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

2. Introduction
Since the early 2000s, planned real investment spending has increased in most of the world’s nations.
As a percentage of global real GDP, however, planned real investment spending in the world’s developed countries has declined. Yet, it has been rising in emerging-economy nations. These are countries transitioning to a developed status.
How do changes in planned real investment spending affect a country’s real GDP?
Reading Chapter 12 will help you answer this question.

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

4. 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

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

6. 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

7. Did You Know That ...
The share of real GDP allocated to real consumption spending is:
66 percent in Germany
60 percent in the United Kingdom
70 percent in the United States
Less than 41 percent in China?
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.

8. 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

9. 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

10. 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

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

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

13. 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

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

15. 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

16. Determinants of Planned Consumption and Planned Saving (cont'd)
Keynes argued that:
The interest rate is not the most important factor in saving and consumption decisions
Rather, real saving and consumption decisions depend primarily on a household’s real disposable income.
Furthermore, a person’s anticipation about future flows of income influences how much of current income is allocated to consumption and how much is allocated to saving.

17. Determinants of Planned Consumption and Planned Saving (cont'd)
The Life-Cycle Theory of Consumption
The most realistic and detailed theory of consumption, often called the life-cycle theory of consumption, considers how a person varies saving and consumption as income ebbs and flows throughout an entire life span.
This theory predicts that when an individual anticipates a higher income in the future, he or she will tend to consume more and save less in the current period than would have been the case otherwise.

18. Determinants of Planned Consumption and Planned Saving (cont'd)
The Permanent Income Hypothesis
A related theory, called the permanent income hypothesis, suggests that the income level that matters for a person’s decisions about current consumption and saving is permanent income, or expected average lifetime income.
Thus, if a person’s flow of income temporarily rises without an increase in average lifetime income, the person responds by saving more and leaving consumption unchanged.

19. Determinants of Planned Consumption and Planned Saving (cont'd)
The Keynesian Theory of Consumption and Saving
Keynes argued that real consumption and saving decisions depend primarily on a household’s current real disposable income.

20. 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

21. 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

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

23. 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

24. Figure 12-1 The Consumption and Saving Functions

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. Determinants of Planned Consumption and Planned Saving (cont'd)
Some relationships
APC + APS  1
MPC + MPS  1 32

33. 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

34. 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)

35. Example: Lower Household Wealth and Subdued Growth in Consumption
Between 2007 and 2009, there was a substantial decline in two key components of real household wealth.
Inflation-adjusted wealth in housing fell by 25 percent
Inflation-adjusted wealth in corporate stocks fell by 50 percent
These wealth reductions shifted the U.S. consumption function downward.
Real disposable income also fell, causing a leftward movement along the consumption function and a further drop in consumption.

36. 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

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

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

39. Example: Adding a Third Dimension Requires New Investment Spending
Of the approximately 40,000 movie screens in the United States, fewer than 8,000 are equipped with digital technology required for projection of three-dimensional (3D) movies.
Conversion to the 3D technology costs about $70,000.
Major movie-theater chains are currently undertaking this investment for more than 1,000 theaters.
This adds up to an aggregate investment expenditure of about $700 million.

40. 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

41. Figure 12-3 Consumption as a Function of Real GDP

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

43. Figure 12-4 Combining Consumption and Investment

44. 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

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

46. 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

47. 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

48. 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

49. Government (G): C + I + G Lump-Sum Tax
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

50. 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

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

52. 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

53. Figure 12-6 The Equilibrium Level of Real GDP

54. 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

55. 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

56. 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

57. Table 12-3 The Multiplier Process

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

59. 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

60. 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

61. 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

62. 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

63. What If The government seeks a larger multiplier effect by funding private spending on certain items rather than buying them directly?
Whether the government gives funds to households and firms for purchasing goods or whether the government makes the purchases directly, the resulting increase in total autonomous expenditure is the same.
Thus, the overall multiplier effect on equilibrium real GDP would also be the same.
So, providing grants of public funds to be spent by households and firms rather than having government purchase the same items will not enlarge the overall theoretical multiplier effect.

64. 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

65. 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

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

67. International Example: The Effect of Higher Autonomous Spending on China’s Real GDP
Most estimates indicate that the marginal propensity to consume in China is about 0.50.
So, assuming no change in the price level, the multiplier would be about 2.
However, economists have estimated that the short-run effect of an initial increase in real autonomous spending on China’s real GDP is only about 1.1.
Therefore, once the higher price level is taken into account, an additional one-unit increase in real autonomous expenditure causes a 1.1 unit increase in China’s annual real GDP.

68. The Relationship Between Aggregate Demand and the C + I + G + X Curve
Aggregate demand consists of:
Consumption
Investment
Government
Foreign sector 68

69. 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

70. 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

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

72. Real disposable income fell by 0.3 percent during the month.
You Are There: Evaluating the Effects of Declining Real Disposable Income
Mark Vitner, an economist with Wells Fargo bank, examines the latest monthly economic data.
Real disposable income fell by 0.3 percent during the month.
Real consumption spending and real saving dipped as well, consistent with the theory.
Vitner summarizes the situation by saying that household budgets are getting tighter and consumers are having difficulty maintaining their standard of living. 72

73. Issues & Applications: A Global Reversal in Planned Investment Spending
In the past, developed countries have displayed the largest upward shifts in their planned investment functions.
Recently, however, larger upward shifts have occurred among the emerging-economy nations, such as China, India, South Korea, and Singapore.
Figure 12-9 on the next slide displays real investment spending as a percentage of global real GDP for developed and emerging nations.

74. Figure Real Investment Spending as a Percentage of Global Real GDP in Two Groups of Nations since 1995
Sources: International Monetary Fund; author’s estimates.

75. Issues & Applications: A Global Reversal in Planned Investment Spending (cont’d)
Variations in planned real investment spending operate through the multiplier to bring about changes in equilibrium real GDP.
Therefore, a country that experiences a larger upward shift in its planned investment function will observe a greater increase in its equilibrium real GDP.
This explains why countries such as China, India, South Korea, and Singapore are emerging to take a place alongside developed nations.

76. 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

77. 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

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

79. 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

80. 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

81. 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

82. Figure C-1 Graphing the Multiplier