Effects Of Investment Expenditure And Interest Rates On The Australian Economy: An Essay.

1(a) Use the aggregate expenditure (AE) model to describe the impact of a growing housing market and what OECD refers to as “solid economic growth” on equilibrium output.
In your answer make sure to discuss the equilibrating process of moving to a new macroeconomic equilibrium output.

1(b) Discuss the connection between the OECD “urging Australia to begin increasing official interest rates’ and how this can “... cool the housing market…”. In your answer explain which components of AE can be affected by rising interest rates. 

2 Use the static AD-AS model to analyse the circumstances under which the Reserve Bank does not raise interest rates as urged by the OECD and the growth in the economy eventuates as predicted by the OECD.

In your answer make sure to use the static AD-AS model to show the initial impact and the long run implications if the Reserve Bank fails to raise interest rates under the circumstances predicted by the OECD. 

3 Referring to the OECD comment of “…hurdles to a long run recovery …” use the dynamic AD-AS model(s) to explain and analyze the impact on equilibrium output and (un)employment in the case where the Reserve Bank does raise interest rates sometime in the
future but where the expansion of the economy is below what is predicted by OECD. 

Aggregate Expenditure (AE) Model

1a In the conceptual framework of economics, the Aggregate Expenditure refers to the current value of the finished products and commodities produced in an economy, within a period of time. Thus, the aggregate expenditure consists of the following components:

AE = C+I+G+NX

[Where, C is the consumption expenditure, G shows the expenditures on part of the government, I denote the investment expenditures in the economy and NX refers to the net exports (exports-imports) of the concerned country] (Johnson 2017)

In the AE Model, thus, the equilibrium occurs at the point where the aggregate supply is equal to the aggregate demand in the economy and in the Classical AE Model:

AE = C+I, with the equilibrium being shown as follows:

                                                                   Figure 1: Equilibrium in the AE Model

                                                                       (Source: As created by the author)

As can be seen from the above figure, the equilibrium occurs at the point where AE = Y, which is drawn with the help of the 45-degree line, which equates the horizontal axis with that of the vertical axis, thereby equating the Aggregate Expenditure with that of the Aggregate Output in the economy (Persson and Tabellini 2012).

Keeping this into consideration, in the current scenario taken into consideration, of that of the growing housing market of Australia, the investment in the housing sector can be seen to be increasing, the effects of which can be seen on the overall economy, with the help of the AE Model as follows (Afr.com 2018).  

                                                 Figure 2: Effects of increase in the investment expenditure

                                                                     (Source: As created by the author)

The increase in the investment expenditure (due to the growth in the housing market) leads to an increase in the Aggregate Expenditure in the economy, which in turn, leads to an increase in the overall output (GDP) of the economy, with the equilibrium in the economy, shifting from the point E0 to E1, as can be seen from the above figure (Burke 2012).

1b In this context, the OPEC can be seen to be urging Australia to increase the rate of interest in the economy, in order to cool down the boom and growth in the housing market. This is suggested, because the rate of interest is inversely related to that of the investment expenditure component of the aggregate expenditure in a country, which can be shown as follows:

Investment Expenditure and Housing Market Growth

                                                         Figure 3: Relationship between Investment and Rate of Interest

                                                                               (Source: As created by the author)

Thus, an increase in the rate of interest can help the economy of Australia to decrease the amount of money borrowed for the purpose of investing in the housing sector of the economy, thereby decreasing the overall investment expenditure in the economy (Mankiw 2014). The effects of the same can be seen with the help of the AE Model, which is as follows:

                                                      Figure 4: Effects of rise in rate of interest on the overall economy

                                                                             (Source: As created by the author)

Thus, the increase in the rate of interest, followed by a fall in the investment expenditure is expected to decrease the Aggregate Expenditure as well as the Aggregate Output (Y) in the economy (Heijdra 2017).

2 . If the Reserve Bank of Australia does not succeed to increase the rate of interest, as urged by the OECD, then the investment expenditure will go on increasing, due to the growth in the housing market of the country, which usually results in increase in both the demand side and the supply side activities in the concerned market of the country (Goodwin et al. 2015). The implications of the same, can be explained with the help of the Static Aggregate Demand and Aggregate Supply Model in the theoretical framework of economics. The AD consists of the following components in this model:

AD = C+G+I+NX (Symbols having their usual meanings as discussed above)

Thus, the interest rate remaining at the low level, the Investment will go on increasing, thereby increasing the Aggregate Demand in the economy (Gallegati, Palestrini and Russo 2017). The effects of the same in the short run and long run, can be seen as follows:

The Short Run Aggregate Supply Curve being positively sloped, the increase in the aggregate demand will have the initial effects to be as follows:

Relationship Between Interest Rates and Investment Expenditure

                                                     Figure 5: Initial Impact of Interest Rate Stagnancy

                                                                (Source: As created by the author)

Thus, in the short run, due to the presence of positively sloped SRAS curve, the increase in the aggregate demand (due to increase in the investment expenditure), leads to both increase in the output level (GDP level) as well as increase in the overall price level in the housing market (Carlin and Soskice 2014).

In the long run, however, the supply curve is vertical as due to the assumption of full employment level. Thus, in this context, also, in the housing market, in the long run, the supply curve is expected to be vertical. The logical interpretation behind the same being the fact that the land resources are limited in the country and thus, after a certain point of time the suppliers in the housing market cannot increase the supply of housing due to the constraint of limitation of the resources for production of new housings in the country (Cohn 2015). Thus, in this context due to the increase in the investment and continuous increase in the aggregate demand, the impacts are expected to be as follows:

                                                           Figure 6: Long run impacts of interest rate stagnancy

                                                                         (Source: As created by the author)

Thus, in the long run, the LRAS being vertical, the output is expected to stay at a constant level, while due to the continuous increase in the aggregate demand (due to the increase in the investment expenditure in response to a stagnated rate of interest), the price level in the economy will go on increasing.

3 . In the Dynamic AD-AS Model, both the aggregate demand as well as aggregate supply are variable in the short run and also in the long run. This is because, in the Dynamic AD-AS Model, the vertical axis does not measure the price levels but takes into account the rate of inflation and the subsequent periods of time are linked together, as the change in the level of inflation in one period leads to a change in the expectations regarding the rates of inflation in the future periods, thereby leading to changes in the aggregate supply in the coming periods, thereby differing from the Static AD-AS model (Gürkaynak and Wright 2012).

Static Aggregate Demand and Aggregate Supply Model

In this context, keeping into consideration the Dynamic AD-AS Model, if the Reserve Bank of Australia succeeds to increase the rate of interest in future, then in response to the same, the demand for borrowing of money for the purpose of investing in the housing market, thereby decreasing the aggregate demand in the housing market. The effects can be seen as follows:

                                            Figure 7: Impacts of rise in rate of interest in the Dynamic AD-AS Model

                                                                        (Source: As created by the author)

As is evident from the above figure, with the increase in the rate of interest and with the subsequent decrease in the level of investment expenditures (due to fall in the borrowings of people to invest in the housing market of the country), the aggregate demand is expected to shift leftward (from DAD1 to DAD2). This fall in the aggregate demand in the housing market is expected to decreases the aggregate supply in the short run (from DAS1 to DAS2), as lack of investment is expected to stall the growth in the housing market of the country (Ascari and Sbordone 2014). If this trend continues for long-term, then in the long run, the dynamic long run supply curve is also expected to move leftwards (from LRAS1 to LRAS1).

This in turn implies that the fall in aggregate demand results to short run decline in the short run aggregate supply and this continues, resulting in the decline in the long run supply in the economy, which in turn signifies that in the long run the equilibrium output decreases (from E1 to E2), which in turn implies that in this scenario, the long run output as well employment level decreases in the economy (Argy 2013). The problem becomes acute when the expansion of the economy is below the predicted level by OECD as in such scenario the fall in the equilibrium output and employment levels in the economy can lead to a recessionary situation or situation of economic stagnation with lesser productive and economic activities, thereby posing as an aggravated hurdle in the aspect of long run recovery in the backdrop of a dampened future growth since the global recession and a situation of low numbers of business creation in Australia.

References: 

Afr.com (2018). OECD says Australian economy ready for higher RBA rates. [online] Financial Review. Available at: https://www.afr.com/news/economy/economy-ready-for-higher-rba-rates-tighter-budget-oecd-says-20171128-gzua5y [Accessed 23 Jul. 2018].

Argy, V., 2013. International macroeconomics: theory and policy. Routledge.

Ascari, G. and Sbordone, A.M., 2014. The macroeconomics of trend inflation. Journal of Economic Literature, 52(3), pp.679-739.

Backhouse, R.E., 2012. Interpreting Macroeconomics: Explorations in the History of Macroeconomic Thought. Routledge.

Burke, T., 2012. The Australian residential housing market: institutions and actors. Australia’s unintended cities, pp.35-49.

Carlin, W. and Soskice, D.W., 2014. Macroeconomics: Institutions, instability, and the financial system. Oxford University Press, USA.

Cohn, S.M., 2015. Reintroducing Macroeconomics: A Critical Approach: A Critical Approach. Routledge.

Gallegati, M., Palestrini, A. and Russo, A. eds., 2017. Introduction to agent-based economics. Academic Press.

Goodwin, N., Harris, J.M., Nelson, J.A., Roach, B. and Torras, M., 2015. Macroeconomics in context. Routledge.

Gürkaynak, R.S. and Wright, J.H., 2012. Macroeconomics and the term structure. Journal of Economic Literature, 50(2), pp.331-67.

Heijdra, B.J., 2017. Foundations of modern macroeconomics. Oxford university press.

Johnson, H.G., 2017. Macroeconomics and monetary theory. Routledge.

Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.

Persson, T. and Tabellini, G., 2012. Macroeconomic policy, credibility and politics. Routledge.