Aggregate expenditure is the amount of spending on goods and services in an economy. It covers household consumption, investment expenditure, government spending, and purchases by foreigners.
Usually, consumption covers the majority of aggregate expenditure. In Indonesia, its contribution reaches 64-65% of the total gross domestic product (GDP). So, it becomes a driving force to stimulate the economy.
Remember, in a closed economy; there is no international trade. Thus, foreigner transactions (import-export) don’t exist. It only exists in an open economy.
Aggregate income is equal to aggregate expenditure.
Aggregate expenditure is one approach to calculate gross domestic product (GDP). Others are aggregate output and aggregate income. All three must produce the same numbers because they represent three approaches to measuring the same metric.
Why is that?
I will take a simple example. Say, there is only business as producers and households as suppliers of labor and entrepreneurship (entrepreneurs). There is no capital and retained capital involved.
The business produces an output of Rp100. They sell it to households and earn revenue of Rp100.
But, not all of that income becomes profit. It must use the revenue to pay wages (say Rp. 40). The rest, profit, goes to the owner’s pocket (Rp60). Households and owners use the money to buy goods and services.
Hence, Total output (Rp. 100) = Total expenditure (workers as much as Rp. 40 + employers as much as Rp. 60) = Total income (wages of Rp. 40 + profit of Rp. 60).
Models, components, and determinants of aggregate expenditure
Economists use the following formula to calculate aggregate expenditure (AE).
AE = C + I + G + (X – M)
- C = Household consumption
- I = Gross private investment
- G = Government expenditure
- E = Export (representing foreigners spending on domestic goods and services)
- M = Import (represents domestic expenditure on foreign goods and services)
Let’s discuss each component and its influencing factors.
Consumption represents household expenditure on goods and services. Goods consist of durable and non-durable items.
Economists explain that household consumption is a function of income. Or in other words, income is the primary determinant of consumption. No consumption if there is no income. If income rises, consumption should increase and vice versa.
It would help if you remembered, income here is income after tax (disposable income). Taxes reduce the money that households can spend. Higher taxes mean less money for consumption.
Furthermore, how sensitive is income to consumption behavior? It depends on what we call the marginal propensity to consume (MPC). The MPC measures additional consumption from extra money households earn.
The maximum MPC value is equal to 1.
If the MPC is high (close to 1), that means the household spends its extra income more on consumption. The rest they save. The higher the MPC, the greater the multiplier effect on aggregate expenditure.
Gross private investment
It is spending on goods and services for future use. It consists of:
- Fixed capital investment, comprising the purchase of capital goods such as machinery and equipment
- Residential investment, i.e., acquisition of new homes by households and landlords
- Inventory investment, i.e., changes in inventory.
Profit expectations and funding costs influence investment. Profit expectations depend on the outlook for demand, reflected in real GDP growth.
Meanwhile, funding costs depend on the real interest rate, i.e., the nominal interest rate after adjusting for the inflation rate. That reflects the real money that businesses spend to pay interest.
Government expenditure consists of national and local government expenditure. Examples are infrastructure and routine expenses, such as employee salaries.
This component excludes transfer payments. The reason is that it doesn’t involve the exchange of goods and services in return.
But you must remember. The GDP calculation includes household expenditure facilitated by transfer payments.
When the economy contracts, the government will increase spending. Higher spending drives demand for goods and services. That, in turn, will spur economic growth.
Net exports equal exports minus imports. Another term is the trade balance.
Exports represent the consumption of domestic goods and services by foreigners. Imports represent the consumption of foreign products and services by domestic consumers.
GDP measures the number of goods and services produced in an economy. That is why in the formula above, imports have a negative sign.
Calculating aggregate expenditure multipliers
The concept of multiplier originated from Keynes – hence it is also called the Keynesian multiplier. It seeks to illustrate how much consumption can affect the economy.
Households spend their income on two choices: consumption and savings. Likewise, when their income increases, they will use it for consumption and saving.
The portion of extra income they use for consumption is known as the marginal propensity to consume (MPC). And, extra income spent on savings is called marginal propensity to save (MPS). The MPC plus MPS is equal to 1, which is their total income.
Keynes defines consumption multipliers by the following formula:
Multiplier = 1 / (1 – MPC)
Because MPC + MPS = 1, we can rewrite the formula above to be:
Multiplier = 1 / MPS
You can see it. The multiplier effect will be higher when MPC is high. In other words, the impact of consumption on the economy will be even more significant when households spend most of their additional income on consumption. High consumption, in turn, stimulates business to increase production.
For your note, in the real world, the multiplier formula is more complicated. Households have more choices than just consumption or savings. For example, they have to pay taxes, which reduces money for consumption and savings. Also, instead of buying domestic products, they prefer imported products. Both reduce the multiplier effect.