Consumption, Real GDP, and the Multiplier

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

Introduction In recent years, the federal government has reported U.S. households save close to 0% of their income. Is the U.S. rate of saving really that low? How does the share of income that goes to saving matter for the U.S. economy? You will find out in this chapter. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Chapter Outline Some Simplifying Assumptions in a Keynesian Model
Determinants of Planned Consumption and Planned Saving Determinants of Investment Determining Equilibrium Real GDP Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Some Simplifying Assumptions in a Keynesian Model
To simplify the income determination model Businesses pay no indirect taxes (sales tax) Businesses distribute all profits to shareholders There is no depreciation The economy is closed; no foreign trade Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Some Simplifying Assumptions in a Keynesian Model (cont'd)
You can do only two things with income (in absence of taxes): consume it or save it 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. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Investment Spending by businesses on things such as machines and buildings (i.e. capital goods), 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. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Spending on Human Capital: Investment or Consumption?
Economists define human capital as the accumulation of investments and training in education. From this perspective, educational expenses should be regarded as a form of investment spending. Nevertheless, in official U.S. government statistics, household spending on education is classified as consumption. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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, the less they wanted to consume. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Determinants of Planned Consumption and Planned Saving (cont'd)
Keynes argued that real saving and consumption decisions depend primarily on a household’s real disposable income. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Table 12-1 Real Consumption and Saving Schedules: A Hypothetical Case
We see from Table 12-1 that as Real Disposable Income rises, Planned Real Consumption also rises, but by a smaller amount, as Keynes suggested. Planned Real Saving also increases with disposable income. Notice, however, the dissaving that takes place in incomes of less than $30,000. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

45-Degree Reference Line The line along which planned real expenditures equal real GDP per year Drawn equidistant from both the horizontal and vertical axes (i.e. at a 45-degree angle). Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 12-1 The Consumption and Saving Functions
Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 12-1 The Consumption and Saving Functions (cont'd)

Autonomous Consumption The part of consumption that is independent of the level of disposable income Represented by A on Figure 12-1, where real disposable income is zero but planned consumption is still $6000 Changes in autonomous consumption shift the consumption function. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Causes of shifts in the consumption function A change besides real disposable income will cause the consumption function to shift. There is a virtually unlimited number of such non- income determinants of consumption Population Changes in Expectations Wealth Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Wealth The stock of assets owned by a person, household, firm or nation For a household, wealth can consist of a house, cars, personal belongings, stocks, bonds, bank accounts, and cash. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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

Average Propensity to Consume (APC) Real consumption divided by real disposable income The proportion of total disposable income that is consumed Notice from column 4 in Table 12-1 that the APC decreases as real disposable income increases APC = Real consumption Real disposable income Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Average Propensity to Save (APS) Real saving divided by real disposable income (DI) Saved proportion of real DI Notice from Column 5 in Table 12-1 that the APS, which is at first negative, finally hits zero at an income level of $30,000 and then becomes positive APS = Real saving Real disposable income Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Marginal Propensity to Consume (MPC) The ratio of the change in real consumption to the change in real disposable income Indicates how much you will change your planned rate of consumption if there is a change in your real disposable income A MPC of .8 tells us that an additional $100 in take- home pay will lead to an additional $80 consumed MPC = Change in real consumption Change in real disposable income Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Marginal Propensity to Save (MPS) The ratio of the change in saving to the change in disposable income A MPS of .2 indicates that out of an additional $100 in take-home pay, $20 will be saved. MPS + MPC must always equal 1, by definition MPS = Change in real saving Change in real disposable income Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Some relationships Average propensity to consume and average propensity to save must sum to 100% of total income. Marginal propensity to consume and marginal propensity to save must sum to 100% of the change in income. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Determinants of Investment
Investment, you will remember, consists of expenditures on new buildings and equipment. Gross private domestic investment has been much more volatile than consumption. Consider the planned investment function, and shifts in the function. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 12-2 Planned Real Investment, Panel (a)
Because a project is only profitable if its rate of return exceeds the opportunity cost of the investment (i.e. the rate of interest), it follows that as interest rate falls, planned investment spending increases. In other words, the rate of planned investment is inversely related to the rate of interest. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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

Shifts in the Investment Function
Any change in a non-interest-rate variable can shift the investment function Future expectations Change in productive technology Change in business taxes Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Determining Equilibrium Real GDP
We are interested in determining the equilibrium level of real GDP per year Horizontal axis is no longer real disposable income but rather real GDP There will still be autonomous consumption Planned consumption equals real GDP along the 45-degree reference line Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 12-3 Consumption as a Function of Real GDP

Determining Equilibrium Real GDP (cont'd)
Recall…The Keynesian model was concerned with changes in AD Now we must add the investment function AD = C + I + G + X Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Recall from figure 11-2 that the equilibrium rate of interest is 5 percent, and the equilibrium rate of investment is $2 trillion per year… Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The $2 trillion of real investment per year is autonomous with respect to real GDP In other words, we can treat this level of investment as constant, regardless of the level of GDP. Businesses plan on investing a particular amount--$2 trillion per year--and will do so no matter what the level of real GDP See Panel (b) of Figure 12-4. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 12-4 Combining Consumption and Investment
To add our investment spending to our consumption function we simply add a line above the C line that we drew in Figure 12-3 that is higher by the vertical distance equal to $2 trillion of autonomous investment spending. Real GDP is equal to C + I at $11 trillion per year, for this is where the C + I line intersects the 45-degree reference line, on which C + I is equal to Y at every point. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 12-5 Planned and Actual Rates of Saving and Investment
Only at the equilibrium level of real GDP of $11 trillion per year will planned saving equal actual saving, planned investment equal actual investment, and hence planned saving equal planned investment. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unplanned increases in business inventories Consumers purchase fewer goods and services than anticipated (i.e. increased saving) This leaves firms with unsold products Firms will respond by cutting back production and employment, and we will move (left) to a lower level of real GDP Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Unplanned decreases in business inventories Consumers purchase more goods and services than anticipated (i.e. decreased saving) Firms will increase production of goods and services and increase employment and we will move (right) to a higher level of real GDP Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Keynesian Equilibrium with Government and the Foreign Sector Added (cont'd)
Government (G): C + I + G Federal, state, and local purchases Does not include transfer payments Is autonomous (determined by political process) We will simplify our model by assuming a lump-sum tax of $1.7 trillion per year to finance $1.7 trillion of G Lump-Sum Tax A tax that does not depend on income or the circumstances of the taxpayer Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The Foreign Sector: C + I + G + X Net exports (X) equals exports minus imports Depends on international economic conditions For simplicity, lets assume that imports exceed exports (net exports, X, is negative), and… Autonomous—independent of real national income Set at -$800 billion per year Copyright © 2008 Pearson Addison Wesley. All rights reserved.

We are now in a position to determine the equilibrium level of real GDP per year We must make certain assumptions… The SRAS is horizontal I, G, and X are autonomous Planned consumption is determined by the level of real GDP Remember that equilibrium always occurs when total planned real expenditures equal real GDP. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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

Figure 12-6 The Equilibrium Level of Real GDP

The Equilibrium Level of Real GDP
Observations If C + I + G + X = Y Equilibrium GDP 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 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The Multiplier (cont'd)
Let us look again at panel (c) of Figure 12-4… Question How can a $2 trillion increase in investment generate a $10 trillion increase in equilibrium real GDP? Answer The multiplier process. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Table 12-3 The Multiplier Process
We trace the effects of a permanent $100 billion increase in autonomous investment spending on the equilibrium level of real GDP. If we assume a marginal propensity to consume of .8, such an increase will eventually elicit a $500 billion increase in the equilibrium level of real GDP. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Examples MPC = 4 5 MPS = 1 Mult. = 1/5 = 5 MPC = 3 4 MPS = 1 Mult. = 1/4 = 4 MPC = 2 3 MPS = 1 Mult. = 1/3 = 3 MPC = 3 5 MPS = 2 Mult. = 1 2/5 = 2.5 MPC = 7 9 MPS = 2 Mult. = 1 2/9 = 4.5 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Measuring the change in equilibrium income from a change in autonomous spending Change in equilibrium real GDP = Multiplier x Change in autonomous spending Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The Multiplier in Practice
The United States is currently experiencing a recession and the government increases spending by $50 billion. If the marginal propensity to consume (MPC) is .75… What would be the multiplier? How much would the investment increase overall spending? What would happen to the multiplier if people saved more of their income? What would happen to the multiplier if people saved less of their income? If the multiplier is 4, how much additional government spending would be necessary to increase the economy by $1 million? If the multiplier is 4, how much would government have to cut spending in order to lower demand by $4 million? Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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. Complete Activity 27: The Magic of the Multiplier Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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
There is clearly a relationship; aggregate demand consists of consumption, investment, government, and the foreign sector. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The Relationship Between Aggregate Demand and the C + I + G + X Curve
There is a major difference, though, between… C + I + G + X curve drawn with price level constant—see Figure 12-9 (Slide 54) AD curve drawn with the price level changing Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The Relationship Between Aggregate Demand and the C + I + G + X Curve (cont'd)
To derive the aggregate demand curve from the C + I + G + X curve, we must now allow the price level to change. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 12-8 Relationship Between AD and the C + I + G + X Curve
In the upper graph, the C + I + G + X curve at a price level equal to 100 intersects the 45-degree reference line at $12 trillion of real GDP per year. That gives us point A (price level = 100; real income = $8 trillion) in the lower graph. When the price level increases to 200, the C + I + G + X curve shifts downward, and the new equilibrium level of real GDP is $10 trillion per year. This gives us point B in the lower graph. Connecting points A and B, we obtain the AD curve. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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

Consumption, Real GDP, and the Multiplier

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