Introduction. Learning Objectives. Learning Objectives. Economics Today Twelfth Edition. Chapter 12 Consumption, Income, and the Multiplier

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Roger LeRoy Miller Economics Today Twelfth Edition Chapter 12 Consumption, Income, and the Multiplier Introduction Consumption spending by households is the largest component of U.S. GDP.

1 Roger LeRoy Miller Economics Today Twelfth Edition Chapter 12 Consumption, Income, and the Multiplier Introduction Consumption spending by households is the largest component of U.S. GDP. To the extent that more households now own shares of stock, how will volatility of stock market prices affect consumption behavior? Copyright 24 Pearson Addison Wesley. All rights reserved. Slide 12-2 Learning Objectives 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 Describe how equilibrium national income is established in the Keynesian model Evaluate why autonomous changes in total planned expenditures have a multiplier effect on equilibrium national income Understand the relationship between total planned expenditures and the aggregate demand curve Slide 12-3 Slide

2 Chapter Outline Chapter Outline Some Simplifying Assumptions in the Keynesian Model Determinants of Planned Consumption and Planned Saving Determinants of Investment Consumption as a Function of Real National Income Saving and Investment: Planned versus Actual Keynesian Equilibrium with Government and the Foreign Sector Added The Multiplier Slide 12-5 Slide 12-6 Chapter Outline Did You Know That... The Multiplier Effect When the Price Level Can Change The Relationship Between Aggregate Demand and the C + I + G + X Curve Periods of steady growth in investment spending are the exception rather than the rule for the U.S. economy? The relationship between investment spending and aggregate income was a focal point of John Maynard Keynes writings about industrial economies? Slide 12-7 Slide

3 Some Simplifying Assumptions in a Keynesian Model Keynes revisited Aggregate demand determines output (horizontal SRAS) We will examine the elements of aggregate demand (AD = C + I + G + X) Prices are fixed, so output is in real terms Some Simplifying Assumptions in a Keynesian Model Assumptions Businesses pay no indirect taxes (sales tax) Businesses distribute all profits to shareholders There is no depreciation The economy is closed Slide 12-9 Slide 12-1 Some Simplifying Assumptions in a Keynesian Model Definitions and relationships revisited Consumption Spending on new goods and services out of a household s current income Saving The act of not consuming all of one s income Savings Accumulation of past saving; a stock variable Some Simplifying Assumptions in a Keynesian Model Definitions and relationships revisited Disposable income = consumption (C) + saving (S) S = disposable income - C Slide Slide

4 Some Simplifying Assumptions in a Keynesian Model Investment The spending by business on things which can be used to produce goods and services in the future Determinants of Planned Keynes was concerned with changes in AD. AD = C + I + G + X Slide Slide Determinants of Planned Real Consumption and Saving Schedules: A Hypothetical Case Keynes argued that saving and consumption decisions depend primarily on an individual s real disposable income. Consumption Function The relationship between planned consumption expenditures and their current level of real income Slide Slide

5 A Shift in the Demand Curve A Shift in the Demand Curve Planned Real Consumption (C, dollars per year) 6, 48, 36, 24, 12, 6, B A Break-even income 45 o C D E F G C = Y d Consumption function 12, 24, 36, 48, 6, Real Disposable Income (Y d dollars per year) H I J K Real Disposable Income (Y d dollars per year) Figure 12-1 Slide Slide Planned Real Consumption (C, dollars per year) Autonomous consumption 6, 48, 36, 24, 12, 6, B A Break-even income C D E 45 o Dissaving 12, 24, 36, F Saving G H C = Y d I J K Consumption function 48, 6, (Equal vertical distance) The Consumption and Saving Functions The Consumption and Saving Functions Planned Real Saving (S, dollars per year) 6, -6, A B 12, C D 24, E F K J I H G 36, 48, 6, Planned Real Saving (S, dollars per year) 6, -6, A 12, Dissaving C B D 24, E F K J I H Saving G 36, 48, 6, Real Disposable Income (Y d dollars per year) Real Disposable Income (Y d dollars per year) Slide Figure 12-1 Slide

6 Determinants of Planned Dissaving Negative saving; spending exceeds income Autonomous Consumption The part of consumption that is independent of the level of disposable income Slide Determinants of Planned Average Propensity to Consume (APC) Consumption divided by disposable income The proportion of total disposable income that is consumed APC = consumption real disposable income Slide Determinants of Planned Average Propensity to Save (APS) Saving divided by disposable income The proportion of total disposable income that is saved Determinants of Planned Question What is your APC and APS? APS = saving real disposable income Slide Slide

7 Determinants of Planned Determinants of Planned Example Example Income = $54, Income increases by $6, to $6, C= $49,2 C = $54, S = $4,8 S = $6, What is the APC? What is the APC? APC = $49,2 APC = $54, $6, =.9 $54, =.911 Slide Slide Determinants of Planned Marginal Propensity to Consume (MPC) The ratio of the change in consumption to the change in disposable income Determinants of Planned Marginal Propensity to Save (MPS) The ratio of the change in saving to the change in disposable income MPC = change in consumption change in real disposable income MPS = change in saving change in real disposable income Slide Slide

8 Determinants of Planned The Consumption and Saving Functions Causes of shifts in the consumption function Non-income determinants of consumption Population Wealth Can you think of other non-income determinants of consumption? Planned Real Consumption (C, dollars per year) C 2 C 1 45 o C 2 C 1 Assume positive economic expectations Y 1 Y 2 Real Disposable Income (Y d dollars per year) Slide Slide 12-3 The Consumption and Saving Functions Determinants of Investment 45 o Planned Real Consumption (C, dollars per year) C 1 C 2 C 1 C 2 Assume wealth decreases AD = C + I + G + X Historically Investment has been more volatile than consumption Y 2 Y 1 Real Disposable Income (Y d dollars per year) Why? Slide Slide

9 Planned Investment Planned Investment Planned Investment Figure 12-2, Panel (a) Slide Figure 12-2, Panel (b) Slide Determinants of Investment Graphing Changes Investment Changes in Investment What causes the investment function to shift? Expectations Productive technology Business taxes Planned Real Consumption (C, dollars per year) r 1 I1 Positive profit outlook I 2 I 1 I 2 Real Disposable Income (Y d dollars per year) Slide Slide

10 Graphing Changes in Investment Consumption as a Function of Real National Income Planned Real Consumption (C, dollars per year) r 1 I 2 I 1 I 2 I 1 Taxes increase Consumption, in recent years,has been a function of disposable income (Y d ). Y d is less than national income (Y). If the difference is constant then Y can be substituted for Y d. Real Disposable Income (Y d dollars per year) Slide Slide Consumption as a Function of Real National Income Consumption as a Function of Real National Income The second component of private aggregate demand is investment spending, I. Figure 12-3 Slide Slide

11 Combining Consumption and Investment Combining Consumption and Investment The equilibrium interest rate is determined by S and I There is no relationship between I and Y I is 1.1 at all levels of Y Given S and I, the interest rate = 5% and S and I = 1.6 trillion I is autonomous Figure 12-4, Panel (a) Slide Figure 12-4, Panel (b) Slide Combining Consumption and Investment Saving and Investment: Planned versus Actual Equilibrium The intersection of the planned saving and planned investment schedules C + I = total planned expenditures Equilibrium: C + I = Y Equilibrium Y = $9 trillion No tendency for businesses to alter the rate of production or the level of employment There are no unplanned inventory changes Figure 12-4, Panel (c) Slide Slide

12 Planned and Actual Rates of Saving and Investment Planned and Actual Rates of Saving and Investment Saving and Investment per Year Saving and Investment per Year Unplanned inventory decrease = $4 billion per year E Actual S = actual I S I Real National Income per Year Real National Income per Year Slide Slide Planned and Actual Rates of Saving and Investment Planned and Actual Rates of Saving and Investment Saving and Investment per Year Figure 12-5 Unplanned inventory decrease = $4 billion per year Actual S = actual I E Unplanned inventory decrease = $4 billion per year Actual S = actual I Planned investment = $1.6 trillion per year Real National Income per Year Slide S I Observations Equilibrium: S planned = I planned I = I planned + I unplanned S = I at all Y levels Only at equilibrium is S planned = I planned When S planned does not equal I planned the economy adjusts Slide

Keynesian Equilibrium with Government and the Foreign Sector Added Government (G) C + I + G Federal, state, and local Does not include transfer payments Is autonomous Lump-sum taxes = G Lump-Sum Tax

13 Keynesian Equilibrium with Government and the Foreign Sector Added 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 Slide Keynesian Equilibrium with Government and the Foreign Sector Added The Foreign Sector C + I + G + X Net exports (X) = exports - imports Autonomous Depends on the economic conditions in each country Slide 12-5 The Determination of Equilibrium Real National Income with Net Exports The Equilibrium Level of Real National Income Slide Figure 12-6 Slide

14 The Equilibrium Level of Real National Income The Multiplier Observations If C + I + G + X = Y Equilibrium 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 Y returns to equilibrium Slide Multiplier The ratio of the change in the equilibrium level of real national income to the change in autonomous expenditures Slide The Multiplier The Multiplier C + I Planned Consumption and Investment per Year C + I = Y 45 o C Planned Consumption and Investment per Year C + I = Y 45 o C Real National Income per Year Slide Real National Income per Year Slide

15 The Multiplier The Multiplier Planned Consumption and Investment per Year C + I = Y 45 o C + I C Without I equilibrium = $3.5 With I equilibrium = $9 The change in Y (5.5) was 5 times the change in I (1.1) Question How can $1.1 trillion of I generate $5.5 trillion of Y? Answer The autonomous spending multiplier Real National Income per Year Slide Slide The Multiplier Process The Multiplier Assumption: MPC =.8 or 4/5 Annual Increase Annual Increase Annual Increase in Real in Planned in Planned National Income Consumption Saving Round ($ billions) ($ billions) ($ billions) 1 ($1 billion per year increase in I) All later rounds The multiplier formula Multiplier = MPC = 1 MPS Totals (C+I+G) Slide Slide

16 The Multiplier The Multiplier Examples MPC = 4 5 MPC = 3 4 MPC = 2 3 MPC = 3 5 MPC = 7 9 MPS = 1 5 MPS = 1 4 MPS = 1 3 MPS = 2 5 MPS = 2 9 Mult. = 1 1/5 = 5 Mult. = 1 1/4 = 4 Mult. = 1 1/3 = 3 Mult. = 1 5/2 = 2.5 Mult. = 1 9/2 = 4.5 Question How does the size of the MPC influence the value of the multiplier? Answer The smaller the MPS, the larger the multiplier The larger the MPC, the larger the multiplier Slide Slide The Multiplier The Multiplier Measuring the Change in Equilibrium Income from a Change in Autonomous Spending Change in equilibrium income = multiplier x change in level of real autonomous spending Question What does the multiplier tell us about the potential impact on the economy for a change in autonomous spending? Slide Slide

17 The Multiplier Effect When the Price Level Can Change Multiplier Effect on Equilibrium of Real National Income The multiplier effect on equilibrium real national income will not be as great if part of the increase in nominal national income occurs because of increases in the price level. Price Level 12 LRAS SRAS With $1 billion increase in autonomous spending AD 2 AD Slide Figure 12-7 Real National Income per Year Slide Multiplier Effect on Equilibrium of Real National Income Multiplier Effect on Equilibrium of Real National Income Price Level LRAS SRAS With price adjustment the multiplier effect is less Real national income increases to $12.3 billion With $1 billion increase in autonomous spending AD 2 Consumption, Investment, Government Purchases, and Net Exports E 1 (C + I + G + X) 1 AD Real National Income per Year Slide Real Income Slide

18 Multiplier Effect on Equilibrium of Real National Income Multiplier Effect on Equilibrium of Real National Income (C + I + G + X) 1 (C + I + G + X) 1 Consumption, Investment, Government Purchases, and Net Exports E 2 E 1 (C + I + G + X) 125 Consumption, Investment, Government Purchases, and Net Exports E 2 E 1 (C + I + G + X) 125 Assume prices increase to 125 C + I + G + X decreases Equilibrium Y falls to $1 trillion 1 12 Real Income Slide Real Income Slide 12-7 The Relationship Between Aggregate Demand and the C + I + G + X Curve The Relationship Between Aggregate Demand and the C + I + G + X Curve 125 B AT P = 1, Y = $12 trillion (A) AT P = 125, Y = $1 trillion (B) Price Level 1 A Price Level 1 A AD AD 12 Real National Income per Year Slide Figure Real National Income per Year Slide

19 Issues and Applications: Is There a Link Between Consumption and the Stock Market? The level of autonomous consumption spending depends on various factors, including the market value of household wealth. More than half of U.S. households own shares of stock. Declines in the market value of these equity shares will dampen autonomous consumption spending. Web Links The following Web links appear in the margin of this chapter in the textbook: Slide Slide Summary Discussion of Learning Objectives The difference between saving and savings and the relationship between consumption and saving is a flow over time while savings is a stock consumption plus saving equals disposable income Summary Discussion of Learning Objectives The primary determinants of planned investment are the interest rate, business expectations, productive technology, and business taxes. The key determinant of consumption and saving in the Keynesian model is disposable income. Slide Slide

20 Summary Discussion of Learning Objectives In the Keynesian model equilibrium national income occurs where the C + I + G + X schedule crosses the 45 degree line. Autonomous changes in total planned expenditure have a multiplier effect on equilibrium national income because an increase in autonomous expenditures increases income which increases consumption. Summary Discussion of Learning Objectives The relationship between total planned expenditures and the aggregate demand curve is inverse. An increase in the price level reduces planned expenditures. Real balance effect Interest rate effect Open economy effect Slide Slide End of Chapter Chapter 12 Consumption, Income, and the Multiplier Copyright 24 Pearson Addison Wesley. All rights reserved. 2

Introduction. Learning Objectives. Learning Objectives. Chapter 12. Consumption, Real GDP, and the Multiplier

Introduction. Learning Objectives. Learning Objectives. Chapter 12. Consumption, Real GDP, and the Multiplier Chapter 12 Consumption, Real GDP, and the Multiplier Introduction Investment spending by businesses is a key component of economic growth. Expenditures on information technology were once expected to provide