Consumption and The Multiplier. OutlineOutline I. The consumption function –Initial assumptions –The pre-Keynesian consumption function –The Keynesian

Consumption and The Consumption and The MultiplierMultiplier

Consumption and The Consumption and The MultiplierMultiplier

OutlineOutline

I. The consumption functionI. The consumption function– Initial assumptionsInitial assumptions– The pre-Keynesian consumption functionThe pre-Keynesian consumption function– The Keynesian consumption functionThe Keynesian consumption function– Propensities to consume and savePropensities to consume and save

II. The MultiplierII. The Multiplier– Brief historyBrief history– The Multiplier in actionThe Multiplier in action– Multiplier and economic policyMultiplier and economic policy

Initial Assumptions - 1Initial Assumptions - 1

• Two sector model of the goods market in Two sector model of the goods market in the economy (no government sector, no the economy (no government sector, no foreign trade).foreign trade).

• A closed economy:A closed economy:– in which households exercise consumption in which households exercise consumption

demand for final goods and services; anddemand for final goods and services; and– Firms demand investment goods. Firms demand investment goods.

Initial Assumptions - 2Initial Assumptions - 2• In this economyIn this economy

AD AD C + I C + I

• Theories to explain how and why households Theories to explain how and why households and firms make consumption and investment and firms make consumption and investment decisions. decisions.

• We will assume investment in the economy is We will assume investment in the economy is given.given.

• We need to introduce a theory to explain how We need to introduce a theory to explain how consumption decisions are made by consumption decisions are made by households.households.

The Pre-Keynesian The Pre-Keynesian Consumption Function - 1Consumption Function - 1


• In microeconomic theory, when households In microeconomic theory, when households have a large number of goods and services have a large number of goods and services to choose from, an important variable to choose from, an important variable influencing the demand for a specific good is influencing the demand for a specific good is its price relative to all other goods and its price relative to all other goods and services:services:

QQdd = f(P), ceteris paribus = f(P), ceteris paribus

• In microeconomic theory, when households In microeconomic theory, when households have a large number of goods and services have a large number of goods and services to choose from, an important variable to choose from, an important variable influencing the demand for a specific good is influencing the demand for a specific good is its price relative to all other goods and its price relative to all other goods and services:services:

QQdd = f(P), ceteris paribus = f(P), ceteris paribus



• When we construct a macroeconomic When we construct a macroeconomic consumption function, we take the relative consumption function, we take the relative price of goods as given.price of goods as given.

• We focus on how households divide their We focus on how households divide their expenditure between consumption of all expenditure between consumption of all goods and services and saving.goods and services and saving.

Y Y C + S C + S

• When we construct a macroeconomic When we construct a macroeconomic consumption function, we take the relative consumption function, we take the relative price of goods as given.price of goods as given.

• We focus on how households divide their We focus on how households divide their expenditure between consumption of all expenditure between consumption of all goods and services and saving.goods and services and saving.

Y Y C + S C + S



• Rewriting the identity, we can define Rewriting the identity, we can define planned savings as being that part of planned savings as being that part of income which households do not intend to income which households do not intend to spend on consumption:spend on consumption:

S S Y - C Y - C

• Rewriting the identity, we can define Rewriting the identity, we can define planned savings as being that part of planned savings as being that part of income which households do not intend to income which households do not intend to spend on consumption:spend on consumption:

S S Y - C Y - C



• In the pre-Keynesian era, the predominant In the pre-Keynesian era, the predominant view was that the rate of interest was the view was that the rate of interest was the main variable influencing the division of main variable influencing the division of income between C and S.income between C and S.

• The pre-Keynesian savings and consumption The pre-Keynesian savings and consumption functions can be written as:functions can be written as:

S = f(r)S = f(r)

C = f(r)C = f(r)

• In the pre-Keynesian era, the predominant In the pre-Keynesian era, the predominant view was that the rate of interest was the view was that the rate of interest was the main variable influencing the division of main variable influencing the division of income between C and S.income between C and S.

• The pre-Keynesian savings and consumption The pre-Keynesian savings and consumption functions can be written as:functions can be written as:

S = f(r)S = f(r)

C = f(r)C = f(r)

The Keynesian Consumption FunctionThe Keynesian Consumption FunctionThe Keynesian Consumption FunctionThe Keynesian Consumption Function

• Keynes accepted that the rate of interest was Keynes accepted that the rate of interest was a variable which influenced consumption a variable which influenced consumption decisions, but he believed that the level of decisions, but he believed that the level of income was more important.income was more important.

C = f(Y)C = f(Y)

S = f(Y)S = f(Y)• ‘‘The fundamental psychological law, upon which we are The fundamental psychological law, upon which we are

entitled to depend with great confidence . . . is that men are entitled to depend with great confidence . . . is that men are disposed, as a rule and on average, to increase their disposed, as a rule and on average, to increase their consumption as their income increases, but not by as much consumption as their income increases, but not by as much as the increase in their income’as the increase in their income’

• Keynes accepted that the rate of interest was Keynes accepted that the rate of interest was a variable which influenced consumption a variable which influenced consumption decisions, but he believed that the level of decisions, but he believed that the level of income was more important.income was more important.

C = f(Y)C = f(Y)

S = f(Y)S = f(Y)• ‘‘The fundamental psychological law, upon which we are The fundamental psychological law, upon which we are

entitled to depend with great confidence . . . is that men are entitled to depend with great confidence . . . is that men are disposed, as a rule and on average, to increase their disposed, as a rule and on average, to increase their consumption as their income increases, but not by as much consumption as their income increases, but not by as much as the increase in their income’as the increase in their income’

• The consumption function describes the The consumption function describes the relationship between consumer spending and relationship between consumer spending and incomeincome

C = CC = Caa + by + by

• Consumption spending, C, has two parts:Consumption spending, C, has two parts:– CCaa = autonomous consumption. This is the part of = autonomous consumption. This is the part of

total consumption which does not vary with the total consumption which does not vary with the level of income. level of income.

– by = income-induced consumption. The product of a by = income-induced consumption. The product of a fraction, b, called the fraction, b, called the marginal propensity to marginal propensity to consume consume (MPC) and the level of income, y.(MPC) and the level of income, y.

• The consumption function is a line that intersects The consumption function is a line that intersects the vertical axis at Cthe vertical axis at Caa. It has a slope equal to b.. It has a slope equal to b.

• The consumption function describes the The consumption function describes the relationship between consumer spending and relationship between consumer spending and incomeincome

C = CC = Caa + by + by

• Consumption spending, C, has two parts:Consumption spending, C, has two parts:– CCaa = autonomous consumption. This is the part of = autonomous consumption. This is the part of

total consumption which does not vary with the total consumption which does not vary with the level of income. level of income.

– by = income-induced consumption. The product of a by = income-induced consumption. The product of a fraction, b, called the fraction, b, called the marginal propensity to marginal propensity to consume consume (MPC) and the level of income, y.(MPC) and the level of income, y.

• The consumption function is a line that intersects The consumption function is a line that intersects the vertical axis at Cthe vertical axis at Caa. It has a slope equal to b.. It has a slope equal to b.

Dem

and

Dem

and

0 0

ConsumptionConsumptionfunction (Cfunction (Caa + by) + by)

Output, yOutput, y

The consumption function relates consumer spending to The consumption function relates consumer spending to the level of income.the level of income.

Dem

and

Dem

and

0 0


CCaa


Output, yOutput, y

Dem

and

Dem

and

0 0


CCaa

{{autonomousautonomousconsumptionconsumption


Output, yOutput, y

Dem

and

Dem

and

0 0


CCaa

{{autonomousautonomousconsumptionconsumption

slope bslope b


Output, yOutput, y

The Consumption FunctionThe Consumption FunctionThe Consumption FunctionThe Consumption Function

• Although output is on the horizontal axis, Although output is on the horizontal axis, output and income in this simple economy output and income in this simple economy are identicalare identical

• Output generates income that is all received Output generates income that is all received by householdsby households

• As output rises by $1, consumption increases As output rises by $1, consumption increases by the marginal propensity to consume (b) by the marginal propensity to consume (b) times $1times $1

• Although output is on the horizontal axis, Although output is on the horizontal axis, output and income in this simple economy output and income in this simple economy are identicalare identical

• Output generates income that is all received Output generates income that is all received by householdsby households

• As output rises by $1, consumption increases As output rises by $1, consumption increases by the marginal propensity to consume (b) by the marginal propensity to consume (b) times $1times $1

Marginal Propensity To Consume Marginal Propensity To Consume (MPC) - 1(MPC) - 1


• The MPC is always less than 1.The MPC is always less than 1.• Suppose the MPC = .75Suppose the MPC = .75• An increase in income of $100 would increase An increase in income of $100 would increase

consumption byconsumption by

bbyy

==

.75 x $100.75 x $100

==

$75$75

• The MPC is always less than 1.The MPC is always less than 1.• Suppose the MPC = .75Suppose the MPC = .75• An increase in income of $100 would increase An increase in income of $100 would increase

consumption byconsumption by

bbyy

==

.75 x $100.75 x $100

==

$75$75



• If a consumer receives a dollar of income, If a consumer receives a dollar of income, consumer will spend some of it and save the consumer will spend some of it and save the rest.rest.

• The fraction that the consumer spends is The fraction that the consumer spends is determined by the MPCdetermined by the MPC

• The fraction of income that the consumer The fraction of income that the consumer saves is determined by the saves is determined by the marginal marginal propensity to save (MPS)propensity to save (MPS)

• The sum of the MPC and MPS is always 1The sum of the MPC and MPS is always 1

• If a consumer receives a dollar of income, If a consumer receives a dollar of income, consumer will spend some of it and save the consumer will spend some of it and save the rest.rest.

• The fraction that the consumer spends is The fraction that the consumer spends is determined by the MPCdetermined by the MPC

• The fraction of income that the consumer The fraction of income that the consumer saves is determined by the saves is determined by the marginal marginal propensity to save (MPS)propensity to save (MPS)

• The sum of the MPC and MPS is always 1The sum of the MPC and MPS is always 1

Changes In The Consumption FunctionChanges In The Consumption FunctionChanges In The Consumption FunctionChanges In The Consumption Function

• The level of autonomous consumption and the The level of autonomous consumption and the MPC can change causing movements in the MPC can change causing movements in the consumption functionconsumption function

• If the level of autonomous consumption is higher, it If the level of autonomous consumption is higher, it will shift the entire consumption function.will shift the entire consumption function.

• Changes in the marginal propensity to consume Changes in the marginal propensity to consume will change the slope of the consumption function.will change the slope of the consumption function.

• The level of autonomous consumption and the The level of autonomous consumption and the MPC can change causing movements in the MPC can change causing movements in the consumption functionconsumption function

• If the level of autonomous consumption is higher, it If the level of autonomous consumption is higher, it will shift the entire consumption function.will shift the entire consumption function.

• Changes in the marginal propensity to consume Changes in the marginal propensity to consume will change the slope of the consumption function.will change the slope of the consumption function.

Autonomous Consumption ChangesAutonomous Consumption ChangesAutonomous Consumption ChangesAutonomous Consumption Changes

• Increases in consumer wealth will cause an Increases in consumer wealth will cause an increase in autonomous consumption.increase in autonomous consumption.

• Consumer wealth Consumer wealth consists of the value of consists of the value of stocks, bonds and consumer durables.stocks, bonds and consumer durables.

• Increases in consumer confidence will increase Increases in consumer confidence will increase autonomous consumption.autonomous consumption.

• Increases in consumer wealth will cause an Increases in consumer wealth will cause an increase in autonomous consumption.increase in autonomous consumption.

• Consumer wealth Consumer wealth consists of the value of consists of the value of stocks, bonds and consumer durables.stocks, bonds and consumer durables.

• Increases in consumer confidence will increase Increases in consumer confidence will increase autonomous consumption.autonomous consumption.

Movements Of The Consumption Movements Of The Consumption FunctionFunction


Output, yOutput, y

Dem

and

Dem

and

CCaa00

CCaa11

An increase in autonomous consumption from An increase in autonomous consumption from CCaa

00 to C to Caa11 shifts the entire consumption function. shifts the entire consumption function.

Marginal Propensity To Consume Marginal Propensity To Consume ChangesChanges

Marginal Propensity To Consume Marginal Propensity To Consume ChangesChanges

• Consumers’ perceptions of changes in their Consumers’ perceptions of changes in their income affect their MPCincome affect their MPC

• If consumers believe that an increase in If consumers believe that an increase in their income is permanent, they will their income is permanent, they will consume a higher fraction of the increased consume a higher fraction of the increased income than if the increase were believed to income than if the increase were believed to be temporarybe temporary

• Consumers’ perceptions of changes in their Consumers’ perceptions of changes in their income affect their MPCincome affect their MPC

• If consumers believe that an increase in If consumers believe that an increase in their income is permanent, they will their income is permanent, they will consume a higher fraction of the increased consume a higher fraction of the increased income than if the increase were believed to income than if the increase were believed to be temporarybe temporary



Output, yOutput, y

Dem

and

Dem

and

Slope bSlope b

Slope bSlope b11

An increase in MPC from b to bAn increase in MPC from b to b11 increases the slope increases the slope of the consumption function.of the consumption function.

The Multiplier - IntroductionThe Multiplier - IntroductionThe Multiplier - IntroductionThe Multiplier - Introduction

• We now need to introduce the Multiplier theory and investigate in more detail the process by which income or output changes when an autonomous change occurs in any of the components of aggregate demand.

• We now need to introduce the Multiplier theory and investigate in more detail the process by which income or output changes when an autonomous change occurs in any of the components of aggregate demand.

The Multiplier - Brief History1The Multiplier - Brief History1The Multiplier - Brief History1The Multiplier - Brief History1

• Concept first developed by Richard Khan.Concept first developed by Richard Khan.

• Early theory was employment multiplier.Early theory was employment multiplier.

• Keynes first made use of Kahn’s multiplier Keynes first made use of Kahn’s multiplier in 1933, when he discussed the effects of an in 1933, when he discussed the effects of an increase in government spending of £500 (a increase in government spending of £500 (a sum assumed to be just sufficient to employ sum assumed to be just sufficient to employ a man for one year in the construction of a man for one year in the construction of public works)public works)

• Concept first developed by Richard Khan.Concept first developed by Richard Khan.

• Early theory was employment multiplier.Early theory was employment multiplier.

• Keynes first made use of Kahn’s multiplier Keynes first made use of Kahn’s multiplier in 1933, when he discussed the effects of an in 1933, when he discussed the effects of an increase in government spending of £500 (a increase in government spending of £500 (a sum assumed to be just sufficient to employ sum assumed to be just sufficient to employ a man for one year in the construction of a man for one year in the construction of public works)public works)

The Multiplier - Brief History - 2The Multiplier - Brief History - 2The Multiplier - Brief History - 2The Multiplier - Brief History - 2

• Keynes wrote:Keynes wrote:

‘‘If the new expenditure is additional and not merely If the new expenditure is additional and not merely in substitution for other expenditure, the increase of in substitution for other expenditure, the increase of employment does not stop there. The additional employment does not stop there. The additional wages and other incomes paid out are spent on wages and other incomes paid out are spent on additional purchases, which in turn lead to further additional purchases, which in turn lead to further employment . . . the newly employed who supply the employment . . . the newly employed who supply the increased purchases of those employed on the new increased purchases of those employed on the new capital works will, in their turn, spend more, thus capital works will, in their turn, spend more, thus adding to the employment of others; and so on’adding to the employment of others; and so on’

• Keynes wrote:Keynes wrote:

‘‘If the new expenditure is additional and not merely If the new expenditure is additional and not merely in substitution for other expenditure, the increase of in substitution for other expenditure, the increase of employment does not stop there. The additional employment does not stop there. The additional wages and other incomes paid out are spent on wages and other incomes paid out are spent on additional purchases, which in turn lead to further additional purchases, which in turn lead to further employment . . . the newly employed who supply the employment . . . the newly employed who supply the increased purchases of those employed on the new increased purchases of those employed on the new capital works will, in their turn, spend more, thus capital works will, in their turn, spend more, thus adding to the employment of others; and so on’adding to the employment of others; and so on’

The Multiplier - Brief History - 3The Multiplier - Brief History - 3The Multiplier - Brief History - 3The Multiplier - Brief History - 3

• By the time of the publication of the By the time of the publication of the General General TheoryTheory in 1936, Keynes had placed the in 1936, Keynes had placed the multiplier at the heart of how an economy can multiplier at the heart of how an economy can settle into an underemployment equilibrium. settle into an underemployment equilibrium.

• In the In the General TheoryGeneral Theory, Keynes focused , Keynes focused attention on the investment multiplier, attention on the investment multiplier, explaining how a collapse in investment and explaining how a collapse in investment and business confidence can cause a multiple business confidence can cause a multiple contraction of output.contraction of output.

• By the time of the publication of the By the time of the publication of the General General TheoryTheory in 1936, Keynes had placed the in 1936, Keynes had placed the multiplier at the heart of how an economy can multiplier at the heart of how an economy can settle into an underemployment equilibrium. settle into an underemployment equilibrium.

• In the In the General TheoryGeneral Theory, Keynes focused , Keynes focused attention on the investment multiplier, attention on the investment multiplier, explaining how a collapse in investment and explaining how a collapse in investment and business confidence can cause a multiple business confidence can cause a multiple contraction of output.contraction of output.

The Multiplier In Action - 1The Multiplier In Action - 1The Multiplier In Action - 1The Multiplier In Action - 1

• From this, it was only a short step to suggest From this, it was only a short step to suggest how the government spending multiplier how the government spending multiplier might be used to reverse the process.might be used to reverse the process.

• Example:Example:– Let’s assume that the MPC is 0.8 at all levels of income Let’s assume that the MPC is 0.8 at all levels of income

(MPS = 0.2)(MPS = 0.2)

– Whenever income increases by $10, consumption Whenever income increases by $10, consumption increases by $8 and $2 is saved.increases by $8 and $2 is saved.

– We assume that prices remain constant, and that a We assume that prices remain constant, and that a margin of spare capacity and unemployed labour exists margin of spare capacity and unemployed labour exists which the government wishes to reduce.which the government wishes to reduce.

• From this, it was only a short step to suggest From this, it was only a short step to suggest how the government spending multiplier how the government spending multiplier might be used to reverse the process.might be used to reverse the process.

• Example:Example:– Let’s assume that the MPC is 0.8 at all levels of income Let’s assume that the MPC is 0.8 at all levels of income

(MPS = 0.2)(MPS = 0.2)

– Whenever income increases by $10, consumption Whenever income increases by $10, consumption increases by $8 and $2 is saved.increases by $8 and $2 is saved.

– We assume that prices remain constant, and that a We assume that prices remain constant, and that a margin of spare capacity and unemployed labour exists margin of spare capacity and unemployed labour exists which the government wishes to reduce.which the government wishes to reduce.


• Suppose the government increases public Suppose the government increases public expenditure by $1 million, keeping taxation expenditure by $1 million, keeping taxation at its existing level.at its existing level.

• The government could increase transfer The government could increase transfer payments. Alternatively, the government payments. Alternatively, the government might wish to invest in public works or might wish to invest in public works or social capital (e.g. road construction).social capital (e.g. road construction).

• Suppose the government increases public Suppose the government increases public expenditure by $1 million, keeping taxation expenditure by $1 million, keeping taxation at its existing level.at its existing level.

• The government could increase transfer The government could increase transfer payments. Alternatively, the government payments. Alternatively, the government might wish to invest in public works or might wish to invest in public works or social capital (e.g. road construction).social capital (e.g. road construction).

Injection of $1 million

public works programme

$1m$0.8m$0.64msuccesively small stages of income generation

• Initial increase in income largeInitial increase in income large

• Households spend 0.8 of their increase in Households spend 0.8 of their increase in income on consumption ($800,000)income on consumption ($800,000)

• Further stages of income generation occur, Further stages of income generation occur, with each successive stage being smaller with each successive stage being smaller than the previous one.than the previous one.

• Initial increase in income largeInitial increase in income large

• Households spend 0.8 of their increase in Households spend 0.8 of their increase in income on consumption ($800,000)income on consumption ($800,000)

• Further stages of income generation occur, Further stages of income generation occur, with each successive stage being smaller with each successive stage being smaller than the previous one.than the previous one.


• The eventual increase in income resulting The eventual increase in income resulting from the initial injection is the sum of all the from the initial injection is the sum of all the stages of income generationstages of income generation

The value of the government spending multiplier = The value of the government spending multiplier =

Change in incomeChange in income

Change in government spendingChange in government spending

oror

k = k = YY

GG

• The eventual increase in income resulting The eventual increase in income resulting from the initial injection is the sum of all the from the initial injection is the sum of all the stages of income generationstages of income generation

The value of the government spending multiplier = The value of the government spending multiplier =

Change in incomeChange in income

Change in government spendingChange in government spending

oror

k = k = YY

GG


• Providing that saving is the only leakage of demand, the Providing that saving is the only leakage of demand, the value of k depends upon the MPC.value of k depends upon the MPC.

• The formula for the multiplier in this model is:The formula for the multiplier in this model is:

k = 1k = 1

1 - b1 - b

(where b = MPC)(where b = MPC)• The larger the MPC, the larger the value of the The larger the MPC, the larger the value of the

multiplier.multiplier.• In our model, the value of the multiplier is 5 - an initial In our model, the value of the multiplier is 5 - an initial

increase in public spending will subsequently increase increase in public spending will subsequently increase income by $5 million. income by $5 million.

• Providing that saving is the only leakage of demand, the Providing that saving is the only leakage of demand, the value of k depends upon the MPC.value of k depends upon the MPC.

• The formula for the multiplier in this model is:The formula for the multiplier in this model is:

k = 1k = 1

1 - b1 - b

(where b = MPC)(where b = MPC)• The larger the MPC, the larger the value of the The larger the MPC, the larger the value of the

multiplier.multiplier.• In our model, the value of the multiplier is 5 - an initial In our model, the value of the multiplier is 5 - an initial

increase in public spending will subsequently increase increase in public spending will subsequently increase income by $5 million. income by $5 million.

Multiplier and economic policyMultiplier and economic policyMultiplier and economic policyMultiplier and economic policy

• Implications are that it is possible to use Implications are that it is possible to use discretionary fiscal policy to control or discretionary fiscal policy to control or influence the level of aggregate demand.influence the level of aggregate demand.

• Monetarists would dispute the beneficial Monetarists would dispute the beneficial effects - would point to the ‘crowding out’ effects - would point to the ‘crowding out’ effects of a widening budget deficit.effects of a widening budget deficit.

• What is the evidence?What is the evidence?

• Implications are that it is possible to use Implications are that it is possible to use discretionary fiscal policy to control or discretionary fiscal policy to control or influence the level of aggregate demand.influence the level of aggregate demand.

• Monetarists would dispute the beneficial Monetarists would dispute the beneficial effects - would point to the ‘crowding out’ effects - would point to the ‘crowding out’ effects of a widening budget deficit.effects of a widening budget deficit.

• What is the evidence?What is the evidence?

Documents

Consumption and The Multiplier. OutlineOutline I. The consumption function –Initial assumptions –The pre-Keynesian consumption function –The Keynesian