1. Chapter 9 Consumption, Investment, and the Multiplier

2. Copyright © 2005 Pearson Education Canada Inc.9-2 Learning Objectives 9.1 Distinguish between saving and savings and explain how saving and consumption are related. 9.2 Explain the key determinants of consumption and saving in the Keynesian model. 9.3 Identify the primary determinants of planned investment.

3. Copyright © 2005 Pearson Education Canada Inc.9-3 Learning Objectives 9.4 Describe how equilibrium national income is established in the Keynesian model. 9.5 Evaluate why autonomous changes in total planned expenditures have a multiplier effect on equilibrium national income. 9.6 Understand the relationship between total planned expenditures and the aggregate demand curve.

4. Copyright © 2005 Pearson Education Canada Inc.9-4 Saving and Consumption Definitions & Relationships Disposable Income (Y d ) = Consumption (C) + Savings(S) National Income (Y) = Disposable Income (Y d ) – Taxes (T)

5. Copyright © 2005 Pearson Education Canada Inc.9-5 Determinants of Planned Consumption and Planned Saving Keynes argued that saving and consumption decisions depend primarily on an individual’s real current income. Consumption Function  The relationship between planned consumption expenditures and their current level of real income.

6. Copyright © 2005 Pearson Education Canada Inc.9-6 Determinants of Planned Consumption and Planned Saving (1)(2) (3) (4) (5) Planned RealPlanned Real Saving Marginal Marginal DisposalReal Con- Per Year Propensity Propensity Income persumption (S  Y d -C ) to Consume to Save CombinationYear (Y d ) per year (C) (1) - (2) (MPC   C/  Y d ) ( MPS  S/  Y d ) 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 -800 -400 0 400 800 1,200 1,600 2,000 ----.8 ----.2

7. Copyright © 2005 Pearson Education Canada Inc.9-7 Determinants of Planned Consumption and Planned Saving 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 A B C D E F G H I J K Consumption function Autonomous consumption Saving Dissaving C = Y d Break-even income 45  (equal vertical distance)

8. Copyright © 2005 Pearson Education Canada Inc.9-8 Dissaving Determinants of Planned Consumption and Planned Saving 0 2,000 -2,000 4,000 12,00016,000 20,000 8,000 Real Disposable Income (Y d dollars per year) Planned Real Saving (S, dollars per year) C B A D E F G H I J K Saving (equal vertical distance)

9. Copyright © 2005 Pearson Education Canada Inc.9-9 Determinants of Planned Consumption and Planned Saving Dissaving  Negative saving; spending exceeds income. Autonomous Consumption  The part of consumption that is independent of the level of disposable income.

10. Copyright © 2005 Pearson Education Canada Inc.9-10 Determinants of Planned Consumption and Planned Saving Marginal Propensity to Consume (MPC)  The ratio of the change in consumption to the change in disposable income.

11. Copyright © 2005 Pearson Education Canada Inc.9-11 Determinants of Planned Consumption and Planned Saving Marginal Propensity to Save (MPS)  The ratio of the change in saving to the change in disposable income.

12. Copyright © 2005 Pearson Education Canada Inc.9-12 Determinants of Planned Consumption and Planned Saving

13. Copyright © 2005 Pearson Education Canada Inc.9-13 Determinants of Planned Consumption and Planned Saving Causes of Shifts in the Consumption Function  Non-income determinants of consumption Population Expectations Wealth

14. Copyright © 2005 Pearson Education Canada Inc.9-14 C2C2 Determinants of Planned Consumption and Planned Saving 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

15. Copyright © 2005 Pearson Education Canada Inc.9-15 C2C2 C2C2 Y2Y2 C1C1 Determinants of Planned Consumption and Planned Saving Real Disposable Income (Y d dollars per year) Planned Real Consumption (C, dollars per year) 45 o C1C1 Y1Y1 Assume wealth decreases

16. Copyright © 2005 Pearson Education Canada Inc.9-16 Determinants of Investment Historically  Investment has been more volatile than consumption. Why?

17. Copyright © 2005 Pearson Education Canada Inc.9-17 Planned investment Rate of Interestper Year (percent per year)($ billions) 7.520 7.030 6.540 6.050 5.560 5.070 4.580 4.090 3.5100 3.0110 Determinants of Investment

18. Copyright © 2005 Pearson Education Canada Inc.9-18 Determinants of Investment 0102030405060708090100 Planned Investment per Year ($ billions) Rate of Interest (percent per year) 110 3.0 4.0 4.5 5.5 6.0 6.5 7.0 7.5 5.0 3.5 I

19. Copyright © 2005 Pearson Education Canada Inc.9-19 Determinants of Investment What Causes the Investment Function to Shift? 1) Expectations 2) Productive technology 3) Business taxes

20. Copyright © 2005 Pearson Education Canada Inc.9-20 Determinants of Investment Planned Investment per Year ($ billions) Rate of Interest (percent per year) I1I1 r1r1 I1I1 Positive profit outlook

21. Copyright © 2005 Pearson Education Canada Inc.9-21 Determinants of Investment Planned Investment per Year ($ billions) Rate of Interest (percent per year) I1I1 r1r1 I1I1 I2I2 Positive profit outlook I2I2

22. Copyright © 2005 Pearson Education Canada Inc.9-22 Determinants of Investment Planned Investment per Year ($ billions) Rate of Interest (percent per year) I1I1 r1r1 I1I1 Taxes Increase I2I2 I2I2

23. Copyright © 2005 Pearson Education Canada Inc.9-23 Autonomous consumption Equilibrium in the Keynesian Model Real National Income per Year ($ billions) Planned Consumption per Year ($ billions) 050100150200250 50 100 150 100 250 30 45 o reference line C = Y 45 o C C is a function of real national income. Assume MPC =.8

24. Copyright © 2005 Pearson Education Canada Inc.9-24 Equilibrium in the Keynesian Model Real Investment per Year ($ billions) Real National Income per Year ($ billions) 0 200400600 I 70 There is no relation between I and Y -- $70 billion at all Y levels I is autonomous

25. Copyright © 2005 Pearson Education Canada Inc.9-25 Equilibrium in the Keynesian Model Real National Income per Year ($ billions) Planned Consumption and Planned Investment per Year ($ billions) 0 100200300400600 100 300 500 30 45 o C + I = Y 400 200 600 500 C C + I 1) C + I = total planned expenditures 2) Equilibrium: C + I = Y 3) Equilibrium Y = $500 billion

26. Copyright © 2005 Pearson Education Canada Inc.9-26 Equilibrium in the Keynesian Model Total Planned Expenditures  When all expenditures in the economy are added together (C+I+G+(X-M)) it is called the Total Planned Expenditure function.  The slope of this function is called the Marginal Propensity to Spend (MPE).

27. Copyright © 2005 Pearson Education Canada Inc.9-27 Equilibrium in the Keynesian Model Marginal Propensity to Spend (MPE)  Represents the portion of money that is spent in the domestic economy out of every extra dollar of national income received.  The remaining portion is called leakages (savings, taxes and imports).

28. Copyright © 2005 Pearson Education Canada Inc.9-28 Increase Neither (equilibrium) Decrease Equilibrium in the Keynesian Model (1)(2)(3)(4)(5)(6)(7)(8)(9)(10)(11) Direction Netof Change RealRealExportsTotal PlannedUnplannedin Real NationalDisposablePlannedPlannedPlannedGovernment(exports-ExpendituresInventoryNational IncomeTaxesIncomeConsumptionSavingInvestmentSpendingimports)(4)+(6)+(7)+(8)ChangesIncome 200 250 300 400 500 600 650 700 800 100 150 200 300 400 500 550 600 700 110 150 190 270 350 430 470 510 590 -10 0 10 30 50 70 80 90 110 70 100 10 290 330 370 450 530 610 650 690 770 -90 -80 -70 -50 -30 -10 0 +10 +30

29. Copyright © 2005 Pearson Education Canada Inc.9-29 45  Equilibrium in the Keynesian Model Real National Income per Year ($ billions) Consumption, Investment, Government Purchases, and Net Exports ($ billions) 0 100200300400800 100 300 500 400 200 700 600 700500 E2E2 650 C E1E1 150 TPE = C + I + G + (X-M)

30. Copyright © 2005 Pearson Education Canada Inc.9-30 The Multiplier Multiplier  The ratio of the change in the equilibrium level of real national income to the change in autonomous expenditures.  It happens because income received by one group is (mostly) being spent on goods and services produced elsewhere in the economy.

31. Copyright © 2005 Pearson Education Canada Inc.9-31 The Multiplier Assumption: MPE =.8 or 4/5 (1)(2)(3)(4) Annual IncreaseAnnual IncreaseAnnual Increase in Realin Plannedin National IncomeExpendituresLeakages Round($ billions per year)($ billions per year)($ billions per year) 1 ($10 billion per year increase in I )10.008.0002.000 28.006.4001.600 36.405.1201.280 45.124.0961.024 54.093.2770.819............ All later rounds16.3813.1073.277 Totals (C + I + G + (X-M)) 50.0040.0010.000

32. Copyright © 2005 Pearson Education Canada Inc.9-32 The Multiplier The Multiplier Formula Multiplier = Proportion of leakages 1

33. Copyright © 2005 Pearson Education Canada Inc.9-33 The Multiplier The multiplier is larger when the proportion of leakages is smaller:  The marginal propensity to save is smaller  The marginal propensity to import is smaller  The marginal tax rate is lower

34. Copyright © 2005 Pearson Education Canada Inc.9-34 The Multiplier The Multiplier Formula can also be calculated as: Multiplier = 1 – Marginal Propensity to Spend 1

35. Copyright © 2005 Pearson Education Canada Inc.9-35 Multiplier Effect on Equilibrium of Real National Income Real National Income per Year ($ billions) Price Level 0 LRAS AD 1 500 120 SRAS AD 2 With $10 billion increase in autonomous spending 550 125 530

36. Copyright © 2005 Pearson Education Canada Inc.9-36 The Relationship Between the Total Planned Expenditure and the Aggregate Demand Curve Real Income ($ billions) Consumption, Investment, Government Purchases, and Net Exports (C + I + G + X) 100 E1E1 800 (C + I + G + X) 200 E2E2 600 -Assume prices increase to 200 -C + I + G + X decreases -Equilibrium Y falls to $600 billion 45 

37. Copyright © 2005 Pearson Education Canada Inc.9-37 The Relationship Between Total Planned Expenditures and the Aggregate Demand Curve Real Income ($ billions) Price Level AD A 800 100 - At P = 100, Y = 800 (A) - At P = 200, Y = 600 (B) B 600 200

38. Copyright © 2005 Pearson Education Canada Inc.9-38 The Relationship Between Total Planned Expenditures and the Aggregate Demand Curve rise in level of personal wealth fall in personal taxes fall in personal debt more optimistic expectations about the economy fall in real interest rates decrease in business taxes more optimistic expectations of profitability more spending in the economy decrease in value of the Canadian dollar increase in value of our trading partners’ currency increase in our trading partners’ GDP decrease in Canadian import taxes Increases Aggregate Demand and TPE Consumption Investment Government Net Exports

39. Copyright © 2005 Pearson Education Canada Inc.9-39 The Relationship Between Total Planned Expenditures and the Aggregate Demand Curve fall in level of personal wealth rise in personal taxes rise in personal debt less optimistic expectations about the economy rise in real interest rates increase in business taxes less optimistic expectations of profitability less spending in the economy increase in value of the Canadian dollar decrease in value of our trading partners’ currency decrease in our trading partners’ GDP increase in Canadian import taxes Decreases Aggregate Demand and TPE Consumption Investment Government Net Exports