Income and Expenditure Saving and Consuming

The Multiplier Households have two choices that they can make with their disposable income. Spend it Save it Depending on the choices consumers make, each $1 spent in the economy multiplies to a final value of much more than $1 of added economic activity.

Marginal Propensity to Consume (MPC) The United States is a consumer-driven economy (> 2/3 of all economic activity). Disposable income (income after taxes) is Y d which a person then chooses to consume or save. Y d = C + S MPC (marginal propensity to consume) is the proportion of an extra $1 of Y d that a person choose to consume. MPS (marginal propensity to save) is the proportion of an extra $1 of Y d that a person choose to save. MPC + MPS = 1 Let’s look at an example…

A Household’s Disposable Income (Y d ) YdYd Consumption (C)Savings (S)MPC (C/Δ Y d )MPS (S/Δ Y d ) As Y d increases by $10: C increases by 8 S increases by 2. We can use this information to create this household’s consumption function. C = a + MPC(Y d ) C = 5 +.8(Y d ) What if everyone in the economy acted like this household?

The Multiplier at Work: A Micro Example Keith is a chicken farmer. Keith decides to spend $1000 on some chicken coops at Suhaib’s farm supply shop. This money now starts to be circulated around the economy. 1.Suhaib now has $1000 from the sale and spends 80% ($800) on clothes at Khea’s boutique. 2.Khea now has $800 from the sale and spends 80% ($640) to fix her car at Clara’s garage. 3.Clara now has $640 from the sale and spends 80% ($512) at Joanna’s grocery store. 4.Joanna now has $512 from the sale and spends 80% ($409.60) with Lexus’s catering. After only 5 rounds of spending, the original $1000 spent has created over DOUBLE that amount ($ ) in economic activity. If we had continued until someone was trying to spend 80% of nothing, Keith’s original $1000 purchase would have produced $5000 in spending. M = 1/(1-MPC) = 1/(1 -.8) = 1/.2 = 5 Since MPC + MPS = 1, we can also say M = 1/MPS

Multiplier in the Macroeconomy The multiplier is the ratio of the total change in real GDP caused by an autonomous change in the aggregate spending to the size of that autonomous change. Δ AAS is the autonomous change in aggregate spending Δ Y is the total change in real GDP Multiplier (M) = Δ Y/ Δ AAS Simplified mathematically: M = 1/1 - MPC

Changes in the Consumption Function C = a + MPC(Y d ) What might change C, given that a and Y d remained constant? That is, what might change MPC? 1.Changes in expected future disposable income a.College seniors? 2.Changes in Aggregate Wealth a.Think about how “wealth” is different than “income” b.Stock prices c.Home prices

Investment Spending and the Multiplier Investment usually requires businesses to borrow the capital to invest What makes borrowing more/less expensive? Interest rates have a negative relationship with investment spending Changes in Investment Spending (at any given interest rate): 1.Expected Future rGDP a.What if a company expected the economy to really take off next year? 2.Production capacity a.What is your firm’s current production capacity and current sales? b.What conditions would most likely predict investment spending? Firms that are near production capacity, with expectations of growth of rGDP in the future.

Δ Disposable Income The Multiplier MPC = Δ Consumer Spending Question: If you got a dollar, what could you choose to do with it? Question: How much would you spend and how much would you save? MPS = 1 – MPC (whatever you don’t consume, you save) (1 – MPC) Multiplier = 1 Savings cuts down on the amount of money that can get injected back into the economy