Module Income and Expenditure 16 KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: The nature of the multiplier, which shows how initial changes in spending lead to further changes The meaning of the aggregate consumption function, which shows how current disposable income affects consumer spending How expected future income and aggregate wealth affect consumer spending The determinants of investment spending Why investment spending is considered a leading indicator of the future state of the economy

MPC & MPS AND DISPOSABLE INCOME You use your income in two ways – buying goods & services OR saving for the future. The MPC (marginal propensity to consume) and MPS (marginal propensity to save) tell us what percentage of your income you are spending and what percentage of your income you are saving.

Marginal Propensity to Consume (MPC) The fraction of any change in disposable income (income left over after taxes) that is consumed. MPC= Change in Consumption Change in Disposable Income MPC = ΔC/ΔDI

Marginal Propensity to Save (MPS) The fraction of any change in disposable income that is saved. MPS= Change in Savings Change in Disposable Income MPS = ΔS/ΔDI

Marginal Propensities Remember, people do two things with their disposable income, consume it or save it! MPC + MPS = 1 Therefore MPC = 1 – MPS Therefore MPS = 1 – MPC

Marginal Propensities Calculate the following: Mary just got a raise of $100 a week. She put $25 in her savings account and spent $75. What is her MPC and MPS? Joe’s taxes dropped by $50 a week. He uses the extra money to pay his sister $45 a week to clean his apartment. The rest he saves. What is his MPC and MPS?

The Spending Multiplier Effect An increase in spending will result in an even larger increase in GDP due to the fact that every dollar spent is spent again multiple times. Any money spent is someone else’s income and therefore subject to spending. Because we both spend and save our income the MPC & MPS are important.

The First Round of Government Spending Causes The Biggest Splash MPC of 75% G spends $200 billion on the highways. Highway workers save 25% of $200 billion [$50 billion] & spend 75% or $150 billion on boats. Boat makers save 25% of $150 bil. [$37.50 bil.] & spend 75% or $112.50 bil. on iPod Minis, etc. Total Spending has already reached $462.5 b

Spending Multipliers The limiting factor is savings. For every additional dollar spent a portion of it will be saved (the MPS). The spending multiplier is the reciprocal of the MPS Multiplier = 1/MPS or 1/(1-MPC). The larger the MPC (the smaller the MPS) the larger the multiplier will be.

ME (spending multiplier) ME = 1/MPS MPC ME (spending multiplier) 90% .9 10 .8 5 .75 4 The larger the MPC, the smaller the MPS, and the greater the multiplier. This is because we are spending more of our income and saving less. .60 2.5 .5 2 This is the “simple multiplier” because it is based on a “simple model of the economy”.

Using the Multiplier The multiplier can be used to calculate how any change in spending will affect total income (GDP). The formula used is: Change in GDP = Multiplier x Change in Autonomous Aggregate Spending ∆Y (GDP) = 1 ____ __ (1 - MPC) X ∆ AAS

Spending Multiplier Since any change in GDP is the result of the change in spending x multiplier, you can find the multiplier by dividing the change in GDP by the change in autonomous aggregate spending. Multiplier = ∆ GDP/ ∆ AAS Knowing that any change in spending will have a multiplied effect government can calculate how much to change autonomous aggregate spending by dividing the needed change in GDP by the multiplier. ∆ AAS = ∆ GDP/ multiplier

Current Disposable Income and Consumption The data clearly show a positive relationship between current disposable income and consumer spending. The Aggregate Consumption Function describes this relationship for the economy as a whole C = A + MPC x Yd C – Consumption (total amount spent) A - Autonomous spending (amount spent regardless of income) MPC – Marginal Propensity to Consume (% of any change in income that is spent – the slope of the line) Yd – Disposable income (income after taxes)

If disposable income (Yd) increases then Consumption (C) increases (we move up along the Consumption Function) If disposable income (Yd) decreases then Consumption (C) decreases (we move down along the Consumption Function)

Shifts of the Aggregate Consumption Function Changes in Expected Future Disposable Income If you expect a higher income in the future, you will spend more now but if you expect a lower income in the future you will save more now. Changes in Aggregate Wealth Wealth is the accumulation of savings The greater your present wealth the less you have to save and vice versa Note: remind your students of the demand and supply “shifters” from earlier in the course. These are similar by increasing or decreasing consumption at all levels of current disposable income.   1. Changes in Expected Future Disposable Income Suppose a college senior was about to graduate and already had a job lined up. In other words, she knows that her current disposable income was going to rise. This expectation of more income in the future shifts the consumption function upward Wealth is accumulated assets, and this is very different from disposable income. If you own a house, a car, shares of stock or even a savings account, you have wealth. Suppose that the stock market has a bad year and the value of your wealth substantially declines. This lost wealth, even if it is only on paper, usually causes people to reduce their consumption. The consumption function shifts downward

If Consumers expect their future incomes to be higher they will buy more today, shifting the curve upward If Consumers’ wealth decreases today they will save more and spend less today, shifting the curve downward Figure 16.4 Shifts of the Aggregate Consumption Function Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Decide if the following will a) increase or decrease Consumption (C), and b) indicate if the change was the result of movement along the curve or a shift in the curve A large segment of the population (baby boomers) nears retirement age. Gradual shrinkage in the value of real assets owned by consumers. Real GDP (output) increases, increasing disposable income. The Federal government decreases income taxes. The savings rate for households increases. An increase in the unemployment rate. A steady rise in the stock markets.

Investment Spending Investment spending fluctuates greatly over a business cycle Economists distinguish between planned and actual investment Planned investment (purchase of capital) depends on three factors The interest rate The expected future level of GDP The current level of production capacity Although consumer spending is much larger than investment spending, booms and busts in investment spending tend to drive the business cycle. In fact, most recessions originate as a fall in investment spending.

The Interest Rate and Investment Spending A business’s decision to spend or borrow money is determined by the current interest rate versus their projected rate of return When a firm considers investment spending, they are really doing a little benefit-cost analysis on the dollars they are about to spend.   Example: A firm is considering building a new factory. This will increase sales, but it will also require borrowing to fund the investment. Expected return on the investment = expected economic profit from the factory = (total revenue minus total cost)/investment cost. The market interest rate is the cost of investment. 1. Interest rate is cost of borrowed funds. 2. Interest rate is also cost of investing your own funds (no borrowing), since it is income forgone. The factory will only go ahead if the firm expects a rate of return higher than the cost of the funds they would have to borrow to finance that project. If the interest rate rises, fewer projects will pass that test, and as a result investment spending will be lower. Thus there is a negative relationship between the interest rate and dollars of investment spending. r r’ I I’

Expected Future Real GDP, Production Capacity, and Investment Spending eve Expected Future Real GDP, Production Capacity, and Investment Spending An increase in expected future real GDP or the need for more productive capacity will result in more investment at the same interest rate There are some factors that would increase investment spending at any interest rate.   Expected Future Real GDP Suppose a firm believed that the economy was really going to take off next year. This firm might increase investment spending in anticipation of increased sales. After all, you can’t build a factory overnight; the firm must begin the factory now to take advantage of more customers in the coming year. Production Capacity Suppose a firm can produce 100,000 units if the factory is producing 24/7. The firm’s full capacity is 100,000 units. Right now, the firm has enough customers to produce only 50%, or 50,000 units, of full capacity. A firm in this situation would not likely be looking to increase investment. After all, if orders from customers were to increase, it would be easy to satisfy those orders without increasing the size of the factory. The best conditions for new investment spending consists of firms that are near production capacity with expectations of strong real GDP in the future. r I I’

Planned vs Actual Investment Firms investment spending takes two forms: spending on capital and changes in inventory When a firm’s inventories are higher than intended due to an unforeseen decrease in sales, the result is unplanned investment If sales are greater than expected the result is a negative inventory investment In any given period actual investment is equal to planned investment spending plus unplanned inventory investment Note: remind your students of the demand and supply “shifters” from earlier in the course. These are similar by increasing or decreasing consumption at all levels of current disposable income.   1. Changes in Expected Future Disposable Income Suppose a college senior was about to graduate and already had a job lined up. In other words, she knows that her current disposable income was going to rise. This expectation of more income in the future shifts the consumption function upward Wealth is accumulated assets, and this is very different from disposable income. If you own a house, a car, shares of stock or even a savings account, you have wealth. Suppose that the stock market has a bad year and the value of your wealth substantially declines. This lost wealth, even if it is only on paper, usually causes people to reduce their consumption. The consumption function shifts downward

Directions: Decide if the following is an a) increase or a decrease in Investment, b) if this was the result of a movement along the curve or a shift of the curve and c) if it was planned Investment or unplanned Investment An unexpected increase in consumer spending An increase in interest rates cause a rise in the cost of business borrowing Economic booms in Japan and Europe increase demand for US exports A steady rise in the growth rate of GDP An unanticipated fall in sales