Aggregate Expenditure Model

Question

a)     Data from the Chinese property market suggests that housing sales and prices have fallen sharply in recent months. There is a concern that the housing market crash in China may be followed by an economic downturn. Using the Aggregate Expenditure model (AE-450-line diagram), explain how a housing market crash may lead to a recession in China.

b)     Should the government advise the households in China to become cautious about their spending and save more in this situation? Explain utilising the same diagram you use in part 2(a).

Answer 1

Angie, that's a great question – a real question, the kind that makes you think!

It's not just about houses; it's about how everything's connected.

The Chinese housing market and a potential recession? Let's untangle that with the help of the AE model and see if we can make some sense of it...

Starting with the first part of your question: Housing Market Crash and Recession in the AE Model.

1. Sharp drops in housing sales and prices can immediately start to ripple through the economy as a whole. In the Aggregate Expenditure (AE) model, this shows up primarily as a decrease in investment (e.g., falling residential construction) and consumption (in this case, due to a combination of the wealth effect and falling consumer confidence).
2. As people feel less wealthy, they cut back on spending. Businesses respond by laying off workers and reducing production (or as we've seen in the recent U.S. economy, by laying workers off and demanding those who stay work overtime to maintain production levels).
3. This sets off a multiplier effect, where initial spending cuts lead to further rounds of reduced income and spending. Ultimately, this means that the AE curve shifts downwards, lowering the equilibrium level of GDP, pushing the economy into a recession, and cauing a rightward shift of unplanned inventory (since fewer people are buying what's on the market anyway).

Let's look at part 2 of your question: Should the Government Encourage Saving?

1. In this scenario, widespread calls for households to save more risk triggering the paradox of thrift.
2. While saving more can be smart for an individual family, if everyone does it at once—especially during an economic downturn—consumption drops even further, Aggregate Expenditure is going to fall, causing GDP to decline and making the recession worse.
3. In fact, lower GDP means even total savings might end up falling.
4. Traditionally, policymakers try to counteract these kinds of shocks through fiscal policy interventions (e.g., infrastructure spending, like the Infrastructure Investment and Jobs Act (IIJA) of 2021 in the U.S.) and monetary policy (e.g., lowering interest rates) to revitalize demand and stabilize the housing market.
5. This is a move to restore consumption and confidence.

Ultimately, encouraging everyone to save more right in the midst of a downturn could be counterproductive.

While it might be prudent for individual households to be mindful of their finances, from a macroeconomic perspective, the government should aim to shore up aggregate demand, not stifle it further.

Let me know if that helps, and thanks for the great question!