MPC, MPS & Investment Spending

 We use the multiplier to explain the effects of changes in spending on the economy  Ceteris paribus, an increase in spending increases income & GDP by that same amount  As a result, disposable income rises, which leads to more spending and increased production

 MPC is a measure of the total effect MPC = ∆ consumer spending ∆ disposable income  Because we are looking at the part of each additional dollar that consumers will spend, the MPC is a number between 0 and 1  The remainder (1 - MPC) is the Marginal Propensity to Save

 Each $1 of spending adds to GDP, and this translates into a round of consumer spending (MPC X $1), then another round, etc.  Ultimately, the impact of that change in spending is a multiple of the original change  The total increase in Real GDP from x dollars of spending = 1/(1-MPC) X x  At each stage, some of the rise in income “leaks out” because it is saved. The formula shows the cumulative effect of several “rounds” of spending

 The multiplier is the ratio of total change in Real GDP to the size of autonomous change in spending (the cause of the chain reaction) ∆Y -OR- 1 ∆AAS (1-MPC)  Size of the multiplier depends on MPC – Higher MPC, higher multiplier  Taxes, foreign trade, etc. complicate the model Tax Multiplier = - MPC/(1-MPC)  The tax multiplier is ALWAYS negative

 Largest determinant of consumer spending is disposable income  Consumption function is c = a + MPC  y d  The a represents autonomous consumer spending, the amount a household would spend even if it had no income  For households, MPC = ∆c/∆ y d

C = A + MPC  Y D  Y D is the aggregate disposable income of a society  Aggregate CF is the relationship between Y D and consumption for the economy as a whole  This equation graphs as a linear function, with A as the vertical axis intercept

 Two factors will shift CF 1. Expectations about future disposable income – Expecting good times will shift CF up, expecting hard times will shift it down – “permanent income hypothesis” 2. Changes in aggregate wealth – Those with the most savings (wealth) can afford to spend more & a rise in aggregate wealth will shift CF up, while a fall in aggregate wealth will shift it down – “life cycle hypothesis”

 Because of the multiplier, booms & busts in investment spending tend to drive the business cycle I= I Planned + I Unplanned

 Planned investment spending is dependent on 3 factors: 1. Interest rates Drive residential construction. Impact other investment spending. Businesses only invest when the rate of return is higher than the cost (or opportunity cost) of the funds. High interest rate makes any investment project less attractive.

 Planned investment spending is dependent on 3 factors: 2. Expected Real GDP Firms who don’t expect sales growth plan for minimal investment spending. Expected sales growth results in need to expand production capacity. 3. Production Capacity If current capacity is higher than needed for current sales, growing capacity is a lesser concern.

 Investment demand curve shows the inverse relationship between interest rates and investment demand.

Factors that increase Expected Rate of Return (shift curve right) Factors that decrease Expected Rate of Return (shift curve left)  Operating costs  Operating costs  Taxes  Taxes  Stock on hand  Stock on hand  Expected sales (good conditions)  Expected sales (bad conditions)  Technology/innovation

 Businesses maintain inventories to satisfy buyers  Inventory investment – Value of total inventories in an economy over a period of time. This can be a negative number when inventories are reduced.  If sales fall, businesses might end up with larger inventories than expected (unplanned inventory investment)  Rising inventories signal economic slowdown