Module Income and Expenditure 16 KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: The nature of the multiplier, which shows how initial changes in spending lead to further changes The meaning of the aggregate consumption function, which shows how current disposable income affects consumer spending How expected future income and aggregate wealth affect consumer spending The determinants of investment spending Why investment spending is considered a leading indicator of the future state of the economy

The Multiplier: An Informal Introduction Marginal Propensity to Consume (MPC) Marginal Propensity to Save (MPS) MPC = ∆ Consumer Spending ∆ Disposable Income MPS = ∆ Saving ∆ Disposable Income   For now, we will ignore the government (or public sector) and we will ignore net exports (or foreign sector) in the economy. Consumption is a huge fraction (more than 2/3) of total spending in the economy. After a person pays his taxes, he is left with disposable income that can either be consumed or saved. Yd = C + S When a person gets more Yd, he will increase both C and S. The marginal propensity to consume MPC = (Δ Consumption/Δ Disposable Income). The MPC is the amount by which consumer spending rises if current disposable income rises by $1 and is the slope of the consumption function. The marginal propensity to save MPS = (Δ Saving/Δ Disposable Income). MPC + MPS = 1 Thus the MPC = (Δ C/Δ Yd) = .8 and The MPS = (Δ S/Δ Yd) = .20. So if this household receives $1 of additional Yd, they will consume 80 cents and save 20 cents of it. MPC + MPS = 1 MPC = 1 - MPS MPS = 1 - MPC

The Multiplier: An Informal Introduction Autonomous Change in Aggregate Spending (AAS) Multiplier ∆Y = 1 _________ (1 - MPC) X ∆AAS The federal government recently enacted the American Recovery and Reinvestment Act of 2009. This “stimulus package” of $787 billion was intended to spark job growth to reverse the worst recession since the Great Depression. How was this supposed to work?   The short answer is that $1 of spending in one area of the economy multiplies into more than $1 of spending throughout the economy. Note: Remind the students that the Circular Flow diagram showed that money spent by one person is received as income by another person. Thinking bank to this diagram will help to understand the spending multiplier.    The consumption function is an equation showing how an individual household’s consumer spending varies with the household’s current disposable income. The simplest version of a consumption function is a linear equation: c = a + MPC yd Let’s assume that everyone in the economy spends 80% of every additional dollar of new disposable income. What would happen if there was an injection of new spending into the economy? Note: Create an example that uses a few of your students. Example: Ted is a chicken farmer in the local community. Suppose Ted decides to spend $1000 on some chicken coops at Anthony’s farm supply shop. This money now starts to be circulated around the economy. 1. Anthony now has $1000 from the sale and spends 80% ($800) on clothes at Marcia‘s boutique. 2. Marcia now has $800 from the sale and spends 80% ($640) to fix her car at Pat’s garage. 3. Pat now has $640 from the sale and spends 80% ($512) at Dianna’s grocery store. 4. Dianna now has $512 from the sale and spends 80% ($409.60) with Catherine’s catering company. After 5 rounds of spending, we’ve created $2361.60, more than DOUBLE the original injection of spending!!!!! If we had continued until someone was trying to spend 80% of nothing, Ted’s initial $1000 purchase would have multiplied to a total of $5000 in income/spending. The spending multiplier can be shown to be equal to: M = 1/(1-MPC) = 1/(1-.80) = 1/.2 = 5 Since MPC + MPS = 1, we can also say that M=1/MPS In the macroeconomy: The multiplier is the ratio of the total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change. DAAS is the autonomous change in aggregate spending DY is the total change in real GDP. Multiplier is equal to DY/DAAS, or 1 / (1 – MPC) Multiplier = ∆Y _____ ∆AAS = 1 _________ (1 - MPC)

Current Disposable Income and Consumer Spending Relationship between Disposable Income and Consumer Spending Consumption Function Autonomous Consumer Spending (A) Aggregate Consumption Function C = A + MPC X DI Generally the consumption function is modeled: c = a + MPC yd   Using the hypothetical information from the table above: c = 5 + .80Yd If Yd increases from $10 to $20, C increases from $13 to $21. This is seen as a movement upward along the fixed consumption function. What would cause C to increase, no matter the level of Yd? There are several factors that will shift the consumption function upward or downward.

Shifts of the Aggregate Consumption Function Changes in Expected Future Disposable Income Permanent Income Hypothesis Changes in Aggregate Wealth Life-cycle Hypothesis Note: remind your students of the demand and supply “shifters” from earlier in the course. These are similar by increasing or decreasing consumption at all levels of current disposable income.   1. Changes in Expected Future Disposable Income Suppose a college senior was about to graduate and already had a job lined up. In other words, she knows that her current disposable income was going to rise. This expectation of more income in the future shifts the consumption function upward Wealth is accumulated assets, and this is very different from disposable income. If you own a house, a car, shares of stock or even a savings account, you have wealth. Suppose that the stock market has a bad year and the value of your wealth substantially declines. This lost wealth, even if it is only on paper, usually causes people to reduce their consumption. The consumption function shifts downward

Investment Spending Planned Investment Although consumer spending is much larger than investment spending, booms and busts in investment spending tend to drive the business cycle. In fact, most recessions originate as a fall in investment spending.

The Interest Rate and Investment Spending A decrease in the real interest rate will result in more gross private investment When a firm considers investment spending, they are really doing a little benefit-cost analysis on the dollars they are about to spend.   Example: A firm is considering building a new factory. This will increase sales, but it will also require borrowing to fund the investment. Expected return on the investment = expected economic profit from the factory = (total revenue minus total cost)/investment cost. The market interest rate is the cost of investment. 1. Interest rate is cost of borrowed funds. 2. Interest rate is also cost of investing your own funds (no borrowing), since it is income forgone. The factory will only go ahead if the firm expects a rate of return higher than the cost of the funds they would have to borrow to finance that project. If the interest rate rises, fewer projects will pass that test, and as a result investment spending will be lower. Thus there is a negative relationship between the interest rate and dollars of investment spending. r r’ I I’

Expected Future Real GDP, Production Capacity, and Investment Spending eve Expected Future Real GDP, Production Capacity, and Investment Spending An increase in either expected future real GDP or production capacity will result in more investment at the same interest rate There are some factors that would increase investment spending at any interest rate.   Expected Future Real GDP Suppose a firm believed that the economy was really going to take off next year. This firm might increase investment spending in anticipation of increased sales. After all, you can’t build a factory overnight; the firm must begin the factory now to take advantage of more customers in the coming year. Production Capacity Suppose a firm can produce 100,000 units if the factory is producing 24/7. The firm’s full capacity is 100,000 units. Right now, the firm has enough customers to produce only 50%, or 50,000 units, of full capacity. A firm in this situation would not likely be looking to increase investment. After all, if orders from customers were to increase, it would be easy to satisfy those orders without increasing the size of the factory. The best conditions for new investment spending consists of firms that are near production capacity with expectations of strong real GDP in the future. r I I’