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Copyright ©2011 by Pearson Education, Inc.All rights reserved.

Chapter 12

Consumption, Real GDP, and the Multiplier

12-2Copyright © 2011 Pearson Education, Inc. All rights reserved.

Introduction

In theory, higher interest rates should increase households’ borrowing costs and give them an incentive to cut back on their consumption spending

However, since 1989, the impact of interest-rate changes on household consumption has decreased substantially

Why has this happened?

Reading this chapter will help you answer this question


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


Learning Objectives (cont'd)

• Describe how equilibrium real GDP is established in the Keynesian model

• Evaluate why autonomous changes in total planned expenditures have a multiplier effect on equilibrium real GDP

• Understand the relationship between total planned expenditures and the aggregate demand curve


Chapter Outline

• Some Simplifying Assumptions in a Keynesian Model

• Determinants of Planned Consumption and Planned Saving

• Determinants of Investment• Determining Equilibrium Real GDP


Chapter Outline (cont'd)

• Keynesian Equilibrium with Government and the Foreign Sector Added

• The Multiplier• How a Change in Real Autonomous

Spending Affects Real GDP When the Price Level Can Change

• The Relationship Between Aggregate Demand and the C + I + G + X Curve


Did You Know That...

• In the 1990s, some posited that the adoption of new information technologies might have made recessions obsolete?

• Since then, a significant drop in information technology investment has contributed to the Great Recession of the late 2000s

• Understanding consumption expenditures helps us evaluate the effects of variations in business investment on real GDP


Some Simplifying Assumptions in a Keynesian Model

• To simplify the income determination model

1. Businesses pay no indirect taxes (sales tax)

2. Businesses distribute all profits to shareholders

3. There is no depreciation

4. The economy is closed; no foreign trade


Some Simplifying Assumptions in a Keynesian Model (cont'd)

• Real Disposable Income– Real GDP minus net taxes, or after-tax real

income

• Consumption– Spending on new goods and services out of a

household’s current income

– Whatever is not consumed is saved

– Consumption includes such things as buying food and going to a concert



• Saving

– The act of not consuming all of one’s current income

– Whatever is not consumed out of spendable income is, by definition, saved

– Saving is an action measured over time (a flow)

– Savings are a stock, an accumulation resulting from the act of saving in the past



• Consumption Goods

– Goods bought by households to use up, such as food and movies

• Consumption plus saving equals disposable income

• Saving equals disposable income minus consumption



• Investment

– Spending by businesses on things such as machines and buildings, which can be used to produce goods and services in the future

– The investment part of real GDP is the portion that will be used in the process of producing goods in the future



• Capital Goods

– Producer durables; nonconsumable goods that firms use to make other goods


Determinants of Planned Consumption and Planned Saving

• In the classical model, the supply of saving was determined by the rate of interest

– The higher the rate, the more people wanted to save, and the less they wanted to consume


Determinants of Planned Consumption and Planned Saving (cont'd)

• Keynes argued that: – The interest rate is not the most important

determinant of individual’s real saving and consumption decisions

– Real saving and consumption decisions depend primarily on a household’s real disposable income


AD = C + I + G + X


• Keynes was concerned with changes in AD


• Consumption Function

– The relationship between amount consumed and disposable income

– A consumption function tells us how much people plan to consume at various levels of disposable income




• Dissaving

– Negative saving; a situation in which spending exceeds income

– Dissaving can occur when a household is able to borrow or use up existing assets


Table 12-1 Real Consumption and Saving Schedules: A Hypothetical Case



• 45-Degree Reference Line

– The line along which planned real expenditures equal real GDP per year


Figure 12-1 The Consumption and Saving Functions



• Autonomous Consumption

– The part of consumption that is independent of the level of disposable income

– Changes in autonomous consumption shift the consumption function


• Average Propensity to Consume (APC)

– Real consumption divided by real disposable income

– The proportion of total disposable income that is consumed


APC =Real consumption

Real disposable income


• Average Propensity to Save (APS)

– Real saving divided by real disposable income (DI)

– Saved proportion of real DI


APS =Real saving

Real disposable income


MPC =Change in real consumption

Change in real disposable income


• Marginal Propensity to Consume (MPC)

– The ratio of the change in real consumption to the change in real disposable income


MPS =Change in real saving

Change in real disposable income


• Marginal Propensity to Save (MPS)

– The ratio of the change in saving to the change in disposable income


Example: Explaining the Rising U.S. “Saving Rate”

• Between the 1980 and 2007, the average U.S. saving rate declined from 9.0 percent to 1.8 percent, so the average value of the APS fell from 0.090 to 0.018

• By the middle of 2009, however, the saving rate had risen to as high as 6.2 percent, meaning that the APS increased to 0.062


Example: Explaining the Rising U.S. “Saving Rate” (cont’d)

• Why did the saving rate and the APS decline from the 1980s until 2007?

– The official measure fails to include capital gains, which is higher today

– Improved access to credit has induced many to opt to borrow in order to expand consumption

– Households consider increases in property value as a form of saving


Example: Explaining the Rising U.S. “Saving Rate” (cont’d)

• Why did the saving rate and the APS rise between 2007 and 2009?

– Struggling banks cut back on lending, values of financial assets plummeted, and real residential property values declined dramatically

• Why do you suppose that the government officially calculates saving as the residual difference between disposable income and consumption instead of computing consumption as the residual difference between disposable income and saving?


APC =$49,200$54,000 = .911


• Example– Income = $54,000

– C = $49,200

– S = $4,800

• What is the APC?


APC =$54,000$60,000 = .90


• Example– Income increases by $6,000 to $60,000

– C = $54,000

– S = $6,000

• What is the APC?



• Some relationships

– Average propensity to consume and average propensity to save must sum to 100% of total income

– Marginal propensity to consume and marginal propensity to save must sum to 100% of the change in income



• Causes of shifts in the consumption function

– A change besides real disposable income will cause the consumption function to shift

– Non-income determinants of consumption• Population

• Wealth



• Wealth

– The stock of assets owned by a person, household, firm or nation

– For a household, wealth can consist of a house, cars, personal belongings, stocks, bonds, bank accounts, and cash


Example: Consumption Effects of Changes in Housing versus Financial Wealth

• In the United States, tax rates on household wealth in the form of home ownership are low compared with those on stocks, bonds, and other financial assets

• Thus, a change in the real value of housing wealth generates a larger effect on real consumption spending than a change in the real value of financial wealth

• Estimates imply that every $1 decrease in real U.S. housing wealth in the late 2000s likely shifted the consumption function downward by about 3 times as much as each $1 decrease in real financial wealth


Determinants of Investment

• Investment, you will remember, consists of expenditures on new buildings and equipment

– Gross private domestic investment has been volatile

– Consider the planned investment function, and shifts in the function


Figure 12-2 Planned Real Investment, Panel (a)


Figure 12-2 Planned Real Investment, Panel (b)


Example: Could Collapsing Confidence Explain Plummeting Business Investment Spending?

• Since the end of 2007, the flow of U.S. business investment spending has decreased by more than 25 percent

• Economists George Akerlof and Robert Shiller suggest that a loss of business confidence explains this significant decline in business investment expenditures

• As a consequence, the investment schedule has shifted leftward, so that businesspeople are now making fewer investment expenditures at any given rate of interest


Determining Equilibrium Real GDP

• We are interested in determining the equilibrium level of real GDP per year

– Consumption as a function of real GDP

– The 45-degree reference line


Figure 12-3 Consumption as a Function of Real GDP


Determining Equilibrium Real GDP (cont'd)

• Adding the investment function

AD = C + I + G + X


Figure 12-4 Combining Consumption and Investment



• Saving and investment: planned versus actual

– Only at equilibrium real GDP will planned saving equal actual saving

– Planned investment equals actual investment

– Hence planned saving is equal to planned investment


Figure 12-5 Planned and Actual Rates of Saving and Investment



• Unplanned increases in business inventories

– Consumers purchase fewer goods and services than anticipated

– This leaves firms with unsold products and inventories will rise

– Businesses respond by cutting back production and reducing employment



• Unplanned decreases in business inventories

– Business will increase production of goods and services and increase employment

– Ultimately there will be an increase in real GDP


Keynesian Equilibrium with Government and the Foreign Sector Added

• To this point we have ignored the role of government in our model

• We also left out the foreign sector of the economy in our model

• Let’s think about what happens when we add these elements


Keynesian Equilibrium with Government and the Foreign Sector Added (cont'd)

• 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



• The Foreign Sector: C + I + G + X

– Net exports (X) equals exports minus imports

– Depends on international economic conditions

– Autonomous—independent of real national income


Table 12-2 The Determination of Equilibrium Real GDP with Government and Net Exports Added



• Determining the equilibrium level of GDP per year

– We are now in a position to determine the equilibrium level of real GDP per year

– Remember that equilibrium always occurs when total planned real expenditures equal real GDP


Figure 12-6 The Equilibrium Level of Real GDP



The Equilibrium Level of Real GDP• Observations

– If C + I + G + X = Y • Equilibrium GDP

– 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


The Multiplier

• Multiplier

– The ratio of the change in the equilibrium level of real national income to the change in autonomous expenditures

– The number by which a change in autonomous real investment or autonomous real consumption is multiplied to get the change in equilibrium real GDP


The Multiplier (cont'd)

• Question– How can a $100 billion increase in investment

generate a $500 billion increase in equilibrium real GDP?

• Answer– The multiplier process


Table 12-3 The Multiplier Process



• The multiplier formula

Multiplier = 11 - MPC = 1

MPS



• By taking a few numerical examples, you can demonstrate to yourself an important property of the multiplier

– The smaller the MPS, the larger the multiplier

– The larger the MPC, the larger the multiplier



• Examples

MPC = 34

MPS = 14

Mult. =1

1/4= 4

MPC = 45

MPS = 15

Mult. =1

1/5= 5

MPC = 23

MPS = 13

Mult. =1

1/3= 3

MPC = 79

MPS = 29

Mult. =1

2/9= 4.5

MPC = 35

MPS = 25

Mult. =1

2/5= 2.5


Change in equilibrium real GDP = Multiplier x Change in autonomous spending


• Measuring the change in equilibrium income from a change in autonomous spending



• Significance of the multiplier

– It is possible that a relatively small change in consumption or investment can trigger a much larger change in real GDP


How a Change in Real Autonomous Spending Affects Real GDP When the Price Level Can Change

• So far our examination of how changes in real autonomous spending affects equilibrium real GDP has considered a situation in which the price level remains unchanged

• Our equilibrium analysis has only considered how AD shifts in response to investment, government spending, net exports


How a Change in Real Autonomous Spending Affects Real GDP When the Price Level Can Change (cont'd)

• When we take into account the aggregate supply curve, we must also consider responses of the equilibrium price level to a multiplier-induced change in AD


Figure 12-7 Effect of a Rise in Autonomous Spending on Equilibrium Real GDP


The Relationship Between Aggregate Demand and the C + I + G + X Curve

• Aggregate demand consists of consumption, investment, government, and the foreign sector


The Relationship Between Aggregate Demand and the C + I + G + X Curve (cont'd)

• There is a major difference between the two:

– C + I + G + X curve drawn with price level constant

– AD curve drawn with the price level changing



• To derive the aggregate demand curve from the C + I + G + X curve, we must now allow the price level to change



• What are some of the effects of a price level increase?

– Real balance effect

– Interest rate effect

– The open economy effect


Figure 12-8 The Relationship Between AD and the C + I + G + X Curve


Issues and Applications: The Diminishing Effect of Interest Rate Changes on U.S. Real Consumption Spending

• In recent years, the impact of interest rate changes on real consumption has been declining

• One reason for this is that more U.S. employers are able to cushion their responses to higher U.S. interest rates by borrowing internationally

• Secondly, more U.S. residents own their own homes than in the 1980s and 1990s, and ready access to home equity loans has become widespread


Figure 12-9 Estimated Impacts of a 1-Percentage Point Interest Rate Increase on Real U.S. Consumption Spending Since 1945


Issues and Applications: The Diminishing Effect of Interest Rate Changes on U.S. Real Consumption Spending (cont’d)

• Why do home equity loans constitute household dissaving?

• How does reduced sensitivity of consumption spending to interest rate changes likely make real GDP less volatile in the face of variations in market interest rates?


Summary Discussion of Learning Objectives

• The difference between saving and savings and the relationship between saving and consumption

– Saving is a flow over time while savings is a stock

– Consumption plus saving equals disposable income


Summary Discussion of Learning Objectives (cont'd)

• Key determinants of consumption and saving in the Keynesian model

– In the classical model, the interest rate is the fundamental determinant of saving

– In the Keynesian model, the primary determinant is disposable income

– DI increases, so does C



• The key determinants of planned investment

– The interest rate, business expectations, productive technology, and business taxes



• How equilibrium real GDP is established in the Keynesian model

– Equilibrium national income occurs where the C + I + G + X schedule crosses the 45-degree line



• Why autonomous changes in total planned expenditures have a multiplier effect on equilibrium real GDP

– As consumption increases, so does real GDP, which induces further consumption spending

– The ultimate expansion of real GDP is equal to the multiplier times the increase in autonomous expenditures



• The relationship between total planned expenditures and the aggregate demand curve

– AD consists of consumption, investment, and government purchases, plus the foreign sector

– Difference• C + I + G + X curve drawn with price level constant

• AD with the price level changing


Figure B-1 Graphing the Multiplier

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Consumption, Real GDP, and the Multiplier - wps.aw.comwps.aw.com/wps/media/objects/6780/6942921/studynotes/update_not… · Consumption, Real GDP, and the Multiplier ... • Evaluate