Consumption, Investment and the Multiplier: Chapter 9

What is GDP? Gross Domestic Product (GDP)-Gross Domestic Product (GDP)- is the nation’s expenditure on all the final goods and services produced during the year at market price.

How is GDP calculated? You learned one way to calculate GDP is by adding all of Nation’s expenditures. Another method used is the income approach (not discussed here).

Nation’s Expenditures Consumption Investment Government Spending Net Exports C= GDPI +G + XnXnXnXn + This lecture will concentrate on Consumption

Consumption Consumption is the nation’s expenditures on all final goods and services produced during the year at market prices –Consumption was almost $2 trillion dollars in 2002

Consumption Americans spend over 95% of their income after taxes The total of everyone’s expenditures is called consumption Consumption is designated by the letter C

C is the largest sector of GDP CC is just over two-thirds of GDP

Consumption (Continued) The consumption functions states –As income rises, consumption (C) rises, but not as quickly Income = Consuption + Saving + taxes Y = C + S + t and, Disposible Income = Consuption + Saving Yd = C + S or, Yd = Y - t Therefore, consumption varies with disposable income (DI)

Consumption and Disposable Income As Income rises so does Consumption NOT AS QUICKLY! NOT AS QUICKLY! BUT DIC DI increases... C increases but by a smaller amount DIC DI decreases... C decreases but by a smaller amount

Two Ways To View Consumption- Income Relationship 1.As the ratio of total consumption to total disposable income. (APC) 2.As the relationship of changes in consumption to changes in disposable income. (MPC)

The Marginal Propensity to Consume The marginal propensity to consume (MPC) is the fraction of each additional (marginal) dollar of disposable income spent on consumption.

Marginal Propensity to Consume (MPC) MPC = in Consumption in Income CHANGE CHANGE

Marginal Propensity to Consume (MPC) Table 4 Year DI C S 1998 $30000 $23000 $ $40000 $31000 $9000

Marginal Propensity to Consume (MPC) Table 4 (continued) Year DI C S 1998 $30000 $23000 $ $40000 $31000 $ Change

Table 4 (Continued) Year DI C S 1998 $30000 $23000 $ $40000 $31000 $ Change MPC = = = =.8 Change in C Change in DI

Table 4 (Continued) Year DI C S 1998 $30000 $23000 $ $40000 $31000 $ Change MPC = = = =.8 Change in C Change in DI MPS = = = =.2 Change in S Change in DI

The MPC and MPS MPS = 0.20MPC = 0.80

45 $1000 $6000 ?

Graphing the Consumption Function If Consumption rose at the same rate as Disposable Income... A graph of this function would be a 45 line Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Expenditure ($) Disposable Income ($)

C $ $6000 Saving = $300 $2700 $3000 Dissaving = $300 $2700 Saving = - $300

C Dissaving Saving

Graphing the Consumption Function Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line. DI C S Expenditure ($) Disposable Income ($)

Graphing the Consumption Function DI C S Saving is the vertical distance between the “C” line and the 45 degree line Expenditure ($) Disposable Income ($)

Graphing the Consumption Function DI C S Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.

Graphing the Consumption Function DI C S Saving is the vertical distance between the “C” line and the 45 degree line Expenditure ($)

Graphing the Consumption Function DI C S Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.

Graphing the Consumption Function DI C S Saving is “0” at 1000 DI because there is NO distance between the C line and the 45 degree line.

Graphing the Consumption Function DI C S Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.

Graphing the Consumption Function DI C S When DI is “0” the level of Consumption is called Autonomous Consumption (AC)

Graphing the Consumption Function DI C S Saving is the vertical distance between the “C” line and the 45 degree line. Saving is negative to the left of where the C line crosses the 45 degree line

Autonomous vs. Induced Autonomous means Self Governing

Autonomous Consumption versus Induced Consumption Autonomous consumption (AC) is the level of consumption when disposable income is “0” –It is called autonomous because it is independent of change in disposable income

Induced Consumption Induce consumption (IC) is that part of consumption which varies with the level of disposable income –As disposable income rises, induced income rises –As disposable income fall, induced income falls

C = Autonomous C + Induced C So Induced C = C – Autonomous C

C $0 This is your Autonomous Consumption

Graphing the Consumption Function DI C S DI = 0 What is IC? IC = C - AC IC = IC = 0

Graphing the Consumption Function DI C S DI = 1000 What is IC? IC = C - AC IC = IC = 375

Graphing the Consumption Function DI C S DI = 2000 What is IC? IC = C - AC IC = IC = 815

Graphing the Consumption Function DI C S DI = 3000 What is IC? IC = C - AC IC = IC = 1125

Determinants of Consumption 1.Disposable Income  The most important determinant of consumption 2.Credit Availability 3.Stock of Liquid Assets  in the hands of consumers 4.Stock of Durable Goods  in the hands of consumers 5.Keeping up with the Jones's 6.Consumer Expectations

Permanent Income Hypothesis (Milton Friedman) People gear their consumption to their expected lifetime average earnings more than to their current income –Apparently there are quite a few deviations from the behavior predicted by the permanent income hypothesis

The Determinants of Saving There is no single reason why people save Some spend virtually all of their disposable income Some spend more than they earn Americans now save less than 5% of disposable income Americans used to save 7-10% of disposable income

Investment

Investment “Investment” is the thing that really makes our economy go and grow! Investment is any NEW –Plant and equipment Investment is any NEW –Additional inventory Investment is any NEW –Residential housing

Inventory Investment Includes only net change Date Level of Inventory Jan. 1, 2003 $120 million July 1, million Dec. 31, million

Inventory Investment Includes only net change Date Level of Inventory Jan. 1, 2003 $120 million July 1, million Dec. 31, million Started the year with $120 million Ended the year with 130 million The net change is a (+) 10 million

Inventory Investment (Continued) Includes only net change Date Level of Inventory Jan. 1, 2003 $130 million July 1, million Dec. 31, million Started the year with $130 million Ended the year with 120 million The net change is a (-) 10 million

Investment in Plant and Equipment Investment in plant and equipment is more stable than inventory –Even in bad years companies will still invest a substantial amount in new plant and equipment This is mainly because old and obsolete factories, office buildings, and machinery must be replaced –This is the depreciation part of investment

Residential Construction Involves replacing old housing as well as adding to it Fluctuates considerably from year to year Has mortgage interest rates play a dominant role

Investment Investment is the most volatile sector in our economy GDP = C + + G + Xn Fluctuations in GDP are largely fluctuations in investment I

Investment (Continued) Recessions are touched off by declines in investment Recoveries are brought about by rising investment

How Do Savings Get Invested? Money saved is put into stocks and bonds Banks loan money based on their demand deposits and reserve requirements Businesses take this money and buy new plant and equipment, and add to their inventory Corporations also use “retained earnings” and “depreciation allowances”

Gross Investment vs Net Investment In the equation: GDP = C + I + G + Xn GDP = C + I + G + Xn “I”The “I” represent gross investment Gross investment - depreciation = net investment –Depreciation is taking into account for the fact that plant & equipment wear out and houses deteriorate

Gross Investment - Depreciation = Net Investment –Depreciation is taking into account for the fact that plant & equipment wear out and houses deteriorate. –start the year with 10 machines –bought 6 machines (gross investment) –worn out/obsolete - 4 machines (depreciation) –end the year with 12 machines –actual gain of 2 machines (net investment)

Calculate Gross Investment and Net Investment Date level of inventory Jan 1 $60 billion July 1 55 billion Dec billion Expenditures on new plant & equipment $120 billion $120 billion Expenditures on new residential housing $ 90 billion $ 90 billion Depreciation on plant & equipment and residential housing $30 billion 6-27

Solution Date level of inventory Jan1 $60 billion July 1 55 billion Dec billion inventory investment $ 10 Expenditures on new plant & equipment new P & E 120 $120 billion new RH 90 Expenditures on new residential housing gross investment 220 $ 90 billion - depreciation - 30 Depreciation on plant & equipment and net investment $ 190 Residential housing $30 billion

Building Capital Investment involves sacrifice (on someone’s part) To invest –We must work more –We must consume less (save)

Determinants of the Level of Investment Sales outlook Capacity utilization rate Interest rate Expected rate of profit (ERP)

The Sales Outlook You won’t invest if the sales outlook is bad –If sales are expected to be strong the next few months the business is probably willing to add inventory –If sales outlook is good for the next few years, firms will probably purchase new plant and equipment

Capacity Utilization Rate This is the percent of plant and equipment that is actually being used at any given time You won’t invest if you have a lot of unused capacity –During recessions, why build more when you are not using all of what you have Other factors –Manufacturing is a shrinking part of U.S. economy due to imports and increasing investment overseas by U.S. Companies

The Interest Rate You won’t invest if interest rates are too high Interest rate = The interest paid / The amount borrowed Assume you borrow $1000 for one 12 %, how much interest do you pay?.12 = X $1000 X = $120

The Interest Rate You won’t invest if interest rates are too high Interest rate = The interest paid / The amount borrowed X = $120 $1000 X =.12 = 12 % Assume you borrowed $1000 for one year and paid $120 interest. What was the interest rate?

You Won’t Invest If Interest Rates Are Too High In general, the lower the interest rate, the more business firms will borrow To know how much they will borrow and whether they will borrow, you need to compare the interest rate with the expected rate of profit Even if they are investing their own money they need to make this comparison

Why Do Firms Invest? Firm’s will only invest if the expected profit rate is “high enough” Firms invest when –Their sales outlook is good –Their capacity utilization rate is high –Their expected profit rate is high Even if firm’s invest their own money, the interest rate is still a consideration

45 $1000 $6000 ?

C C+I This Distance Equals GrossInvestment

Graphing the C + I Line To keep things simple so we can read the graph we’re going to assume the level of investment stays the same for all levels of income

Simplifying Assumption C C+I C line and the C+I line are parallel

Graphing the C + I Line How much is I when disposable income is 1000, 2000, and 3,000? The C line and the C+I line are parallel. Therefore I is about 480 at every level of disposable income. 480

Government Spending

Government Purchases versus Transfer Payments The government spends trillions of dollars a year –GDP = C + I + G + Xn GThe G in our formula refers to Government purchases It does NOT refer to transfer payments.

What is a transfer payment? Transfer payments is the government taking money from one group and giving it to another group in the economy.

Transfer Payments Include Social Security –Transferring between the generations Veteran Benefits –Transferring money to veterans Unemployment Benefits –Transferring from the employed to the Unemployed.

Government Purchases vs. Transfers –A–Approximately half is “transfer payments” The largest transfer payment is social security These payments eventually end up in the “C” part GDP (after they are spent) –A–Approximately half is “government purchases” The largest government purchase is defense These end up in the “G” part of GDP

Graphing in “G” C C+I C+I+G G

Graphing the C + I + G + Xn Line How much is G? Answer: 400

The Export-Import Sector

The Basis for International Trade The basis for international trade is that a nation can import a particular good or service at a lower cost than if it were produced domestically –In other words, if you can buy it cheaper than you can make it you should buy it –This maxim is true for individuals and nations

A Summing Up: C + I + G + Xn Net exports = X n X n = Exports - Imports

C C+I C+I+GC+I+G+(X-M) Due to Imports being greater than Exports

C + I + G + Xn Why is the C + I + G + X n line lower than the C + I + G line? Answer: It is lower because net exports (X n ) are negative

The World’s Top Ten Exporting Nations, 1999

The GAPS & The Multiplier

The Multiplier and Its Applications Any change in spending (C, I, or G) will set off a chain reaction, leading to a multiplied change in GDP GDP = C + I + G + Xn How much the multiplied change is depends on the MPC and MPS

Calculating the Multiplier Remember MPC + MPS = 1, therefore, MPS = 1 - MPC Multiplier = MPC Multiplier = MPS Because the multiplier (like C) deals with spending, 1/(1-MPC) is a more appropriate formula)

Calculating the Multiplier The MPC is.5. Find the multiplier

Calculating the Multiplier (Continued) The MPC is.5. Find the multiplier Multiplier = = = = MPC 1 1 –.5 1.5

Calculating the Multiplier Step-by-Step Working of the Multiplier When MPC is.5 $1, $ $ $ $ $ $ $ $ $ etc. $ etc. $2, It is surely much easier to use the multiplier of 2 (2 X $1,000 = $2000) than to go through this process and add up all the figures

Calculating the Multiplier (Continued) The MPC is.75. Find the multiplier

Calculating the Multiplier (Continued) The MPC is.75. Find the multiplier Multiplier = = = = MPC 1 –.75.25

Applications of the Multiplier The Multiplier is used to calculate the effect of changes in C, I, or G on GDP GDP = 2,500; Multiplier = 3; C rises by 10 What is the new level of GDP? GDP New = GDP Initial + (Change in spending X Multiplier) GDP New = ( 10 x 3) GDP New = ( 30) GDP New = 2530

Applications of the Multiplier The Multiplier is used to calculate the effect of changes in C, I, or G on GDP GDP = X; Multiplier = 3; C rises by 10 What happens to GDP? GDP New = GDP Initial + (Change in spending X Multiplier) GDP New = X + ( 10 x 3) GDP New = X + ( 30) GDP increases by 30

Applications of the Multiplier The Multiplier is used to calculate the effect of changes in C, I, or G on GDP GDP = X; Multiplier = 7; G falls by 5 What happens to GDP? GDP New = GDP Initial + (Change in spending X Multiplier) GDP New = X + ( -5 x 7) GDP New = X + ( -35) GDP decreases by 35

Applications of the Multiplier How big is the multiplier (M)? M = distance between the equilibrium GDP and the full- employment GDP / by the gap M = 2 / 2 = 1

Applications of the Multiplier How big is the multiplier (M)? M = distance between the equilibrium GDP and the full- employment GDP / by the gap M = 500 / 200 = 2.5

Graphing the C + I + G + Xn Line To keep the graph as simple as possible, we are assuming the government spends a constant amount of money regardless of the level of disposable income

The Relationship Between Total Planned Expenditures and the Aggregate Demand Price Level Real GDP Total Planned Consumption C, G, I, N, X Real GDP TPE 100p TPE 200p