Upload
luke-alexander
View
226
Download
0
Embed Size (px)
Citation preview
The Multiplier and the Consumption Function
Module 16
Spending
In 2009, the US Congress passed the American Recovery and Reinvestment Act – a $787 billion program to spark job growth and combat the recession.
Why did economists think a stimulus package would help the economy?
Spending
Each $1 spent by the government would produce some multiple of dollars earned and spent by consumers
The Government Spends Money that ends up in someone’s pocket
That person spends some of that money and it ends up in someone else’s pocket
And so on…
And so on…
Figure 10.1 The Circular-Flow DiagramRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers
Spending
But spending can also come from other sources – including investment…
Spending
Suppose the housing construction industry spent an additional $100 billion on new construction of homes:
1) That’s an additional $100 billion to GDP2) That $100 billion goes to others who will spend some of it3) Let’s say the people who get the $100 billion save $20 billion
and spend the rest4) That’s $80 billion in more activity that goes into pockets as
profits or wages5) Those people in turn save $16 billion and spend $64 billion6) And so on…
The Multiplier
The initial $100 billion investment is called the autonomous change in spending.
How much total increase to GDP should result from this $100 billion autonomous change in spending?
We could add up all the rounds of spending…
Change in GDP = ($100 billion + $80 billion + 64 billion + …)
But this is an infinite series, and who has the time?
The Multiplier
Instead, we can calculate the multiplier (M) – a value by which we can multiply the autonomous change in spending to obtain the change in output:
ΔY = M x ΔAAS
Δ = change inY = output (GDP)AAS = autonomous spending
The Multiplier
To determine the value of this multiplier, we need to know what proportion of the money people receive they will end up spending
We call this the marginal propensity to consume (MPC)
MPC = Δ Consumer spendingΔ Disposable income
The Multiplier
Total spending would equal:AAS + MPC (AAS) + MPC2(AAS) + MPC3(AAS)…
OrAAS (1 + MPC + MPC2 + MPC3…)
And(1 + MPC + MPC2 + MPC3…) = 1 = M
(1-MPC)
The Multiplier
In our example, people spent $80 billion of the $100 billion, so:
MPC = 80/100 = .8
We can then use the formula for the multiplier:M = 1/(1-MPC)M = 1/(1-.8) = 1/.2 = 5
Total increase in GDP = ΔY = M x ΔAAS = 5 x $100 Billion = $500 Billion
Spending and Saving
Notice in our example that whatever money was not spent, was saved.
We can also calculate a marginal propensity to save (MPS)
MPS = Δ Consumer savingsΔ Disposable income
Spending and Saving
Since these represent the only two options for disposing of income, we can say that:
MPC + MPS = 1
Which also means: MPS = 1-MPC
So the multiplier = 1/(1-MPC) OR 1/MPS
Example
1. Data show that when consumers received an additional $20 million in income, they put $5 million in the bank
a. Calculate the marginal propensity to consume
b. How much would output increase with an autonomous aggregate spending increase of $30 million
Example
2. Suppose a $1 million business investment generates a $2.5 million increase in GDP
a. Calculate the marginal propensity to consume
Household Consumption
How does household consumer spending relate to household income?
There will be some spending, no matter what income level – we call this autonomous consumer spending
And then spending of additional income will be governed by the MPC
Figure 16.1 Current Disposable Income and Consumer Spending for American Households in 2008Ray and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers
The Consumption Function
An equation showing how an individual household’s consumer spending varies with the
household’s disposable income
c = a + MPC × yd
Where:c = consumer spendinga = autonomous consumer spendingyd = disposable income
Figure 16.2 The Consumption FunctionRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers
Aggregate Consumption Function
An equation showing how aggregate consumer spending varies with aggregate disposable income
C = A + MPC × YD
Where:C = aggregate consumer spendingA = autonomous aggregate consumer
spendingYD = aggregate disposable income
Income Effect
• If you expect that your income will continue to rise, you will spend more now than your current income would otherwise indicate
• Permanent Income Hypothesis– Milton Friedman– Consumer spending is more dependent on
expectations of future income than of current income
Figure 16.4 Shifts of the Aggregate Consumption FunctionRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers
Effect of Expected Income
Incomes expected to rise:Increase in autonomous
spending
Incomes expected to fall:Decrease in autonomous
spending
Wealth Effect
• Wealth– accumulated savings and assets over time– Affects consumer spending– Increased aggregate wealth increases aggregate
spending
• Life-Cycle Hypothesis– People plan their spending across their lifetimes– Save more earlier, spend out of savings later
Investment Spending
• Investment spending also drives GDP and the business cycle, though to a lesser extent than consumer spending
• Recessions often start with declines in investment spending– Planned v. actual spending– What affects investment spending?
Interest Rates
• The cost of borrowing money
• Particularly affects construction industry as interest rates will be faced by both producers and consumers
• Inverse relationship – as interest rates rise, investment spending falls
Expected Growth in GDP
• If businesses expect sales to grow more in the future, they will increase investment spending in the present– New production capacity
• If business expect slow growth, investment spending declines– maintain or replace obsolete production capacity
Inventories
• Businesses will often satisfy demand out of inventories
• Higher than planned inventories can result from lower than expected sales– Unplanned inventory investment– Increasing inventories could mean economy is slowing
Actual Investment Spending=Planned investment spending + Unplanned inventory investment
ProblemsFor each event, explain whether the initial effect is a change in planned investment spending or a change in unplanned inventory investment, and indicate the direction of the change
1. An unexpected increase in consumer spending
2. A sharp rise in the cost of borrowing
3. A sharp increase in the economy’s growth rate of real GDP
4. An unanticipated fall in sales