The principle of effective demand proposed by John Maynard Keynes as an essential theoretical difference between his theory of Keynesian economics and classical economics indicates that aggregate expenditures are primarily based on existing levels of income and production. If people have more income, then they are inclined to spend more. Less income inevitably leads to less spending.

However, a number of other factors also affect aggregate expenditures independent of income. For example, a typical consumer like Duncan Thurly might decide to increase his personal consumption by purchasing an excruciatingly painful root canal from his dentist, Dr. Nova Cain. This extra spending is NOT the result of a sudden windfall of income. Duncan did not receive a year-end bonus from his boss nor did he find a leather satchel of $100 bills on the sidewalk.

Alternatively, the thriving community of Shady Valley might decide to build a new elementary school. This extra spending is NOT the result of an expanding economy. A windfall of tax revenues did flood into the city's bank account.

Rather, these expenditures are undertaken for "other reasons" unrelated to income or production. Duncan's specific reason is to eliminate the excruciatingly painful cavity in his tooth. The specific reason underlying Shady Valley's increase in spending is to replace an old elementary school that was destroyed by a flood of the adjacent Shady Valley River, after it was flattened by a massive tornado, which arose on the heals of a major earthquake centered directly under the school.

What They Do

Determinants

The exhibit to the right presents the aggregate expenditures line, labeled AE. Aggregate expenditures determinants can trigger either an increase or a decrease in aggregate expenditures.

• Increase in Aggregate Expenditures: An increase in aggregate expenditures is illustrated by an upward shift of the aggregate expenditures line. At each income and production level, one or more of the four sectors have greater aggregate expenditures. Click the [Increase] button to illustrate.


• Decrease in Aggregate Expenditures: A decrease in aggregate expenditures is illustrated by a downward shift of the aggregate expenditures line. At each income and production level, one or more of the four sectors have fewer aggregate expenditures. Click the [Decrease] button to illustrate.

What They Are

• Interest Rates: Higher interest rates increase the cost of the borrowing used to finance some types of consumption and investment expenditures (such as automobiles, furniture, factories, and delivery vehicles). If the cost of borrowing increases, the household and business sectors are less likely to undertake the resulting expenditures on consumer durable goods and capital goods. As such, aggregate expenditures decrease and the aggregate expenditures line shifts down. Lower interest rates work in the opposite manner, causing an upward shift of the aggregate expenditures line.


• Consumer Confidence: If people have more confidence about the state of the economy and are optimistic that the goods times will continue, then they are more likely to boost their spending. However, this extra spending is not the result of extra income. As such, aggregate expenditures increase and the aggregate expenditures line shifts up. A drop in consumer confidence works in the opposite manner with a downward shift in the aggregate expenditures line.


• Wealth: Wealth affects aggregate expenditures, especially consumption and investment, in one of two ways. An increase in financial wealth (including stocks, bonds, and especially money) motivates the household and business sectors to increase consumption and investment expenditures. Like other expenditure increases, this results in an upward shift of the aggregate expenditures line. Alternatively, an increase in physical wealth (including automobiles, furniture, factories, and delivery vehicles) reduces the need to buy these consumer durable goods and capital goods. This leads to a decrease aggregate expenditures and a downward shift of the aggregate expenditures line.


• Technology: The development of new technology invariably triggers greater investment expenditures in capital goods. A new technology requires new capital, different capital, a great deal of capital to implement the technology. Technological advances invariably trigger an increase investment and aggregate expenditures, and thus shift the aggregate expenditures line upward. While less realistic, a decline in technology would cause a downward shift of the aggregate expenditures line.


• Fiscal Policy: At the federal level, the desire to counter business cycle instability though fiscal policy is an ever present possibility. The federal government is inclined to increase autonomous government purchases to counter a business-cycle contraction, which causes an upward shift of the aggregate expenditures line. Alternatively, if a business-cycle expands to the point of triggering inflation, then the government is likely to decrease autonomous government purchases, which causes a downward shift of the aggregate expenditures line.


• Exchange Rates: Currency exchange rates are the prices of one nation's currency in terms of other currencies. A change in these rates, affects the relative prices of exports and imports. If, for example the price of Mexican pesos increases from $0.10 per peso to $0.11 per peso, then Mexican imports into the United States become more expensive and U.S. exports to Mexico become less expense. As such, imports fall and exports rise, increasing net exports and causing the aggregate expenditures line to shift upward. A opposite change in exchanges rates result in a downward shift of the aggregate expenditures line.