2. Outline: 1.Spending and real GDP—the connection 2.Components of aggregate expenditure 3.Determinants of consumption spending 4.The consumption function 5.The fundamental law of consumption 6.The consumption-income line 7.Shifts of the consumption-income line

3. The Keynesian model is based on the idea that total spending is subject to short run fluctuations. Short run fluctuations in total spending for domestically- produced goods and services, or aggregate expenditure, produce changes in real GDP, employment, and prices. It’s spending, stupid!

4. AE = C + I P + G + NX, where: AE is aggregate expenditure C is personal consumption expenditure I P is planned investment expenditure G is government expenditure for goods & services. NX is net exports, or exports minus imports.

5. For Keynes, real GDP and employment depend on spending. So that begs the question: What does spending depend on?

6. Real Consumption Spending Real Disposable Income Interest Rate Wealth Consumer Confidence + + + -

7. www.bea.gov 1991

8. Real Disposable Income (Billions) Real Consumption (Billions) 02,000 1,0002,600 2,0003,200 3,0003,800 4,0004,400 5,000 6,0005,600 7,0006,200 8,0006,800 Hypothetical Data on Disposable Income and Consumption

9. Consumption Function Slope = 0.6 The consumption function reveals the spending plans of households at alternative levels of (real) disposable income.

10. Representing the consumption function by a linear equation The equation for the consumption function can be written as: C = a + bY D where: a is the intercept of the function b is the slope of the function or the marginal propensity to consume. Y D is real disposable income, or GDP net of all taxes but including transfer payments.

11. The marginal propensity to consume (or MPC) is the amount by which consumption spending changes when disposable income changes by one dollar. The MPC gives the slope of the consumption function. Let  C represent the change in consumption from one point to another on the line. Let  Y D denote the corresponding change in disposable income. Thus we have:

12. People show a tendency, as a rule an on average, to increase their consumption when their income increases—but not by as much as the increase in income Thus we can say: 0 < b < 1

13. Income or GDP (Billions) Net Taxes (Billions) Disposable Income (Billions) Consumption (Billions) 2,000 0 3,0002,0001,0002,600 4,0002,000 3,200 5,0002,0003,0003,800 6,0002,0004,0004,400 7,0002,0005,000 8,0002,0006,0005,600 9,0002,0007,0006,200 The Relationship Between Real GDP and Consumption

14. The Consumption- Income Line 0 Real Consumption (Billions) 800 5,000 5,600 7,0008,000 A B Real Income or GDP (Billions)

15. The consumption-income can shift due to: 1.A change in taxes, ceteris paribus 2.A change in transfers, ceteris paribus 3.A change in autonomous consumption (a) Note that: Transfer payments  Net Taxes  Taxes  Net Taxes 

16. Income  Disposable Income  Consumption  A change in net taxes (T) will impinge on aggregate expenditure indirectly, by its affect on disposable income Disposable Income  Consumption  Taxes  Consumption-income line shifts upward

17. Consumption-Income line when T = 2,000 Consumption-Income line when T = 500

18. The Consumption-Income line will shift upward when:  Household wealth  Interest rates  Consumer confidence The Consumption-Income line will shift downward when:  Household wealth  Interest rates  Consumer confidence

19. Real Consumption (Billions) Real Income or GDP (Billions) 0 1300 1800 800 a = 1300 a = 800 a = 1800 Change in autonomous consumption produces a shift of the income-consumption line

21. Source: Poterba (2000) Billions of 1999 dollars

22. Percen-tage of owners Common stock excluding pensions All Common Stock Non-Equity Financial Assets Housing equity Net Worth Top.5 percent 41.437.024.210.225.6 Next.5 Percent 11.810.77.84.68.4 Next 4 percent 27.727.226.220.523.4 Next 5 percent 10.311.314.015.411.4 Next 10 percent 7.29.813.920.112.8 Bottom 80 percent 1.74.114.029.318.5 Percent of Assets Owned by U.S. Households, 1998 Source: Poterba (2000), based on 1998 Survey of Consumer Finances