CHAPTER 12- CONSUMPTION, REAL GDP, MULTIPLIER

CONSUMPTION FUNCTION I

The consumption function is the relationship between consumption (household sector spending) and disposable income.

In the consumption function, consumption is directly related to disposable income and is positive even at zero disposable income:

The 45-Degree Line

The 45-degree line represents all points where consumption and income are exactly equal.

C = YD

U.S. Consumption and Income

DISPOSABLE INCOME (billions of dollars per year)

$1000 2000 3000 4000

Actual consumer spending

6000

5000

4000

3000

2000

1000

0 5000 6000 7000

45°

$7000

198019811982198319841985198619871988198919901991199219931994199519961997

19981999

2000

CONS

UMPT

ION

(billi

ons

of d

olla

rs p

er y

ear)

C = YD

AUTONOMOUS INCOME

Have you ever known people who spend money with out any income?

2. When disposable income is 0 and consumption still exists (food, clothing, shelter- basics) this is autonomous consumption

3. Whether one has to dig into one’s savings, go on welfare, or else beg, borrow or steal, or call mom, one will spend that minimum amount

HOW DOES THIS WORK? Income is low- households tend to Dissave..

(borrow from savings or borrow from other sources)

Income increases- household aggregate income eventually equals and exceeds current consumption

The Keynesian model assumes that there is a positive relationship between consumption and income.

3 6 9

Planned ConsumptionExpenditures(trillions of dollars)

Real Disposable Income(trillions of dollars)

6

9

12

3

1245º

45º Line

C

Saving

Dis-saving

•However, as income increases, consumption increases by a smaller amount.• Thus, the slope of the consumption function (line C) is less than 1• (less than the slope of the 45° line).

Disposable IncomeYd= C+S

If we spend… cannot save. If we spend… more activity

(production) takes place in the economy… potential to increase GDP

What happens if we do not save at all?

WHAT IS THE DECIDING FACTOR ON WHETHER YOU SPEND OR NOT?

IncomeKeynes felt we could learn a lot

about consumption by focusing on the relationship between income and spending.

He said income and consumer spending rise in tandem..

If you know how much income consumers have to spend (Yd), you can predict what they will spend

KEYNE’S CONSUMPTION FUNCTION

Keynes referred to this as “fundamental law” that men are disposed as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income.

*1)At low levels of aggregate income, the consumption expenditures of households will exceed their disposable income (when household income is low, households dissave- they either borrow or draw from past savings to purchase consumption goods

45 Degree Line

45 Degree Line

$50 100 150 200 250 300 350 400

C = YD

Saving

DissavingConsumption Function

C = $50 + 0.75YD

A

CD

E

B

G

Keynes Cont.As with most theories, Keynes asks us

to assume away a lot of the problem. We will assume there is a specific

employment level of output. NARU is present when full-employment capacity is attained.

Wages and prices are completely inflexible until full employment is reached

Government’s taxing, spending and monetary policies are constant.

Keynes said that the economy needs to be directed to full-employment through aggregate expenditures.(C + I + G + X-M )

A sluggish economyThere are a number of ways to jump-start

the economy…Fiscally: taxing & spending. Affects on ADShould the classical or Keynesian

approach be used…. Or should an eclectic approach be used?

KEYNESIAN ECONOMICS Works only on the AD curve Assumes AS is stationary Critics of Keynes:

…But this will cause deficits! …But the government can’t spend that much!

KEYNES’ MULTIPLIER EFFECT Any new spending (G) becomes new income

(Y) to someone.

New income (Y) after taxes (T), called disposable income (Yd), is divided into new spending (C) and new saving (S).

Y = C + S + T Yd = Y – T = C + S ΔYd = ΔC + ΔS

WHAT DO YOU THINK MARGINAL PROPENSITY TO CONSUME MEANS???

You get a “windfall.” How much of those $$ will you spend… (marginally?) How much will you save? (marginally?)

Yd = C + S ΔYd = ΔC + ΔS Divide through by ΔYd: 1 = ΔC/ΔYd + ΔS/ΔYd

Define: marginal propensity to consume (MPC)

MPC = ΔC / ΔYd marginal propensity to save (MPS)

MPS = ΔS / ΔYd 1 = MPC + MPS, always

THE MULTIPLIER EFFECT In each cycle, part of the new income is set

aside as saving (MPS). So, the next round of income-spending is

smaller than the previous round. As new income grows, it ultimately reaches

its maximum. The power of the multiplier effect is

controlled by the size of MPS.

THE MULTIPLIER EFFECT Spending multiplier = 1/MPS

MPS 1/10 1/5 1/4 1/3

Spending Multiplier

10 5 4 3

WHAT REALLY IS THE MULTIPLIER?

The multiplier is based on two concepts already covered:

1. GDP is the nation’s expenditure on all the final goods and services produced during the year at market prices.

2. GDP=C+I+G+(X-M) = Aggregate Demand

SUMMARY Y = C + S + T Y is national

income Yd = Y – T = C + S Yd is disposable

income MPC = ΔC / ΔYd MPS = ΔS / ΔYd MPC + MPS = 1, always spending multiplier = 1/MPS tax multiplier = - (spending multiplier –

1)

Obviously if C goes up the entire GDP will go up also. When there is any change in spending- it will have a multiplied effect on GDP

*When money is spent by one person, it becomes someone else’s income.

When someone spends a dollar, perhaps someone who received that dollar would spend 80 cents and of that 80 cents received by the next person perhaps 64 cents…

If we add up all the spending

generated by that one dollar, it will add up to four or five or six times that dollar…

Hence, the name “multiplier.”

The multiplier tells us the extent to which the rate of total spending will change in response to an initial change in the flow of expenditure.

Multiplier = 11 - MPC

Any change in spending (C, I, or G.) will set off a chain reaction,Leading to a multiplied change in GDP. If $1 million investment resulted in $4 million additional income, the multiplier would be 4

THE MULTIPLIER PROCESS

1. $100 billion in unsold goods appear

3. Income reduced by $100 billion 4. Consumption reduced by $75 billion

5. Sales fall $75 billion6. Further cutbacks in employment or wages

7. Income reduced by $75 billion more

8. Consumption reduced by $56.25 billion more

Factor markets

Product markets

Business firms

Households

9. And so on

2. Cutbacks in employment or wages

ExpenditureStage

AdditionalIncome(Dollars)

Marginal Propensity To Consume

AdditionalConsumption

(Dollars)

For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.

1,000,000 750,000 562,500 421,875 316,406 237,305 177,979 133,484 100,113 75,085

225,253

750,000 562,500 421,875 316,406 237,305 177,979 133,484 100,113 75,085 56,314

168,939

Round 1 Round 2 Round 3 Round 4 Round 5 Round 6 Round 7 Round 8 Round 9 Round 10

3/4 3/4 3/4 3/4 3/4 3/4 3/4 3/4 3/4 3/4 3/4

Total 4,000,000 3,000,000 3/4

All Others

The Multiplier Principle

• The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75% 3/4).• Here, a $1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until . . . effectively, $4 million is spent in the economy.