Explore the relationship between aggregate expenditure, construction output and employment in a developed or developing country.
Explore the relationship between aggregate expenditure, construction output and employment in a developed or developing country.
In a broad sense, macroeconomics can be viewed as the study of aggregate trends in an economy and has been a central concern of economists for centuries. By observing all the economic theories that have been developed throughout the history of mankind, it can be concluded that aggregate expenditure, construction output and employment are highly dependent one to the other. Before their relationship is further analysed though, some of their basic concepts should be defined. Because of the limitations in the length of this paper, it was not possible to analyse all of the different theories, therefore the Keynesian approach to the subject was chosen. A detailed study of the Basic Keynesian Aggregate Expenditure Model will help us understand why changes in aggregate expenditure exert a powerful influence on equilibrium output and employment.
First of all there are several assumptions that need to be made in order to simplify the analysis; wages and prices are completely inflexible until full employment capacity is reached and government's taxing, spending and monetary policies are constant. Equality between aggregate expenditure and output is central to the Keynesian analysis.
Aggregate expenditure is defined by Keynes (1936) as a relationship between intended expenditures and income. Aggregate expenditure is essentially the same concept as aggregate demand, except that in aggregate expenditure relates expenditures to income, whereas aggregate demand relates expenditures on output to the price level. Aggregate demand is defined as an inverse relationship between the price level and expenditure on output. The central assumption of Keynesian economic theory is that aggregate expenditure determines the equilibrium level of national income.
As Samuelson and Nordhaus (1992) describe, aggregate demand refers to the total amount that different sectors in the economy, household, business, government and foreign, willingly spend in a given period. The four components of aggregate demand (often written AD) are: consumption expenditures, investment expenditures, government purchases, and net exports depend on the level of prices, as well as on monetary policy, and other factors.
Fig 1: Aggregate demand
Aggregate supply refers to the total quantity of goods and services that the nation's businesses are willing to produce and sell in a given period. Aggregate supply (often written AS) depends upon the price level, the productive capacity of the economy, and the level of costs (Samuelson and Nordhaus, 1992).
Fig 2: Aggregate supply
The output market equilibrium (E) is given by the intersection of the AS and AD curves. In other words, the economy will settle at the output and price level given by the equilibrium of aggregate demand ...
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Fig 1: Aggregate demand
Aggregate supply refers to the total quantity of goods and services that the nation's businesses are willing to produce and sell in a given period. Aggregate supply (often written AS) depends upon the price level, the productive capacity of the economy, and the level of costs (Samuelson and Nordhaus, 1992).
Fig 2: Aggregate supply
The output market equilibrium (E) is given by the intersection of the AS and AD curves. In other words, the economy will settle at the output and price level given by the equilibrium of aggregate demand and supply.
Fig 3: Interaction of aggregate demand and supply
Construction output is the goods and services produced as a result of economic activity (www.bized.ac.uk/glossary). As explained by Baumol and Blinder (1988), there are several ways to measure the total output, the most common one is the Gross Domestic Product (GDP) that is the total value of all goods and services produced in the domestic economy over a given time period, usually a year. There is also Gross National Product (GNP); the only difference with GDP is that GNP includes the net property income from abroad.
To make things more clear, equilibrium is present in the Keynesian model when GNP equals the value of current output. This can also be presented by the following graph.
Fig 4: Keynesian equilibrium
In this graph, along the 45o line, aggregate expenditures AE are equal to the total output. Depending on the level of aggregate expenditures, each point along the 45o line is a potential equilibrium; that means that within the Keynesian model there are many possible equilibrium levels of output and consequently employment as well. That is because employment is directly linked to output.
If any of the components of aggregate demand changes, has an impact on the actual aggregate demand, the output and finally the employment. This can be better understood from the following example.
If the aggregate demand is increased from AD to AD1, then as it can be seen from the graph, output is increased therefore demand for labour increases and employment is increased as well.
Fig 5
If the aggregate demand is decreased from AD to AD2, then as it can be seen from the graph, output is decreased therefore demand for labour decreases and employment is decreased as well.
Fig 6
Case Study
(The following data have been taken from a case study from the Occidental College of Los Angeles)
Equilibrium Level of Income, Output, and Employment
Possible Levels of Employment (millions of persons)
(1)
Total Output (GNP) (billions of dollars)
(2)
Planned Consumption (billions of dollars)
(3)
Planned Injections (I+G) (billions of dollars)
(4)
Planned Net Exports (billions of dollars)
(5)
Planned Aggregate Expenditure (billions of dollars)a
(6)
Unplanned Inventory Change (billions
of dollars)b
(7)
Tendency of Employment, Output, and Income
(8)
90
00
10
20c
30
4,600
4,900
5,200
5,500
5,800
3,000
3,200
3,400
3,600
3,800
,700
,700
,700
,700
,700
200
50
00
50
0
4,900
5050
5,200
5,350
5,500
-300
-150
0
-150
-300
Increase
Increase
Equilibrium
Decrease
Decrease
aPlanned C+I+G+X as indicated by columns 3,4 and 5
bTotal output (column 2) less planned aggregate expenditures (column 6)
cFull employment
Table 1
The table above presents data for planned consumption, investment, government purchases and net exports, where C= Consumers, I= investors, G= Government, X= net exports. Reflecting the assumptions of the Keynesian model, investment is not dependent on the level of income. So, the injections of government are assumed to be constant (at $1,700 billion). Within the Keynesian model, planned consumption increases with income, but it increases by a smaller amount than does income (because some of the additional income is allocated to saving and taxes). As income increases by $300 billion (from $4,600 billion to $4,900 billion, for example), consumption increases by $200 billion. While planned net exports decline with income, they do not cause an increase in consumption since they are relatively small. Thus, aggregate expenditure (column 6) increases as income expands. For the economy illustrated by the table, Keynesian equilibrium takes place at a GNP of $5.2 trillion, the income level at which planned aggregate expenditures are just equal to total output (aggregate supply). An employment level of 110 million is associated with the $5.2 trillion output.
Let us consider the situation where the output of the economy temporarily expands to $5.5 trillion. Employment will increase from 110 to 120 million. Because of the higher income, households will increase their spending to $3.6 trillion. When added to the $1.7 trillion of spending by investors and governments, and the $50 billion in net exports, total spending is equal to $5.35 trillion, $150 billion less than output. The total spending of consumers, investors, and governments will thus be insufficient to purchase the $5.5 billion of output. Unwanted and unplanned business inventories of $150 billion will arise. Of course, business firms will not continue to produce goods they cannot sell, so they will reduce production during the subsequent period. As production is cut back, output and employment will fall. The unemployment rate will rise. Given the spending plans of decision-makers, the $5.5 trillion income level cannot be maintained in the future.
In an opposite situation, the output of the economy falls to $4.9 trillion. At that income level, purchasers of goods and services would spend $5.05 billion (column 6) on current output. Business firms would be selling more than they are currently producing. Their inventories would decline below normal levels. Business firms would respond to this happy state of affairs by expanding output. Production would increase, so would employment. Income would rise toward the Keynesian equilibrium level of $5.2 trillion.
As it was seen, aggregate expenditure is the catalyst of the Keynesian Model. Changes in expenditure lead to changes in output and employment. Therefore, theoretically, a government can increase employment amongst other things by using the basic tools of aggregate supply and aggregate demand analysis and reach full employment. However, as suggested by Pianta (1997), nowadays, views and policies have developed and since the 1970s a new orthodoxy of a "natural rate" of unemployment is accepted, set by the structure of the economy and labour supply and a "non-accelerating inflation rate of unemployment" (NAIRU) is defined as the rate after which a reduction in unemployment has the effect to increase prices. Many changes in the growth model of advanced economies have emerged in the last decade. Therefore, there is a general move towards abandoning traditional Keynesian policies; a new orthodoxy of anti-inflationary monetary policy, fiscal consolidation and reduction of state intervention in the economy has started dominating the economic opinion and policy in both advanced and developing countries.
References
. Baumol, W.J. and Blinder, A.S., (1988), Economics, Principles and Policy
2. Keynes, John Maynard, (1936), The General Theory of Employment, Interest and Money
3. Pianta, M., (1997), Unemployment and Aggregate Demand, article
4. Samuelson, P.A. and Nordhaus, W.D., (1992), Economics
5. www.bized.ac.uk/glossary
6. www.faculty.oxy.edu/whitney/htlm, Occidental College of Los Angeles
Bibliography
. Begg, David, (2000), Economics
2. Sachs, J.D. and Larrain, F.B., (1993), Macroeconomics in the Global Economy
Semester Paper 1
Construction Economics 1
