1. Income and Expenditure
Chapter 11

2. The Multiplier Effect
A closer examination of C + I + G reveals an interesting phenomena:
Increases in spending (C + I + G) lead to an increase in GDP that is greater than the original spending increase!
Why does this happen?

3. The Multiplier Effect
Suppose a business invests $1 million in new capital (capital investment)
That $1 million turns into $1 million in income for the workers that produce the capital investment
Those workers then spend that income, or at least a percentage of that income

4. The Multiplier Effect
Whatever percentage they spend, becomes income for other workers.
Who, in turn, spend a percentage of that income.
And so on
And so on…to a certain point

5. The Multiplier Effect
Thus, there is a MULTIPLIER EFFECT that ripples throughout the economy.
An original business investment of $1 million has brought about a much greater increase in Real GDP

6. The Multiplier Effect How large is the total affect?
What percentage of total disposable income is likely to be consumed (spent?)
The AVERAGE PROPENSITY TO CONSUME (APC)
What percentage of total disposable income is likely to be saved?
The AVERAGE PROPENSITY TO SAVE (APS)

7. The Multiplier Effect The Marginal Propensity to Consume (MPC)
The increase in consumer spending when disposable income rises by $1
The Marginal Propensity to Save (MPS)
The increase in savings when disposable income rises by $1
∆ Consumer Spending
∆ Disposable Income
MPC =
∆ Consumer Savings
∆ Disposable Income
MPS =

8. MPC and MPS The Spending Multiplier =
Because you must either spend or save additional income, MPC + MPS = 1
The Spending Multiplier =
(1-MPC) OR MPS

9. The Multiplier Effect
An autonomous change in aggregate spending is an initial change in the desired level of spending by firms, households, or government at a given level of real GDP.
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.

10. The Spending Multiplier
(1-MPC)
Multiplier = 1
MPS
∆Y = Multiplier X ∆S
The Spending Multiplier
What is the multiplier if MPC is .9? 10
What is the multiplier if MPS is .25 4
So, a $1 million increase in capital investment spending, with an MPC of .8, would result in how much of an increase in GDP?
$5 Million

11. __∆ Spending____
∆ Disposable Income
Multiplier = 1___
(1-MPC)
MPC =
Practice
∆Y = Multiplier X ∆S
Multiplier = 1__
MPS
If you disposable income increases from $10,000 to $15,000, and your consumption increases from $9,000 to $12,000, what is your MPC?
If disposable incomes increases by $5 billion and consumer spending increases by $4 billion, what is the MPC?
If the MPC is 0.9 and investment spending increases by $50 billion, what will be the change in GDP (assume no taxes or trade)?
Suppose investment spending increases by 50 billion and as a result the equilibrium income increases by $200 billion. What is the investment multiplier?

12. Increase Government Spending OR Cut Taxes?
With an MPC of .75, which would provide a greater impact on the economy:
A $100 billion increase in Government spending or
A $100 billion tax cut?
A $100 billion increase in G…Why?

13. Increase Government Spending OR Cut Taxes?
The initial impact of the Government spending will be $100 billion in Consumption by Government.
Followed by .75 of the income earned being consumed (.25 saved).
The tax cut will initially lead to 75% of the $100 billion being “consumed” and 25% saved.

14. Increase Government Spending OR Cut Taxes?
So, it actually takes a LARGER tax cut to bring about the same impact as an increase in government spending.

15. Disposable Income and Consumer Spending, 2003
What do you notice
about the relationship?
For each income group, average disposable income in 2003 is plotted versus average consumer spending in For example, point A shows that among the group with an annual income of $40,000 to $49,999, average disposable income was $42,842 and average consumer spending was $39,757. The data clearly show a positive relationship between disposable income and consumer spending: higher disposable income leads to higher consumer spending.
What do you notice?

16. The Consumption Function Graph
Shows the relationship between CONSUMPTION and DISPOSABLE INCOME (Personal Income – taxes).
Shows SAVINGS and DISSAVINGS

17. The Consumption Function Graph
The consumption function relates a household’s current disposable income to its consumer spending. The vertical intercept, a, is individual household autonomous spending: the amount of a household’s consumer spending if its current disposable income is zero. The slope of the consumption function line, cf, is the marginal propensity to consume, or MPC: of every additional $1 of current disposable income, C MP – $1 of it is spent.

18. Aggregate Consumption Function, 2003
The data from the figure from slide 5 are reproduced here, along with a line drawn to fit the data as closely as possible. For American households in 2003, the best estimate of a is $14,184 and the best estimate of MPC is 0.597, or approximately 0.6.

19. Aggregate Consumption Function, 2009
Autonomous
Consumer
Spending is
$17,594.
MPC =
0.52
For American households in 2009, the best estimate of the average household’s autonomous consumer spending is $17,594, and the best estimate of the MPC is 0.518, or 0.52.

20. What might have happened to change?
Comparison 2003 to 2009
2003
Autonomous Consumer Spending is $14,184.
MPC = 0.6
2009
Autonomous Consumer Spending is $$17,594.
MPC = 0.52
What might have happened to change?

21. Shifts in the Aggregate Consumption Function
Changes in Expected Future Disposable Income
Expect increase in future DI – Shifts Consumption Function up (increases)
Changes in Aggregate Wealth (The Wealth Effect)
Greater wealth (overall assets, including the value of stocks, not just income) leads to greater consumption

22. Shifts in Aggregate Consumption Function
The effect of an increase in expected future disposable income. Consumers will spend more at every given level of current disposable income, YD. As a result, the initial aggregate consumption function CF1, with aggregate autonomous spending 1, shifts up to a new position at CF2 and aggregate autonomous spending A2. An increase in aggregate wealth will also shift the aggregate consumption up.

23. Shifts in Aggregate Consumption Function
The effect of a reduction in expected future disposable income. Consumers will spend less at every given level of current disposable income, DY. Consequently, the initial aggregate consumption function CF1, with aggregate autonomous spending A1, shifts down to a new position at CF2 and aggregate autonomous spending A2. A reduction in aggregate wealth will have the same effect.

24. Practice
Check Your Understanding 11-2.

25. Investment Spending Business spending on capital goods
Includes changes in inventory
Includes all construction: business and home

26. Investment Spending Vital to economic growth
Consumer spending is larger than investment spending.
Investment spending drives the business cycle.
Most recessions originate with a fall in investment.

27. Investment Change During Six Recessions

28. Investment Spending
Planned investment spending is the investment spending that business intend to undertake during a given period.
Most dependant on the cost of borrowing (INTEREST RATES)
Higher interest rates = higher costs = lower Investment
Lower interest rates = lower costs = greater Investment

29. Investment Spending
According to the accelerator principle, a higher growth rate of real GDP leads to higher planned investment spending, but a lower growth rate of real GDP leads to a lower planned investment spending.
In 2006, when real GDP growth turned negative, planned investment spending especially in residential investment spending—plunged, accelerating the economy’s slide into recession.

30. Investment Spending and Inventory
Inventories are stocks of goods held to satisfy future sales.
Inventory investment is the value of the change in total inventories held in the economy during a given period.
Unplanned inventory investment occurs when actual sales are more or less than businesses expected, leading to unplanned changes in inventories.
Actual investment spending is the sum of planned investment spending and unplanned inventory investment.
I = Iunplanned + Iplanned

31. Income-Expenditure Model and Assumptions
Income-Expenditure model shows how changes in spending including investment spending lead to changes in real GDP through the actions of the multiplier.
Assumption: Changes in overall spending lead to changes in aggregate output.
Assumption: The interest rate is fixed.
Assumption: Taxes, government transfers, and government purchases are all zero.
Assumption: Exports and imports are both zero.

32. Planned Aggregate Spending and Real GDP
GDP = C + I
YD = GDP
C = A + MPC *YD
AEPlanned = C + IPlanned
Planned aggregate spending is the total amount of planned spending in the economy.
Assumed that government spending and exports-imports are zero so
GDP = C + I.
The consumption function

33. Planned Aggregate Spending and Real GDP
AEplanned = C + Iplanned
The level of planned aggregate spending in a given year depends on the level of real GDP in that year.
Assume C = x YD, Iplanned =500
If GDP = 500, YD = 500, C= x500=600, and AEplanned = 1100

34. Aggregate Consumption Function and Planned Aggregate Spending
Showing the table graphically,
The lower line, CF, is the aggregate consumption function constructed from the data. The upper line, AEPlanned, is the planned aggregate spending line, also constructed from the data. It is equivalent to the aggregate consumption function line shifted up by $500 billion, the amount of planned investment spending, IPlanned.

35. Income-Expenditure Equilibrium
The economy is in income–expenditure equilibrium when GDP is equal to planned aggregate spending.
Income–expenditure equilibrium GDP is the level of GDP at which GDP equals planned aggregate spending.

36. Income-Expenditure Equilibrium
Income–expenditure equilibrium occurs at E, the point where the planned aggregate spending line, AEPlanned, crosses the 45-degree line. At E, the economy produces GDP* of $2,000 billion, the only point at which GDP equals planned aggregate spending, AEPlanned, and unplanned inventory investment, IUnplanned, is zero. At any level of GDP less than GDP*, AEPlanned exceeds GDP. As a result, unplanned inventory spending, Iunplanned, is negative and firms respond by increasing reduction. At any level of GDP greater than GDP*, GDP exceeds AEPlanned. Unplanned inventory investment, Iunplanned, is positive and firms respond by reducing production.

37. Keynesian Cross
The Keynesian cross diagram identifies income-expenditure equilibrium as the point where the planned aggregate spending line crosses the 45-degree line.
Developed by Paul Samuelson.

38. Multiplier Process and Inventory Adjustment
When planned spending by households and firms does not equal the current aggregate output by firms, this difference shows up in changes in inventories.
Over time, the firms’ response to inventory changes moves real GDP to equilibrium.
Changes in inventories are considered a leading indicator of future economic activity.

39. Multiplier Process and Inventory Adjustment
Panel (a) illustrates the change in GDP* caused by an autonomous increase in planned spending. The economy is initially at equilibrium point E1 with an equilibrium GDP1* equal to 2,000. AEPlanned increases by 400 and shifts the planned aggregate spending line upward by 400. The economy is no longer in income–expenditure equilibrium: GDP is equal to 2,000, but AEPlanned, is now 2,400, represented by point X. The vertical distance between the two planned aggregate spending lines, equal to 400, represents IUnplanned = – 400—the negative inventory investment that the economy now experiences. Firms respond by increasing production, and the economy eventually reaches a new income–expenditure equilibrium at E2 with a higher level of equilibrium GDP, GDP2*, equal to 3,000. The increase in GDP* is several times larger than the autonomous increased in planned spending, reflecting the effects of the multiplier on the economy.
Panel (b) shows the corresponding rightward shift of the AD curve generated by the increase in AEPlanned. The change in GDP*, from GDP1* to GDP2*, corresponds to the increase in quantity demanded of aggregate output at any given aggregate price level.

40. The Paradox of Thrift
In the Paradox of Thrift, households and producers cut their spending in anticipation of future tough economic times.
It is called a paradox because what’s usually “good” (saving to provide for your family in hard times) is “bad” (because it can make everyone worse off).