Consumption, Real GDP, and the Multiplier Chapter 12 Consumption, Real GDP, and the Multiplier

Introduction During the Great Recession of the late 2000s, inflation adjusted spending on goods and services by U.S. household declined by 2 percent, while the levels of wealth, indebtedness and income of households fell significantly. Why and how was the decrease in U.S. consumption spending related to the declines in household wealth, debts and income? Reading this chapter will help you answer this question.

Learning Objectives Distinguish between saving and savings and explain how consumption and saving are related Explain the key determinants of consumption and saving in the Keynesian model Identify the primary determinants of planned investment

Learning Objectives (cont'd) Describe how equilibrium real GDP is established in the Keynesian model Evaluate why autonomous changes in total planned expenditures have a multiplier effect on equilibrium real GDP Understand the relationship between total planned expenditures and the aggregate demand curve

Chapter Outline Some Simplifying Assumptions in a Keynesian Model Determinants of Planned Consumption and Planned Saving Determinants of Investment Determining Equilibrium Real GDP

Chapter Outline (cont'd) Keynesian Equilibrium with Government and the Foreign Sector Added The Multiplier How a Change in Real Autonomous Spending Affects Real GDP When the Price Level Can Change The Relationship Between Aggregate Demand and the C + I + G + X Curve

Did You Know That ... At various times from the late 1990s through the mid-2000s, the U.S. saving rate—the ratio of the flow of real, inflation-adjusted saving to real GDP—was negative? In this chapter, you will learn how an understanding of households’ real saving and real consumption spending can help you evaluate fluctuations in a national’s real GDP.

Some Simplifying Assumptions in a Keynesian Model To simplify the income determination model, let’s assume: Businesses pay no indirect taxes (sales tax) Businesses distribute all profits to shareholders There is no depreciation The economy is closed; no foreign trade

Some Simplifying Assumptions in a Keynesian Model (cont'd) Real Disposable Income Real GDP minus net taxes, or after-tax real income Consumption Spending on new goods and services out of a household’s current income Whatever is not consumed is saved Consumption includes such things as buying food and going to a concert

Some Simplifying Assumptions in a Keynesian Model (cont'd) Saving The act of not consuming all of one’s current income Whatever is not consumed out of spendable income is, by definition, saved Saving is an action measured over time (a flow) Savings are a stock, an accumulation resulting from the act of saving in the past

Some Simplifying Assumptions in a Keynesian Model (cont'd) Consumption Goods Goods bought by households to use up, such as food and movies

Some Simplifying Assumptions in a Keynesian Model (cont'd) Accounting identity: Consumption + saving  disposable income Saving  disposable income – consumption 12

Some Simplifying Assumptions in a Keynesian Model (cont'd) Investment Spending by businesses on things such as machines and buildings, which can be used to produce goods and services in the future The investment part of real GDP is the portion that will be used in the process of producing goods in the future

Some Simplifying Assumptions in a Keynesian Model (cont'd) Capital Goods Producer durables; nonconsumable goods that firms use to make other goods

Determinants of Planned Consumption and Planned Saving In the classical model, the supply of saving was determined by the rate of interest The higher the rate, the more people wanted to save, and the less they wanted to consume

Determinants of Planned Consumption and Planned Saving (cont'd) Keynes argued that: The interest rate is not the most important determinant of individual’s real saving and consumption decisions Real saving and consumption decisions depend primarily on a household’s real disposable income

Determinants of Planned Consumption and Planned Saving (cont'd) Keynes was concerned with changes in AD AD = C + I + G + X

Determinants of Planned Consumption and Planned Saving (cont'd) Consumption Function The relationship between amount consumed and disposable income A consumption function tells us how much people plan to consume at various levels of disposable income

Determinants of Planned Consumption and Planned Saving (cont'd) Dissaving Negative saving; a situation in which spending exceeds income Dissaving can occur when a household is able to borrow or use up existing assets

Table 12-1 Real Consumption and Saving Schedules: A Hypothetical Case

Determinants of Planned Consumption and Planned Saving (cont'd) 45-Degree Reference Line The line along which planned real expenditures equal real GDP per year

Figure 12-1 The Consumption and Saving Functions

Determinants of Planned Consumption and Planned Saving (cont'd) Autonomous Consumption The part of consumption that is independent of the level of disposable income Changes in autonomous consumption shift the consumption function

Policy Example: Why Knowing Consumer Sentiment Aids Consumption Forecasts Government economists use the University of Michigan’s Index of Consumer Sentiment to help forecast total U.S. consumption spending over the coming weeks and months. That Index is based on answers to questions about how confident people are about their future disposable income. Household’s confidence about future disposable income affects their autonomous consumption.

Determinants of Planned Consumption and Planned Saving (cont'd) Average Propensity to Consume (APC) Real consumption divided by real disposable income The proportion of total disposable income that is consumed APC = Real consumption Real disposable income

Determinants of Planned Consumption and Planned Saving (cont'd) Average Propensity to Save (APS) Real saving divided by real disposable income (DI) Saved proportion of real DI APS = Real saving Real disposable income

Determinants of Planned Consumption and Planned Saving (cont'd) Marginal Propensity to Consume (MPC) The ratio of the change in real consumption to the change in real disposable income MPC = Change in real consumption Change in real disposable income

Determinants of Planned Consumption and Planned Saving (cont'd) Marginal Propensity to Save (MPS) The ratio of the change in saving to the change in disposable income MPS = Change in real saving Change in real disposable income

Determinants of Planned Consumption and Planned Saving (cont'd) Example Income = $54,000 C = $49,200 S = $4,800 What is the APC? APC = $49,200 $54,000 = .911

Determinants of Planned Consumption and Planned Saving (cont'd) Example Income increases by $6,000 to $60,000 C = $54,000 S = $6,000 What is the APC? APC = $54,000 $60,000 = .90

Determinants of Planned Consumption and Planned Saving (cont'd) Some relationships APC + APS  1 MPC + MPS  1 31

Determinants of Planned Consumption and Planned Saving (cont'd) Causes of shifts in the consumption function A change besides real disposable income will cause the consumption function to shift Non-income determinants of consumption Population Wealth

Determinants of Planned Consumption and Planned Saving (cont'd) Net wealth The stock of assets owned by a person, household, firm or nation (net of any debts owed) For a household, wealth can consist of a house, cars, personal belongings, stocks, bonds, bank accounts, and cash (minus any debts owed)

Why Not … help the economy by taking from the rich and giving to the poor? Redistributing wealth from high-income households to lower- income households would cause the autonomous consumption of lower-income households to rise but the autonomous consumption of high-income households to fall. On net, total household wealth would be unaffected by the redistribution and thus aggregate autonomous consumption would be almost unchanged.

Determinants of Investment Investment, you will remember, consists of expenditures on new buildings and equipment Gross private domestic investment has been volatile Consider the planned investment function, and shifts in the function

Figure 12-2 Planned Real Investment, Panel (a)

Figure 12-2 Planned Real Investment, Panel (b)

Determining Equilibrium Real GDP We are interested in determining the equilibrium level of real GDP per year Consumption as a function of real GDP The 45-degree reference line

Figure 12-3 Consumption as a Function of Real GDP

Determining Equilibrium Real GDP (cont'd) Adding the investment function AD = C + I + G + X

Figure 12-4 Combining Consumption and Investment

Determining Equilibrium Real GDP (cont'd) Saving and investment: planned versus actual Only at equilibrium real GDP will planned saving equal actual saving Planned investment equals actual investment Hence planned saving is equal to planned investment

Figure 12-5 Planned and Actual Rates of Saving and Investment

Determining Equilibrium Real GDP (cont'd) Unplanned increases in business inventories Consumers purchase fewer goods and services than anticipated This leaves firms with unsold products and inventories will rise Businesses respond by cutting back production and reducing employment

Determining Equilibrium Real GDP (cont'd) Unplanned decreases in business inventories Business will increase production of goods and services and increase employment Ultimately there will be an increase in real GDP

Example: A Great Inventory Buildup During the Great Recession For 10 months following the officially designated start of the Great Recession in December 2007, business inventories shrank as U.S. firms managed inventories at relatively low levels. During the last few weeks of 2008, however, unsold business inventories suddenly jumped by nearly $70 billion because of a decline in household spending by a similar amount. 46

Keynesian Equilibrium with Government and the Foreign Sector Added To this point we have ignored the role of government in our model We also left out the foreign sector of the economy in our model Let’s think about what happens when we add these elements

Government (G): C + I + G Lump-Sum Tax Federal, state, and local Keynesian Equilibrium with Government and the Foreign Sector Added (cont'd) Government (G): C + I + G Federal, state, and local Does not include transfer payments Is autonomous Lump-sum taxes = G Lump-Sum Tax A tax that does not depend on income or the circumstances of the taxpayer

The Foreign Sector: C + I + G + X Keynesian Equilibrium with Government and the Foreign Sector Added (cont'd) The Foreign Sector: C + I + G + X Net exports (X) equals exports minus imports Depends on international economic conditions Autonomous—independent of real national income

Table 12-2 The Determination of Equilibrium Real GDP with Government and Net Exports Added

Determining the equilibrium level of GDP per year Keynesian Equilibrium with Government and the Foreign Sector Added (cont'd) Determining the equilibrium level of GDP per year We are now in a position to determine the equilibrium level of real GDP per year Remember that equilibrium always occurs when total planned real expenditures equal real GDP

Figure 12-6 The Equilibrium Level of Real GDP

Keynesian Equilibrium with Government and the Foreign Sector Added (cont'd) The Equilibrium Level of Real GDP Observations If C + I + G + X = Y Equilibrium GDP If C + I + G + X > Y Unplanned decrease in inventories Businesses raise output Y returns to equilibrium If C + I + G + X < Y Unplanned increase in inventories Businesses reduce output

The Multiplier Multiplier The ratio of the change in the equilibrium level of real national income to the change in autonomous expenditures The number by which a change in autonomous real investment or autonomous real consumption is multiplied to get the change in equilibrium real GDP

The Multiplier (cont'd) Question How can a $100 billion increase in investment generate a $500 billion increase in equilibrium real GDP? Answer The multiplier process

Table 12-3 The Multiplier Process

The Multiplier (cont'd) The multiplier formula Multiplier = 1 1 - MPC = MPS

The Multiplier (cont'd) By taking a few numerical examples, you can demonstrate to yourself an important property of the multiplier The smaller the MPS, the larger the multiplier The larger the MPC, the larger the multiplier

The Multiplier (cont'd) Examples MPC = 4 5 MPS = 1 Multiplier = 1/5 = 5 MPC = 3 5 MPS = 2 Multiplier = 1 2/5 = 2.5

The Multiplier (cont'd) Measuring the change in equilibrium income from a change in autonomous spending Change in equilibrium real GDP = Multiplier x Change in autonomous spending

The Multiplier (cont'd) Significance of the multiplier It is possible that a relatively small change in consumption or investment can trigger a much larger change in real GDP

How a Change in Real Autonomous Spending Affects Real GDP When the Price Level Can Change So far our examination of how changes in real autonomous spending affects equilibrium real GDP has considered a situation in which the price level remains unchanged Our equilibrium analysis has only considered how AD shifts in response to investment, government spending, net exports

How a Change in Real Autonomous Spending Affects Real GDP When the Price Level Can Change (cont'd) When we take into account the aggregate supply curve, we must also consider responses of the equilibrium price level to a multiplier-induced change in AD

Figure 12-7 Effect of a Rise in Autonomous Spending on Equilibrium Real GDP

The Relationship Between Aggregate Demand and the C + I + G + X Curve Aggregate demand consists of: Consumption Investment Government Foreign sector 65

There is a major difference between the two: The Relationship Between Aggregate Demand and the C + I + G + X Curve (cont'd) There is a major difference between the two: C + I + G + X curve drawn with price level constant AD curve drawn with the price level changing To derive the aggregate demand curve from the C + I + G + X curve, we must now allow the price level to change

What are some of the effects of a price level increase? The Relationship Between Aggregate Demand and the C + I + G + X Curve (cont'd) What are some of the effects of a price level increase? Real balance effect Interest rate effect The open economy effect

Figure 12-8 The Relationship Between AD and the C + I + G + X Curve

You Are There: In Boise, Idaho, Inventories Accumulate as Desired Saving Rises In the late 2008 and early 2009, Noreen and Rick Capp of Boise, Idaho, began to consume less and save more in order to pay off their credit card debt. The decisions of the Capps and other Boise families to increase planned saving were transmitted to businesses as unplanned inventory buildups. 69

Issues & Applications: Why U. S Issues & Applications: Why U.S. Consumption Spending Dropped in the Late 2000s Between the end of 2007 and mid-2009, aggregate U.S. real consumption spending declined by about $175 billion. Figure 12-9 shows that declines in real disposable income and real household wealth led to a drop in real consumption expenditures.

Figure 12-9 Real Household Debt, Housing Wealth, Disposable Income, and Stock Wealth Indexes Since 1960

Summary Discussion of Learning Objectives The difference between saving and savings and the relationship between saving and consumption Saving is a flow over time while savings is a stock Consumption plus saving equals disposable income

Summary Discussion of Learning Objectives (cont'd) Key determinants of consumption and saving in the Keynesian model In the classical model, the interest rate is the fundamental determinant of saving In the Keynesian model, the primary determinant is disposable income DI increases, so does C

Summary Discussion of Learning Objectives (cont'd) The key determinants of planned investment The interest rate, business expectations, productive technology, and business taxes

Summary Discussion of Learning Objectives (cont'd) How equilibrium real GDP is established in the Keynesian model Equilibrium national income occurs where the C + I + G + X schedule crosses the 45-degree line

Summary Discussion of Learning Objectives (cont'd) Why autonomous changes in total planned expenditures have a multiplier effect on equilibrium real GDP As consumption increases, so does real GDP, which induces further consumption spending The ultimate expansion of real GDP is equal to the multiplier times the increase in autonomous expenditures

Summary Discussion of Learning Objectives (cont'd) The relationship between total planned expenditures and the aggregate demand curve AD consists of consumption, investment, and government purchases, plus the foreign sector Difference C + I + G + X curve drawn with price level constant AD with the price level changing

Figure C-1 Graphing the Multiplier