Animal Spirits Case Study

1. “The economy now needs ‘animal spirits’ in order to support an expansion of non-mining firms, and this is not what monetary policy can directly do”. Use the Aggregate Expenditure model to explain the given statement made by RBA Governor Glenn Stevens. In your answer make sure you explain currently what phase of business cycle Australia is in.

Animal spirits is a concept formed by John Maynard Keynes detailing the optimistic views of investors and their decisions being based on instincts and predispositions. These decisions aren’t based on quantitative evidence of future profits, but rather on feelings that are not factual (Black et al 2009).

Animal spirits can be broken down into five different aspects that affect investment and economic decisions. These include confidence, fairness, corruption, money

Figure 1: The Aggregate Expenditure Model

The aggregate expenditure model, Figure 1, focuses on the short-run relationship between total spending and real gross domestic product (GDP), assuming that the price level is constant. Aggregate expenditure is the sum of expenditures on consumption, investment, government purchases and net exports.

The equilibrium level of GDP, E, exists where the total output measured by GDP, Y0, and the aggregate expenditure, AE0, are equal.

In Figure 1, an increase in aggregate expenditures is illustrated by the upshift shift of the aggregate expenditure line, AE0 to AE1. The firms taking advantage of the low interest rates that the RBA is offering and the optimistic view of future profits can cause this shift. The increase in the aggregate expenditure line, will also shift the equilibrium level of GDP from point E to point A and increase output from Y0 to