Module 16- Consumption, Income, and the Multiplier J.A.SACCO

2 Introduction You have two choices when you earn income-- you can either consume it or save it. What you do not consume is, by definition, what you save. Saving is important because investment is impossible without it. In the United States, the rate of personal saving has dropped significantly over the past several decades.

3 Did You Know That... Personal consumption expenditures in the United States have averaged about two- thirds of gross domestic product for decades? John Maynard Keynes focused much of his research on what determines how much you and I decide to spend

4 Module 16 GOALS Focus on what determines spending and saving Concentrate on the relationship between a persons income and how much they spend (consume) and save Analyze the relationship of consumption, investment, government expenditure, and net exports (GDP) In other words, what causes the changes in GDP? C+I+G+(X-M)

5 Module 16 GOALS Why is this important to our study of economics? ?

6 Some Simplifying Assumptions in the Keynesian Income Determination Model Keynes Revisited Equilibrium level of GDP is demand determined Concentrated on elements of desired aggregate expenditures Horizontal SRAS- Keynesian Range so inflation is not possible/no change in price level Since PL is constant, any change in economic variables such as income, will be equal to a real change in terms in purchasing power Hence-Examine Keynes ideas with inflexible prices

7 Definitions and Relationships Definitions & Relationships Revisited Consumption Spending on new goods and services out of a household’s current income Saving The act of not consuming all of one’s income

8 Definitions and Relationships Consume It! Gone forever Consumption goods (household purchases for immediate satisfaction—food, clothing, movies, etc…) Save It! Able to consume at a future time and perhaps more with interest Two things you can do with income:

9 Definitions and Relationships Consumption + Saving= Disposable Income OR Saving= Disposable Income-Consumption

10 Definitions and Relationships Dissaving- Negative saving. A situation where spending exceeds income. Investment-The spending by business on things which can be used to produce goods and services in the future. Stocks/Flows-A stock is a variable measured at a point in time. A flow is a variable measured over a period of time.

11 Stocks and Flows Which is a stock? Which is a flow? Saving Savings Consumption Investment

12 Stocks and Flows  Saving- (FLOW)- particular rate-daily monthly, yearly  Savings- (STOCK)- certain point in time saving+saving+saving=savings  Consumption-(Flow)- related to saving, consume at a certain rate  Investment-(Flow)- expenditures by firms on new machinery/equipment-yield future stream of income- “fixed investment”

13 Classical Economic View of Consumption and Saving  Saving is based on the interest rate! Interest rate increases Saving increase Consumption decrease Interest rate decreases Saving decreasesConsumption increases

14 Determinants of Planned Consumption and Planned Saving Keynes Says NO!!! Interest rate not the key to what determines an individuals consumption and saving decisions. Keynes argued that saving and consumption decisions depend primarily on an individual’s real current income.

15 Determinants of Planned Consumption and Planned Saving Keynes was concerned with changes in AD. If we can determine the reasons and tendencies of consumption and saving, it might be possible to determine the future macroeconomy.

16 Real Consumption and Saving Schedules: A Hypothetical Case (1)(2)(3)(4)(5)(6)(7) PlannedAverageAverage RealPlannedReal SavingPropensityPropensityMarginal Marginal DisposalReal Con-Per Yearto Consumeto SavePropensityPropensity Income persumption(S=Y d -C)(APC=C/Y d )(APS=S/Y d )to Consumeto Save CombinationYear (Y d )per year (C)(1) - (2)(2)/(1)(3)/(1) A $0 B2,000 C4,000 D6,000 E8,000 F 10,000 G12,000 H14,000 I16,000 J18,000 K20,000 $2,000 3,600 5,200 6,800 8,400 10,000 11,600 13,200 14,800 16,400 18,000 $-2,000 -1,600 -1, ,200 1,600 2,

17 The Consumption and Saving Functions Real Disposable Income (Y d dollars per year) Planned Real Consumption (C, dollars per year) 0 2,000 4,000 8,000 12,000 16,000 20,000 4,0008,00012,00016,00020,000 Consumption function A B C D E FG H I J K C=Y d 45 0 Saving Autonomous consumption Break-even income Dissaving

18 Determinants of Planned Consumption and Planned Saving Causes of Shifts in the Consumption Function. Non-income determinants of consumption. Population- Increase consumption function upward. Expectations- Better times upward/worse times downward. Wealth- Increase real household wealth upward/decrease downward. Can you think of other non-income determinants of consumption?

19 Determinants of Planned Consumption and Planned Saving Household Debt- Can increase consumption with borrowing or more debt. However as accumulate more debt, need to use more disposable income to pat off debt thus decreasing consumption. Inflation- Inflation down/upward, inflation up/downward. Taxes/Transfer Payments- more taxes C and S down/ less taxes C and S up. More transfer payments both C and S up, less C and S down.

20 C2C2 The Consumption and Saving Functions Real Disposable Income (Y d dollars per year) Planned Real Consumption (C, dollars per year) 45 o C1C1 Assume positive economic expectations C1C1 Y1Y1 Y2Y2 C2C2

21 C2C2 C2C2 Y2Y2 C1C1 The Consumption and Saving Functions Real Disposable Income (Y d dollars per year) Planned Real Consumption (C, dollars per year) 45 o C1C1 Y1Y1 Assume wealth decreases Y2Y2

22 The Consumption and Saving Functions Therefore an upward shift in consumption tells us that at all levels of disposable income, consumption is greater. If consumption is greater at all levels of disposable income, saving must be lower., and vice-versa. The only exception is taxes and transfer payments.