Chapter 12 Consumption, Real GDP, and the Multiplier

Slide 12-2 Introduction Investment spending by businesses is a key component of economic growth. Expenditures on information technology were once expected to provide a bigger push to GDP expansion than they have. Why might investment spending and its effect on GDP be rather unpredictable?

Slide 12-3 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

Slide 12-4 Learning Objectives Describe how equilibrium national income is established in the Keynesian model Evaluate why autonomous changes in total planned expenditures have a multiplier effect on equilibrium national income Understand the relationship between total planned expenditures and the aggregate demand curve

Slide 12-5 Chapter Outline Some Simplifying Assumptions in the Keynesian Model Some Simplifying Assumptions in the Keynesian Model Determinants of Planned Consumption and Planned Saving Determinants of Planned Consumption and Planned Saving Determinants of Investment Consumption as a Function of Real GDP Consumption as a Function of Real

Slide 12-6 Chapter Outline Saving and Investment: Planned versus Actual Saving and Investment: Planned versus Actual Keynesian Equilibrium with Government and the Foreign Sector Added Keynesian Equilibrium with Government and the Foreign Sector Added The Multiplier

Slide 12-7 Chapter Outline The Multiplier Effect When the Price Level Can Change The Multiplier Effect When the Price Level Can Change The Multiplier Effect on the Equilibrium Level of Real GDP The Multiplier Effect on the Equilibrium Level of Real GDP

Slide 12-8 Did You Know That... Historically, investment spending has been the most volatile component of GDP? Economist John Maynard Keynes put forth one of the first theories about the relationship among personal consumption, investment spending, and economic growth?

Slide 12-9 Keynes revisited –Aggregate demand determines output (horizontal SRAS) –We will examine the elements of aggregate demand (AD = C + I + G + X) –Prices are fixed, so output is in real terms Some Simplifying Assumptions in a Keynesian Model

Slide Assumptions –Businesses pay no indirect taxes (sales tax) –Businesses distribute all profits to shareholders –There is no depreciation –The economy is closed Some Simplifying Assumptions in a Keynesian Model

Slide Definitions and relationships revisited –Consumption Spending on new goods and services out of a household’s current income –Saving The act of not consuming all of one’s income –Savings Accumulation of past saving; a stock variable Some Simplifying Assumptions in a Keynesian Model

Slide Some Simplifying Assumptions in a Keynesian Model Disposable income equals consumption plus saving. This accounting identity shows that each dollar of take-home income can either be spent or saved.

Slide Investment –The spending by business on things which can be used to produce goods and services in the future Some Simplifying Assumptions in a Keynesian Model

Slide Keynes was concerned with changes in AD. Determinants of Planned Consumption and Planned Saving AD = C + I + G + X

Slide Keynes argued that saving and consumption decisions depend primarily on an individual’s real disposable income. Consumption Function –The relationship between planned consumption expenditures and their current level of real income Determinants of Planned Consumption and Planned Saving

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

Slide C = Y d 45 o Consumption function The Consumption and Saving Functions Real Disposable Income (Y d dollars per year) Planned Real Consumption (C, dollars per year) 12,00024,00036,0000 6,000 12,000 24,000 36,000 48,000 60,000 Break-even income A B C D E F G H I J K Figure 12-1

Slide The Consumption and Saving Functions Real Disposable Income (Y d dollars per year) Planned Real Consumption (C, dollars per year) 12,00024,00036,0000 6,000 12,000 24,000 36,000 48,000 60,000 C = Y d 60,000 Break-even income Consumption function A B C D E F G H I J K 45 o Dissaving Saving Autonomous consumption (Equal vertical distance) Figure 12-1

Slide The Consumption and Saving Functions 0 6,000 -6,000 12,000 36,00048,00060,000 24,000 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 Figure 12-1

Slide The Consumption and Saving Functions 0 6,000 -6,000 12,000 36,00048,00060,000 24,000 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 Dissaving Figure 12-1

Slide Dissaving –Negative saving; spending exceeds income Autonomous Consumption –The part of consumption that is independent of the level of disposable income Determinants of Planned Consumption and Planned Saving

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

Slide Average Propensity to Save (APS) –Saving divided by disposable income –The proportion of total disposable income that is saved Determinants of Planned Consumption and Planned Saving APS = real saving real disposable income

Slide Average propensity to consume and average propensity to save must sum to 100 percent of total income. Marginal propensity to consume and marginal propensity to save must sum to 100 percent of the change in income. Determinants of Planned Consumption and Planned Saving

Slide Example –Income = $54,000 –C = $49,200 –S = $4,800 What is the APC? Determinants of Planned Consumption and Planned Saving APC = $49,200 $54,000 =.911

Slide Example –Income increases by $6,000 to $60,000 –C = $54,000 –S = $6,000 What is the APC? Determinants of Planned Consumption and Planned Saving APC = $54,000 $60,000 =.90

Slide Marginal Propensity to Consume (MPC) –The ratio of the change in consumption to the change in disposable income Determinants of Planned Consumption and Planned Saving MPC = change in consumption change in real disposable income

Slide Marginal Propensity to Save (MPS) –The ratio of the change in saving to the change in disposable income Determinants of Planned Consumption and Planned Saving MPS = change in saving change in real disposable income

Slide Causes of shifts in the consumption function –Non-income determinants of consumption Population Wealth Can you think of other non-income determinants of consumption? Determinants of Planned Consumption and Planned Saving

Slide International Example: Determinants of Investment Spending Investment expenditures by Japanese businesses were depressed throughout the 1990’s, even though interest rates were close to zero. The low cost of borrowing was not enough to offset the effect of poor prospects for growth in consumer spending.

Slide International Example: Determinants of Investment Spending Investment spending in Japan recovered only in 2002, as firms began to anticipate higher sales. Firms began replacing old equipment, and in some cases actually expanded their productive capacity.

Slide Consumption as a Function of Real GDP Figure 12-3

Slide Determinants of Investment Historically –Investment has been more volatile than consumption Why? AD = C + I + G + X

Slide Combining Consumption and Investment Figure 12-4, Panel (c)

Slide Saving and Investment: Planned versus Actual Equilibrium –The intersection of the planned saving and planned investment schedules No tendency for businesses to alter the rate of production or the level of employment –There are no unplanned inventory changes

Slide Planned and Actual Rates of Saving and Investment Real GDP per Year ($ trillions) I Saving and Investment per Year ($ trillions) S Actual S = actual I Unplanned inventory decrease = $400 billion per year E Figure 12-5

Slide Planned and Actual Rates of Saving and Investment Real GDP per Year ($ trillions) E S I Saving and Investment per Year ($ trillions) Actual S = actual I Unplanned inventory decrease = $400 billion per year Unplanned inventory increase = $400 billion per year Planned investment = $1.600 trillion per year Figure 12-5 Actual S = actual I

Slide 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 Keynesian Equilibrium with Government and the Foreign Sector

Slide The Foreign Sector—C + I + G + X –Net exports (X) = exports - imports –Autonomous –Depends on the economic conditions in each country Keynesian Equilibrium with Government and the Foreign Sector

Slide The Determination of Equilibrium Real GDP with Net Exports Table 12-2

Slide The Equilibrium Level of Real GDP Figure 12-6

Slide The Equilibrium Level of Real GDP Observations –If C + I + G + X = Y Equilibrium –If C + I + G + X > Y Unplanned drop in inventories Businesses increase output Y returns to equilibrium –If C + I + G + X < Y Unplanned rise in inventories Businesses cut output Y returns to equilibrium

Slide The Multiplier Multiplier –The ratio of the change in the equilibrium level of real national income to the change in autonomous expenditures

Slide The Multiplier Question –How can $1.1 trillion of I generate $5.5 trillion of Y? Answer –The autonomous spending multiplier

Slide The Multiplier Process Assumption: MPC =.8 or 4/5 Annual IncreaseAnnual IncreaseAnnual Increase in Realin Plannedin Planned National IncomeConsumptionSaving Round($ billions)($ billions)($ billions) 1 ($100 billion per year increase in I ) All later rounds Totals (C+I+G) Table 12-3

Slide The Multiplier The multiplier formula Multiplier = MPC = 1 MPS

Slide The Multiplier Examples MPC = 3 4 MPS = 1 4 Mult. = 1 1/4 = 4 MPC = 4 5 MPS = 1 5 Mult. = 1 1/5 = 5 MPC = 2 3 MPS = 1 3 Mult. = 1 1/3 = 3 MPC = 7 9 MPS = 2 9 Mult. = 1 9/2 = 4.5 MPC = 3 5 MPS = 2 5 Mult. = 1 5/2 = 2.5

Slide The Multiplier Question –How does the size of the MPC influence the value of the multiplier? Answer –The smaller the MPS, the larger the multiplier –The larger the MPC, the larger the multiplier

Slide The Multiplier Measuring the change in equilibrium income from a change in autonomous spending Change in equilibrium income = multiplier x change in level of real autonomous spending

Slide The Multiplier Question –What does the multiplier tell us about the potential impact on the economy for a change in autonomous spending?

Slide Example: A Double-Whammy Multiplier Effect At the end of 2003, both investment spending and net exports increased for the U.S. economy. This amounted to a significant increase in autonomous spending. Due to the multiplier effect, the rate of overall GDP growth exceeded predictions.

Slide The Multiplier Effect When the Price Level Can Change The multiplier effect on equilibrium real GDP will not be as great if part of the increase in nominal GDP occurs because of increases in the price level.

Slide The Multiplier Effect on the Equilibrium Level of Real GDP 0 Price Level AD LRAS SRAS 120 AD 2 With $100 billion increase in autonomous spending Real GDP per Year ($ trillions) Figure 12-7

Slide The Multiplier Effect on the Equilibrium Level of Real GDP Real GDP per Year ($ trillions) Price Level AD 2 SRAS LRAS AD 1 With price adjustment the multiplier effect is less Real national income increases to $12.3 billion With $100 billion increase in autonomous spending Figure 12-7

Slide The Multiplier Effect on the Equilibrium Level of Real GDP Real GDP per Year ($ trillions) Consumption, Investment, Government Purchases, and Net Exports (C + I + G + X) 100 E1E1 12 Figure 12-8

Slide The Multiplier Effect on the Equilibrium Level of Real GDP Real GDP per Year ($ trillions) Consumption, Investment, Government Purchases, and Net Exports (C + I + G + X) 100 E1E1 (C + I + G + X) 125 E2E Figure 12-8

Slide The Multiplier Effect on the Equilibrium Level of Real GDP Real GDP per Year ($ trillions) Consumption, Investment, Government Purchases, and Net Exports (C + I + G + X) E1E1 (C + I + G + X) 125 Assume prices increase to 125 C + I + G + X decreases Equilibrium Y falls to $10 trillion 10 E2E2 Figure 12-8

Slide Issues and Applications: “New Economy” or New Source of Volatility? Proponents of a theory of the “new economy” argued in the 1990’s that information technology expenditures would eliminate any economic downturns –By making firms more productive –By buoying investment spending While IT expenditures contribute to growth of real GDP, they remain a source of volatility.

Slide Summary Discussion of Learning Objectives The difference between saving and savings and the relationship between consumption and saving is a flow over time while savings is a stock consumption plus saving equals disposable income. The key determinant of consumption and saving in the Keynesian model is disposable income.

Slide Summary Discussion of Learning Objectives The primary determinants of planned investment are the interest rate, business expectations, productive technology, and business taxes.

Slide Summary Discussion of Learning Objectives In the Keynesian model equilibrium national income occurs where the C + I + G + X schedule crosses the 45 degree line. Autonomous changes in total planned expenditure have a multiplier effect on equilibrium national income because an increase in autonomous expenditures increases income which increases consumption.

Slide Summary Discussion of Learning Objectives The relationship between total planned expenditures and the aggregate demand curve is inverse. An increase in the price level reduces planned expenditures. –Real balance effect –Interest rate effect –Open economy effect

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