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Consumption, Real GDP and Multiplier
Chapter 12
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ConsumptionReal Disposable Income Real GDP minus net taxes, or after-tax real income
Consumption Spending on new goods and services out of a household’s current income
Whatever is not consumed is saved Consumption includes such things as buying food and going to a concert
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Saving
The act of not consuming all of one’s current income
Whatever is not consumed out of spendable income is, by definition, saved
Saving is an action measured over time (a flow)
Savings are a stock, an accumulation resulting from the act of saving in the past
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Consumption Goods Goods bought by households to use up, such as food and movies
Consumption plus saving equals disposable income
Saving equals disposable income minus consumption
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Investment Spending by businesses on things such as machines and buildings, which can be used to produce goods and services in the future
The investment part of real GDP is the portion that will be used in the process of producing goods in the future
Producer durables; nonconsumable goods that firms use to make other goods
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Classical Model In the classical model, the supply of saving was determined by the rate of interest
The higher the rate, the more people wanted to save, and the less they wanted to consume
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Keynesian View Keynes argued that: The interest rate is not the most important determinant of individual’s real saving and consumption decisions
Real saving and consumption decisions depend primarily on a household’s real disposable income
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Keynesian Consumption function Keynes was concerned with changes in AD (AD= C +I+G+NX)
The relationship between amount consumed and disposable income
A consumption function tells us how much people plan to consume at various levels of disposable income
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Autonomous Consumption The part of consumption that is independent of the level of disposable income
Changes in autonomous consumption shift the consumption function
45-Degree Reference Line - The line along which planned real expenditures equal real GDP per year
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Dissaving
Negative saving; a situation in which spending exceeds income
Dissaving can occur when a household is able to borrow or use up existing assets
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Average Propensity to Consume Average Propensity to Consume (APC) Real consumption divided by real disposable income
The proportion of total disposable income that is consumed
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Average Propensity to Save Average Propensity to Save (APS)
Real saving divided by real disposable income(DI)
Saved proportion of real DI
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Example of APC
Income increases by $6,000 to $60,000
C = $54,000 S = $6,000
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Marginal Propensity to Consume
Marginal Propensity to Consume (MPC) The ratio of the change in real consumption to the change in real disposable income
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Marginal Propensity to Save Marginal Propensity to Save (MPS) The ratio of the change in saving to the change in disposable income
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The Multiplier Multiplier -The ratio of the change in the equilibrium level of real national income to the change in autonomous expenditures
The number by which a change in autonomous real investment or autonomous real consumption is multiplied to get the change in equilibrium real GDP
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Multiplier Formula
It is possible that a relatively small change in consumption or investment can trigger a much larger change in real GDP
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Multiplier example MPC = .9 and MPS =.1 1/1-.9=1/.1= 10 If 50 billion dollars is invested then it will
become 500 billion dollars in real GDP growth due to the Multiplier
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Your turn to use multiplier MPC =.8 MPS=.2 50 billion is invested 1/1-.8 = 1/.2 = 5 5x50= 250 billion Now make a multiplier problem for a
friend.
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Investment Investment is new expenditures on
buildings and equipments. It also includes changes in inventories,
or items produced but not sold by businesses
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Investment Decisions Businesses have an array of investment
choices with varying rates of return (profit) Keynes believed that when interest rates
increase in the credit market planned investment decreased
Conversely, when interest rates decrease then planned investment increases
Therefore, there is a downward sloping investment curve
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Investment shifts Investments may also shift due to: 1. Future expectations of future sales by
business people 2. Changes in productive technology 3. Increases or decreases in taxes
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Adding investment Investment, or what is called autonomous
investment, is added to the Keynesian Income Model
It is parallel and above the consumption function line
It is labeled C + I The addition of Investment to Consumption
raises the level of RGDP or National Income at the equilibrium point of the 45 degree angle
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The increases in Inventories
If consumers purchase fewer goods and services than anticipated this leaves firms with unsold products and inventories will rise
Businesses respond by cutting back production, to reduce unplanned business inventories, thus reducing RGDP
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Decreases in Inventories If there are unplanned decreases in business inventories then business will increase production of goods and services and increase employment
Ultimately there will be an increase in real GDP
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Government Spending Government spending, like investment
is considered autonomous (not determined by levels of disposable income)
G in the model includes federal, state and local government spending.
However, transfer payments, like social security are not included in G.
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Government spending It is estimated that government expenditures
account for about 20% of GDP The Keynesian model assumes a lump sum
tax, which means that real GDP will be reduced by the amount of the lump sum tax. (This tax decreases C and I)
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Foreign Sector The Foreign sector is determined by net
exports (exports - imports). Trade surpluses will increase the real GDP,
and trade deficits will decrease the RGDP The Foreign sector is also autonomous. Together C+I+G+NX are often given the
notation AE (All Expenditures) on the macro model.
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Relationship between models The C+I+G+NX curve you studied in
Chapters 10 and 11 is directly related to the AE curve in the Keynesian income model
The major difference is that the Keynesian income model does not include price level changes of the first Macro model we learned.
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Keynesian Assumptions
1. Businesses pay no indirect taxes (sales tax)
2. Businesses distribute all profits to shareholders
3. There is no depreciation4. The economy is closed; no foreign trade