1. Income and Expenditures
Module 16
Income and Expenditures

2. Intro
How does changes in spending lead to further changes in the economy?
What is disposable income and how does it affect consumer spending?
How does expected future income affect consumer spending?
Why is investment spending considered a leading indicator of the future state of the economy?

3. The Multiplier The 4 Assumptions
Producers are willing to supply additional output at fixed prices.
Take interest rates as given.
Assume there is no government spending or taxes.
Exports and Imports = zero
Use these 4 assumptions to analyze what changes will happen to spending.

4. Investment Spending
Home builders spend $100 billion on home construction
Increase income and value of aggregate output by the same amount b/c $1 of home construction = $1 worth of income for construction worker, suppliers of building materials, electricians, etc.
$100 billion increase of investment spending on building houses = $100 billion more of overall income
Process
Increase of aggregate output leads to an increase in disposable income which flows to households in the form of profits and wages.
This leads to an increase in consumer spending.
This leads to firms increasing output again.
The leads to an increase in disposable income

5. Marginal Propensity to Consume
MPC: Marginal Propensity to Consume
The increase in consumer spending when disposable income rises by $1
When consumer spending changes because of a rise or fall in disposable income, MPC is the change in consumer spending divided by the change in disposable income.
Delta symbol stands for ’change in’ before a word

6. Example: MPC Consumer spending increase $6 billion
Disposable income increases $10 billion
6/10 = .6 = MPC

7. MPC continued
MPC will always be between 0 and 1 bc consumers usually spend some, not all, of their income
Marginal Propensity to Save = MPS
Fraction of an additional dollar of disposable income that is saved
MPS = 1 - MPC

8. Effect on GDP Assumption of no taxes or trade Second round increase
$1 increase in spending raises real GDP and disposable income by $1
$100 billion increase = $100 billion raise to real GDP
Second round increase
Real GDP = MPC X $100 billion
Third round increase
Real GDP = MPC X Previous answer
ETC.
There are an infinite number of rounds on the total effect on real GDP

9. Total Increase in Real GDP from $100 Billion
I = Investment Spending Increase
I = 1 / (1-MPC) X 100 Billion

10. Rounds if MPC = .6 1st Round = 100 Billion
2nd Round = .6 X 100 = 60 billion
3rd Round = .6 * 60 billion = 36 billion
Etc.

11. Total Increase I = 1/(1-MPC) X 100 billion
I = 1/(1-.6) X 100 billion = 250 billion.
250 billion is the total rise in income because eventually disposable income will “leak out” because it’s being saved

12. Autonomous Change in Aggregate Spending
Increases in consumer spending = people feel richer, more comfortable and are willing to increase spending
Initial rise or fall in aggregate spending at any given level of the real GDP = Autonomous Change in Aggregate Spending
Not the result of a chain reaction

13. The Multiplier
The Multiplier is the ratio of total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change
Multiplier = Change in real GDP / Autonomous change in aggregate spending
Change in real GDP = 1/(1-MPC) X Change in Autonomous aggregate spending
The size of the multiplier depends on the MPC
The size determines how large each round of expansion is
The higher the MPC, the less disposable income will “leak out” into savings each round

14. Consumer Spending
Accounts for 2/3rds of total spending on final goods and services
What determines how much consumers spend?

15. Consumer Spending Most important factor: Current Disposable Income
Income after taxes are paid
How can we tell if someone has a lot of disposable income?

16. Consumer Spending

17. The Consumption Function
The consumption function is an equation showing how an individual household’s consumer spending varies with the household’s current disposable income.
C = a + MPC X Yd
C = individual household consumer spending
Yd = individual household current disposable income
A = individual household autonomous consumer spending (the amount a household would spend if they had no disposable income
We assume a = greater than zero

18. The consumption function continued
MPC = change in individual consumer spending / change in individual household disposable income
Change in Consumer spending = MPC X Change in individual household disposable income
Slope = the MPC

20. C = $17, X Yd
MPS = = 0.47
Multiplier =
1/(1-MPC) =
1/MPS = 1/0.47 = 2.13

21. Aggregate Consumption Function
Relationship between current disposable income and aggregate consumer spending
C = A + MPC X Yd
C = consumer spending
YD = Disposable income
A = Aggregate Autonomous Consumer Spending, amount the consumer spending when YD zero

22. Shifts of the Aggregate Consumption Function
Shows the relationship b/w disposable income and consumer spending
When things other than disposable income change, the aggregate consumption function shifts.
2 Things SHIFT the ACF
Expected Future Disposable Income
Changes in Aggregate Wealth

23. Changes in Expected Future Disposable Income
You get a job
You don’t get paychecks for the first 2 months
You will still probably start spending more on goods and services
Ex. nicer work clothes
OR You know your company is about to lay off people
You may lose your job
You start to cut back spending before your pay actually goes away
Figures 16.4 show these 2 shifts

25. Changes in Aggregate Wealth
Someone with more wealth will spend more on goods and services
Wealth is having possessions like houses or other assets that are paid off.
People nearing retirement save up and enter peak earning years
Middle aged couple who have paid off their mortgage and other stuff will spend more
Booming stock market increases wealth and spending
Shifts same as future disposable income

26. Investment Spending
More recessions originate as a fall of investment spending
Consumer Spending is greater impact on business cycles
Planned Investment Spending
investment spending that firms intend to undertake during a given period

27. Interest Rate and Investment Spending
Interest Rates have their highest impact on residential construction
Home builders only build houses that they think they can sell
Houses that are more affordable are more likely to sell when interest rates are low
Firms with investment spending projects will go ahead with a project only if they expect a rate of return higher than the cost of the funds they would have to borrow
Higher interest rates = fewer projects
Retained earnings
Past profits used to finance investment spending

28. Expected Future Real GDP, Production Capacity, and Investment Spending
If a firm has the ability to continue producing its current amount and sell, but they don’t expect sales to grow, they will engage in investment spending to replace existing structures that wear out or have new technologies
If the firm expects sales to grow in the future, they will find its current producing capacity insufficient for future needs and will undertake investment spending
Higher expected future growth rate of GDP = higher level of planned investment spending and vise versa

29. Inventories and Unplanned Investment Spending
Inventories: stocks of goods held to satisfy future sales
Hold to quickly satisfy buyers
Inventory Investment
Value of the change in total inventories held in the economy during a given period
Can only be negative
Unplanned Inventory Investment
When a firm's inventories are higher than intended due to unforeseen decrease in sales.
Actual Investment Spending
Equal to planned investment spending plus unplanned inventory investment

30. Questions - Page 170 #1-5

31. Question 1
Changes in which of the following leads to a shift of the aggregate consumption function?
Expected future disposable income
Aggregate wealth
Current disposable income

32. Answer 1 A and B only Expected future disposable income
Aggregate wealth

33. Question 2 The slope of a family’s consumption function is equal to ….
The real interest rate
The inflation rate
The marginal propensity to consume
The rate of increase in household current
The tax rate

34. Answer 2
C - marginal propensity to consume

35. Question 3
Given the consumption function c=$16, Yd, if individual household current disposable income in $20,000, individual household consumer spending will equal:
$36,000
$26,000
$20,000
$16,000
$6,000

36. Answer 3
C - $20,000
c=$16, Yd
C = 16, ,000

37. Question 4
The level of planned investment spending is negatively related to the ….
Rate of return on investment
Level of consumer spending
Level of actual investment spending
Interest rate
All of the above

38. Answer 4 D- interest rate
The higher the interest rate is, the less investment and loans someone will be willing to take out

39. Question 5 Actual investment spending in any period is equal to ….
Planned investment spending + unplanned inventory investment
Planned investment spending - unplanned inventory investment
Planned investment spending + inventory decreases
Unplanned inventory investment + inventory increases
Unplanned inventory investment - inventory increases

40. Answer 5
Planned investment spending + unplanned inventory investment