because we have a whole chapter that where we're gonna be talking about fiscal policy and future videos. We're gonna talk about this in a lot more detail. Uh So we're just gonna kinda glance over it for now. Net exports is kind of the same. Um We don't get into it too much now. Um The idea is that net exports uh has to do a lot with currency exchange rates and things like that and that that's something that usually deal with by the end of the course. But we'll kind of just talk about it a little bit right now of what are these things that determine the level of exports And it's going to be comparisons between what's happening in our economy here in the U. S. Compared to other economies around the world. So the price level in the USa is increasing versus other countries. If there's a lot of inflation in the in the USa if we see a lot of inflation, well that means the price of things in the U. S. Is a lot more. So there's gonna be more imports. We're gonna be buying things from overseas because they're cheaper than the cost of things in the US. There's more imports. And the opposite is true. If there's low U. S. Inflation there's gonna be more exports because other countries are going to be having that same mentality right where their inflation is going up, they'd rather by the U. S. Goods that are cheaper. Okay so the next one here is GDP growth. So think about if there's a lot of growth in the U. S. If the growth in the U. S. Is more than other countries, well there's gonna be more income, more money to spend. So there's gonna be more money to spend on foreign products as well. So in those cases when there's a lot of US growth, there's gonna be more imports happening as well because we have extra money and we spend that on not only our production but on foreign production as well. So there's more imports. The opposite. If there's low US growth, well, there's gonna be more exports, right? For the same logic that other countries will be buying our products. Finally, the exchange rate between the US dollar and other currencies. So if the US dollar becomes more powerful, if the US dollar value rises, well, that means it can afford more more uh goods from other countries, more imports. Right? So as we have more value in the U. S. Dollar compared to another currency, we're gonna be able to afford more of their stuff. So we're gonna buy more imports. And uh the opposite is true. If the US dollar value falls, well then other people are going to demand our product because our stuff is cheaper for them. All right, so that's how net exports work. The determinants of these different things depends on a lot of different factors. Right? For consumption investment, net exports will get the government purchases later on. But that's about it here for this video. Let's go ahead and move on