1. C HAPTER 12- C ONSUMPTION, R EAL GDP, M ULTIPLIER

2. C ONSUMPTION F UNCTION I  The consumption function is the relationship between consumption (household sector spending) and disposable income.  In the consumption function, consumption is directly related to disposable income and is positive even at zero disposable income:

3. The 45-Degree Line The 45-degree line represents all points where consumption and income are exactly equal. C = Y D

4. U.S. Consumption and Income DISPOSABLE INCOME (billions of dollars per year) $1000200030004000 Actual consumer spending 6000 5000 4000 3000 2000 1000 0 500060007000 45° $7000 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 CONSUMPTION (billions of dollars per year) C = Y D

5. A UTONOMOUS I NCOME Have you ever known people who spend money with out any income? 2. When disposable income is 0 and consumption still exists (food, clothing, shelter- basics) this is autonomous consumption 3. Whether one has to dig into one’s savings, go on welfare, or else beg, borrow or steal, or call mom, one will spend that minimum amount

6. H OW DOES THIS WORK ? Income is low - households tend to Dissave..(borrow from savings or borrow from other sources) Income increases - household aggregate income eventually equals and exceeds current consumption

7. The Keynesian model assumes that there is a positive relationship between consumption and income. 369 P lanned C onsumption E xpenditures (trillions of dollars) R eal D isposable I ncome (trillions of dollars) 6 9 12 3 45º 45º Line C S aving D is-saving However, as income increases, consumption increases by a smaller amount. Thus, the slope of the consumption function (line C) is less than 1 (less than the slope of the 45° line).

8. Disposable Income Yd= C+S If we spend… cannot save. If we spend… more activity (production) takes place in the economy… potential to increase GDP What happens if we do not save at all?

9. W HAT IS THE DECIDING FACTOR ON WHETHER YOU SPEND OR NOT ? Income Keynes felt we could learn a lot about consumption by focusing on the relationship between income and spending. He said income and consumer spending rise in tandem.. If you know how much income consumers have to spend (Yd), you can predict what they will spend

10. K EYNE ’ S C ONSUMPTION F UNCTION Keynes referred to this as “fundamental law” that men are disposed as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income. *1)At low levels of aggregate income, the consumption expenditures of households will exceed their disposable income (when household income is low, households dissave - they either borrow or draw from past savings to purchase consumption goods

11. 45 Degree Line $50100150200250300350400 C = Y D Saving Dissaving Consumption Function C = $50 + 0.75Y D A C D E B G

12. Keynes Cont. As with most theories, Keynes asks us to assume away a lot of the problem. We will assume there is a specific employment level of output. NARU is present when full-employment capacity is attained. Wages and prices are completely inflexible until full employment is reached Government’s taxing, spending and monetary policies are constant.

13. Keynes said that the economy needs to be directed to full-employment through aggregate expenditures. (C + I + G + X-M )

14. A sluggish economy There are a number of ways to jump-start the economy… Fiscally: taxing & spending. Affects on AD Should the classical or Keynesian approach be used…. Or should an eclectic approach be used?

15. K EYNESIAN E CONOMICS Works only on the AD curve Assumes AS is stationary Critics of Keynes: …But this will cause deficits! …But the government can’t spend that much!

16. K EYNES ’ M ULTIPLIER E FFECT Any new spending (G) becomes new income (Y) to someone. New income (Y) after taxes (T), called disposable income (Yd), is divided into new spending (C) and new saving (S). Y = C + S + T Yd = Y – T = C + S ΔYd = ΔC + ΔS

17. W HAT DO YOU THINK M ARGINAL P ROPENSITY TO C ONSUME MEANS ??? You get a “windfall.” How much of those $$ will you spend… (marginally?) How much will you save? (marginally?) Yd = C + S ΔYd = ΔC + ΔS Divide through by ΔYd: 1 = ΔC/ΔYd + ΔS/ΔYd Define: marginal propensity to consume (MPC) MPC = ΔC / ΔYd marginal propensity to save (MPS) MPS = ΔS / ΔYd 1 = MPC + MPS, always

18. T HE M ULTIPLIER E FFECT In each cycle, part of the new income is set aside as saving (MPS). So, the next round of income-spending is smaller than the previous round. As new income grows, it ultimately reaches its maximum. The power of the multiplier effect is controlled by the size of MPS.

19. T HE M ULTIPLIER E FFECT Spending multiplier = 1/MPS MPS1/101/51/41/3 Spending Multiplier 10543

20. W HAT REALLY IS THE MULTIPLIER ? The multiplier is based on two concepts already covered: 1. GDP is the nation’s expenditure on all the final goods and services produced during the year at market prices. 2. GDP=C+I+G+(X-M) = Aggregate Demand

21. S UMMARY Y = C + S + TY is national income Yd = Y – T = C + SYd is disposable income MPC = ΔC / ΔYd MPS = ΔS / ΔYd MPC + MPS = 1, always spending multiplier = 1/MPS tax multiplier = - (spending multiplier – 1)

22. Obviously if C goes up the entire GDP will go up also. When there is any change in spending- it will have a multiplied effect on GDP *When money is spent by one person, it becomes someone else’s income. When someone spends a dollar, perhaps someone who received that dollar would spend 80 cents and of that 80 cents received by the next person perhaps 64 cents… If we add up all the spending generated by that one dollar, it will add up to four or five or six times that dollar… Hence, the name “multiplier.” $1.00 $.80 $.64

23. The multiplier tells us the extent to which the rate of total spending will change in response to an initial change in the flow of expenditure. Any change in spending (C, I, or G.) will set off a chain reaction, Leading to a multiplied change in GDP. If $1 million investment resulted in $4 million additional income, the multiplier would be 4

24. T HE M ULTIPLIER P ROCESS 1. $100 billion in unsold goods appear 3. Income reduced by $100 billion4. Consumption reduced by $75 billion 5. Sales fall $75 billion 6. Further cutbacks in employment or wages 7. Income reduced by $75 billion more 8. Consumption reduced by $56.25 billion more Factor markets Product markets Business firms Households 9. And so on 2. Cutbacks in employment or wages

25. E xpenditure S tage A dditional I ncome ( Dollars ) M arginal P ropensity To C onsume A dditional C onsumption ( Dollars ) For simplicity (here) it is assumed that all additions to income are either spent domestically or saved. 1,000,000 750,000 562,500 421,875 316,406 237,305 177,979 133,484 100,113 75,085 225,253 750,000 562,500 421,875 316,406 237,305 177,979 133,484 100,113 75,085 56,314 168,939 Round 1 Round 2 Round 3 Round 4 Round 5 Round 6 Round 7 Round 8 Round 9 Round 10 3/4 Total4,000,0003,000,0003/4 All Others The Multiplier Principle The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75%  3/4). Here, a $1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until... effectively, $4 million is spent in the economy.