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

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1 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 a bigger push to GDP expansion than they have. Why might investment spending and its effect on GDP be rather unpredictable? 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 GDP 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 Multiplier Effect on the Equilibrium Level of Real GDP Historically, investment spending has been the most volatile component of GDP? Economist John Maynard Keynes put forth one of the first theories about the relationship among personal consumption, investment spending, and economic growth? 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 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 Disposable income equals consumption plus saving. This accounting identity shows that each dollar of take-home income can either be spent or saved. 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 Table 12-1 Slide

5 The Consumption and Saving Functions The Consumption and Saving Functions Planned Real Consumption (C, dollars per year) 60,000 48,000 36,000 24,000 12,000 6,000 0 B A Break-even income 45 o C D E F G C = Y d Consumption function 12,000 24,000 36,000 48,000 60,000 Real Disposable Income (Y d dollars per year) H I J K 12,000 24,000 36,000 48,000 60,000 Real Disposable Income (Y d dollars per year) Figure 12-1 Slide Figure 12-1 Slide Planned Real Consumption (C, dollars per year) Autonomous consumption 60,000 48,000 36,000 24,000 12,000 6,000 0 B A Break-even income C D E 45 o Dissaving F Saving G H C = Y d I J K Consumption function (Equal vertical distance) The Consumption and Saving Functions The Consumption and Saving Functions Planned Real Saving (S, dollars per year) 6, ,000 A B 12,000 C D 24,000 E F K J I H G 36,000 48,000 60,000 Planned Real Saving (S, dollars per year) 6, ,000 A 12,000 Dissaving C B D 24,000 E F K J I H Saving G 36,000 48,000 60,000 Real Disposable Income (Y d dollars per year) Real Disposable Income (Y d dollars per year) Figure 12-1 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 Determinants of Planned Average Propensity to Consume (APC) Consumption divided by disposable income The proportion of total disposable income that is consumed APC = real consumption real disposable income Slide Slide Determinants of Planned Average Propensity to Save (APS) Saving divided by disposable income The proportion of total disposable income that is saved APS = real saving real disposable income Determinants of Planned Average propensity to consume and average propensity to save must sum to 100 percent of total income. Marginal propensity to consume and marginal propensity to save must sum to 100 percent of the change in income. Slide Slide

7 Determinants of Planned Determinants of Planned Example Example Income = $54,000 Income increases by $6,000 to $60,000 C= $49,200 C = $54,000 S = $4,800 S = $6,000 What is the APC? What is the APC? APC = $49,200 APC = $54,000 $60,000 =.90 $54,000 =.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 Causes of shifts in the consumption function Non-income determinants of consumption Population Wealth Can you think of other non-income determinants of consumption? International Example: Determinants of Investment Spending Investment expenditures by Japanese businesses were depressed throughout the 1990 s, even though interest rates were close to zero. The low cost of borrowing was not enough to offset the effect of poor prospects for growth in consumer spending. Slide Slide International Example: Determinants of Investment Spending Consumption as a Function of Real GDP Investment spending in Japan recovered only in 2002, as firms began to anticipate higher sales. Firms began replacing old equipment, and in some cases actually expanded their productive capacity. Slide Figure 12-3 Slide

9 Determinants of Investment Combining Consumption and Investment AD = C + I + G + X Historically Investment has been more volatile than consumption Why? Slide Figure 12-4, Panel (c) Slide Saving and Investment: Planned versus Actual Planned and Actual Rates of Saving and Investment Equilibrium The intersection of the planned saving and planned investment schedules No tendency for businesses to alter the rate of production or the level of employment There are no unplanned inventory changes Saving and Investment per Year ($ trillions) Unplanned inventory decrease = $400 billion per year E Actual S = actual I Real GDP per Year ($ trillions) S I Slide Figure 12-5 Slide

Planned and Actual Rates of Saving and Investment Keynesian Equilibrium with Government and the Foreign Sector Saving and Investment per Year ($ trillions) 2.4 2.0 1.6 1.

10 Planned and Actual Rates of Saving and Investment Keynesian Equilibrium with Government and the Foreign Sector Saving and Investment per Year ($ trillions) Unplanned inventory decrease = $400 billion per year Actual S = actual I E Unplanned inventory increase = $400 billion per year Actual S = actual I Planned investment = $1.600 trillion per year Real GDP per Year ($ trillions) S I 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 Figure 12-5 Slide Slide Keynesian Equilibrium with Government and the Foreign Sector The Determination of Equilibrium Real GDP with Net Exports The Foreign Sector C + I + G + X Net exports (X) = exports - imports Autonomous Depends on the economic conditions in each country Slide Table 12-2 Slide

11 The Equilibrium Level of Real GDP The Equilibrium Level of Real GDP 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 Figure 12-6 Slide Slide The Multiplier The Multiplier Multiplier The ratio of the change in the equilibrium level of real national income to the change in autonomous expenditures Question How can $1.1 trillion of I generate $5.5 trillion of Y? Answer The autonomous spending multiplier Slide Slide

12 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 ($100 billion per year increase in I) All later rounds The multiplier formula Multiplier = MPC = 1 MPS Totals (C+I+G) Table 12-3 Slide Slide The Multiplier The Multiplier Examples Question MPC = 4 5 MPS = 1 5 Mult. = 1 1/5 = 5 How does the size of the MPC influence the value of the multiplier? MPC = 3 4 MPC = 2 3 MPC = 3 5 MPS = 1 4 MPS = 1 3 MPS = 2 5 Mult. = 1 1/4 = 4 Mult. = 1 1/3 = 3 Mult. = 1 5/2 = 2.5 Answer The smaller the MPS, the larger the multiplier The larger the MPC, the larger the multiplier MPC = 7 9 MPS = 2 9 Mult. = 1 9/2 = 4.5 Slide Slide

13 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 Example: A Double-Whammy Multiplier Effect At the end of 2003, both investment spending and net exports increased for the U.S. economy. This amounted to a significant increase in autonomous spending. The Multiplier Effect When the Price Level Can Change The multiplier effect on equilibrium real GDP will not be as great if part of the increase in nominal GDP occurs because of increases in the price level. Due to the multiplier effect, the rate of overall GDP growth exceeded predictions. Slide Slide

14 The Multiplier Effect on the Equilibrium Level of Real GDP The Multiplier Effect on the Equilibrium Level of Real GDP LRAS SRAS LRAS SRAS With price adjustment the multiplier effect is less Real national income increases to $12.3 billion Price Level 120 With $100 billion increase in autonomous spending Price Level With $100 billion increase in autonomous spending AD 2 AD 2 AD 1 AD Real GDP per Year Real GDP per Year Figure 12-7 ($ trillions) Slide Figure 12-7 ($ trillions) Slide The Multiplier Effect on the Equilibrium Level of Real GDP The Multiplier Effect on the Equilibrium Level of Real GDP (C + I + G + X) 100 (C + I + G + X) 100 Consumption, Investment, Government Purchases, and Net Exports E 1 Consumption, Investment, Government Purchases, and Net Exports E 2 E 1 (C + I + G + X) Real GDP per Year Real GDP per Year ($ trillions) ($ trillions) Figure 12-8 Slide Figure 12-8 Slide

15 The Multiplier Effect on the Equilibrium Level of Real GDP Issues and Applications: New Economy or New Source of Volatility? Consumption, Investment, Government Purchases, and Net Exports E 2 (C + I + G + X) 100 E 1 (C + I + G + X) 125 Assume prices increase to 125 C + I + G + X decreases Equilibrium Y falls to $10 trillion Proponents of a theory of the new economy argued in the 1990 s that information technology expenditures would eliminate any economic downturns By making firms more productive By buoying investment spending While IT expenditures contribute to growth of real GDP, they remain a source of volatility Real GDP per Year ($ trillions) Figure 12-8 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

16 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 12 Consumption, Real GDP, and the Multiplier 16

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

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