End of Chapter 10 ECON 151 – PRINCIPLES OF MACROECONOMICS Chapter 12: Consumption, Real GDP, and the Multiplier Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved. 1

Some Simplifying Assumptions in a Keynesian Model To simplify the income determination model Businesses pay no indirect taxes (sales tax) Businesses distribute all profits to shareholders There is no depreciation The economy is closed; no foreign trade

Some Simplifying Assumptions in a Keynesian Model (cont'd) Real 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.

Some Simplifying Assumptions in a Keynesian Model (cont'd) Saving The act of not consuming all of one’s current income Whatever is not consumed 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. Dissaving Negative saving; a situation in which spending exceeds income

Some Simplifying Assumptions in a Keynesian Model (cont'd) Consumption plus saving equals disposable income. Saving equals disposable income minus consumption.

Some Simplifying Assumptions in a Keynesian Model (cont'd) Consumption Goods Goods bought by households to use up, such as food and movies Capital Goods Producer durables; nonconsumable goods that firms use to make other goods

Some Simplifying Assumptions in a Keynesian Model (cont'd) 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.

Spending on Human Capital: Investment or Consumption? Economists define human capital as the accumulation of investments and training in education. From this perspective, educational expenses should be regarded as a form of investment spending. Nevertheless, in official U.S. government statistics, household spending on education is classified as consumption.

Determinants of Planned Consumption and Planned Saving 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, the less they wanted to consume. Keynes argued that real saving and consumption decisions depend primarily on a household’s real disposable income.

Determinants of Planned Consumption and Planned Saving (cont'd) Keynes was concerned with changes in AD as reflected in planned expenditures. His initial focus was on Consumption. AD = C + I + G + X

Determinants of Planned Consumption and Planned Saving (cont'd) Consumption Function 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.

Determinants of Planned Consumption and Planned Saving (cont'd) 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.

Table 12-1 Real Consumption and Saving Schedules: A Hypothetical Case

Determinants of Planned Consumption and Planned Saving (cont'd) 45-Degree Reference Line The line along which planned real expenditures equal real GDP per year On the following graph, DPI is labeled as YD. However, under the Keynesian simplifying assumptions, when all components of AD are reflected, the label becomes Y for real GDP.

Determinants of Planned Consumption and Planned Saving (cont'd) Autonomous Consumption The part of consumption that is independent of the level of disposable income Changes in autonomous consumption shift the consumption function.

Figure 12-1 The Consumption and Saving Functions

Figure 12-1 The Consumption and Saving Functions (cont'd)

Figure 12-1 The Consumption and Saving Functions (cont'd)

Determinants of Planned Consumption and Planned Saving (cont'd) Average Propensity to Consume (APC) Real consumption divided by real disposable income The proportion of total disposable income that is consumed APC = Real consumption Real disposable income

Determinants of Planned Consumption and Planned Saving (cont'd) Average Propensity to Save (APS) Real saving divided by real disposable income (DI) Saved proportion of real DI APS = Real saving Real disposable income

Determinants of Planned Consumption and Planned Saving (cont'd) Marginal Propensity to Consume (MPC) The ratio of the change in real consumption to the change in real disposable income MPC = Change in real consumption Change in real disposable income

Determinants of Planned Consumption and Planned Saving (cont'd) Marginal Propensity to Save (MPS) The ratio of the change in saving to the change in disposable income MPS = Change in real saving Change in real disposable income

Determinants of Planned Consumption and Planned Saving (cont'd) Some relationships Average propensity to consume and average propensity to save must sum to 100% of total income. (APC + APS = 1) Marginal propensity to consume and marginal propensity to save must sum to 100% of the change in income. (MPC + MPS = 1)

Determinants of Planned Consumption and Planned Saving (cont'd) Causes of shifts in the consumption function A change besides real disposable income will cause the consumption function to shift. Non-income determinants of consumption Population Wealth

Determinants of Planned Consumption and Planned Saving (cont'd) Wealth The stock of assets owned by a person, household, firm or nation For a household, wealth can consist of a house, cars, personal belongings, stocks, bonds, bank accounts, and cash.

Determinants of Investment Investment, you will remember, consists of expenditures on new buildings and equipment. Gross private domestic investment has been volatile. Consider the planned investment function, and shifts in the function.

Figure 12-2 Planned Real Investment, Panel (a)

Figure 12-2 Planned Real Investment, Panel (b)

Determining Equilibrium Real GDP (cont'd) Adding the investment function AD = C + I + G + X

Figure 12-4 Combining Consumption and Investment

Determining Equilibrium Real GDP (cont'd) Saving and investment: planned versus actual Only at equilibrium real GDP will planned saving equal actual saving. Planned investment equals actual investment. Hence planned saving is equal to planned investment.

Figure 12-5 Planned and Actual Rates of Saving and Investment

Determining Equilibrium Real GDP (cont'd) Unplanned increases in business inventories Consumers purchase fewer goods and services than anticipated This leaves firms with unsold products Unplanned decreases in business inventories Business will increase production of goods and services and increase employment

Keynesian Equilibrium with Government and the Foreign Sector Added To this point we have ignored the role of government in our model. We also left out the foreign sector of the economy in our model. Let’s think about what happens when we add these elements.

Keynesian Equilibrium with Government and the Foreign Sector Added (cont'd) Government (G): C + I + G Federal, state, and local Does not include transfer payments Is autonomous Lump-sum taxes = G Lump-Sum Tax A tax that does not depend on income or the circumstances of the taxpayer

The Foreign Sector: C + I + G + X Keynesian Equilibrium with Government and the Foreign Sector Added (cont'd) The Foreign Sector: C + I + G + X Net exports (X) equals exports minus imports Depends on international economic conditions Autonomous—independent of real national income

Table 12-2 The Determination of Equilibrium Real GDP with Government and Net Exports Added

Determining the equilibrium level of GDP per year Keynesian Equilibrium with Government and the Foreign Sector Added (cont'd) Determining the equilibrium level of GDP per year We are now in a position to determine the equilibrium level of real GDP per year. Remember that equilibrium always occurs when total planned real expenditures equal real GDP.

Figure 12-6 The Equilibrium Level of Real GDP Recall that planned AD = C + I + G + X Although not identified as such by Keynes, the 45-degree reference line can be thought of as actual expenditures or AS. Equilibrium will occur where AD = AS.

The Equilibrium Level of Real GDP Observations If C + I + G + X = Y Equilibrium GDP If C + I + G + X > Y Unplanned drop in inventories Businesses increase output Y returns to equilibrium If C + I + G + X < Y Unplanned rise in inventories Businesses cut output

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

Table 12-3 The Multiplier Process

The Multiplier (cont'd) The multiplier formula Multiplier = 1 1 - MPC = MPS

The Multiplier (cont'd) By taking a few numerical examples, you can demonstrate to yourself an important property of the multiplier. The smaller the MPS, the larger the multiplier. The larger the MPC, the larger the multiplier.

The Multiplier (cont'd) Measuring the change in equilibrium income from a change in autonomous spending Change in equilibrium real GDP = Multiplier x Change in autonomous spending

The Multiplier (cont'd) Significance of the multiplier It is possible that a relatively small change in consumption or investment can trigger a much larger change in real GDP.

How a Change in Real Autonomous Spending Affects Real GDP When the Price Level Can Change So far our examination of how changes in real autonomous spending affects equilibrium real GDP has considered a situation in which the price level remains unchanged. Our equilibrium analysis has only considered how AD shifts in response to autonomous consumption, investment, government spending, net exports.

How a Change in Real Autonomous Spending Affects Real GDP When the Price Level Can Change (cont'd) When we take into account the aggregate supply curve, we must also consider responses of the equilibrium price level to a multiplier-induced change in AD.

Figure 12-7 Effect of a Rise in Autonomous Spending on Equilibrium Real GDP

The Relationship Between Aggregate Demand and the C + I + G + X Curve There is clearly a relationship; aggregate demand consists of consumption, investment, government, and the foreign sector.

There is a major difference The Relationship Between Aggregate Demand and the C + I + G + X Curve (cont'd) There is a major difference C + I + G + X curve drawn with price level constant AD curve drawn with the price level changing

The Relationship Between Aggregate Demand and the C + I + G + X Curve (cont'd) To derive the aggregate demand curve from the C + I + G + X curve, we must now allow the price level to change. Since we know that at higher prices, real spending is diminished, we can show two C + I + G + X curves at different price levels. We can then plot the equilibrium outcomes of each as AD at the two price levels as reflected on the AS-AD model graph.

Figure 12-8 The Relationship Between AD and the C + I + G + X Curve

End of Chapter 10 ECON 151 – PRINCIPLES OF MACROECONOMICS Chapter 12: Consumption, Real GDP, and the Multiplier Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved. 54 54