Transcript Chapter 12

End of
ECON 151 – PRINCIPLES
OF MACROECONOMICS
Chapter
10
Chapter 12: Consumption, Real
GDP, and the Multiplier
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
1
1
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
12-2
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.
12-3
Some Simplifying Assumptions
in a Keynesian Model (cont'd)


Saving

The act of not consuming all of one’s current income

Whatever is not consumed 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.
Dissaving

Negative saving; a situation in which spending exceeds
income
12-4
Some Simplifying Assumptions
in a Keynesian Model (cont'd)

Consumption plus saving equals
disposable income.

Saving equals disposable income minus
consumption.
12-5
Some Simplifying Assumptions
in a Keynesian Model (cont'd)

Consumption Goods
 Goods
bought by households to use up, such
as food and movies

Capital Goods
 Producer
durables; nonconsumable goods
that firms use to make other goods
12-6
Some Simplifying Assumptions
in a Keynesian Model (cont'd)

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.
12-7
Spending on Human Capital:
Investment or Consumption?

Economists define human capital as the
accumulation of investments and training
in education.

From this perspective, educational
expenses should be regarded as a form
of investment spending.

Nevertheless, in official U.S. government
statistics, household spending on education is
classified as consumption.
12-8
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,
the less they wanted
to consume.

Keynes argued that real saving and consumption
decisions depend primarily on a household’s real
disposable income.
12-9
Determinants of Planned Consumption and
Planned Saving (cont'd)
Keynes was concerned with changes
in AD as reflected in planned expenditures.
 His initial focus was on Consumption.

AD = C + I + G + X
12-10
Determinants of Planned Consumption and
Planned Saving (cont'd)

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.
12-11
Determinants of Planned Consumption and
Planned Saving (cont'd)

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.
12-12
Table 12-1 Real Consumption and Saving
Schedules: A Hypothetical Case
12-13
Determinants of Planned Consumption and
Planned Saving (cont'd)

45-Degree Reference Line
 The
line along which planned real
expenditures equal real GDP per year
 On
the following graph, DPI is labeled as YD.
However, under the Keynesian simplifying
assumptions, when all components of AD are
reflected, the label becomes Y for real GDP.
12-14
Determinants of Planned Consumption and
Planned Saving (cont'd)

Autonomous Consumption
 The
part of consumption that is independent
of the level of disposable income
 Changes
in autonomous consumption
shift the consumption function.
12-15
Figure 12-1
The Consumption
and Saving
Functions
12-16
Figure 12-1 The Consumption
and Saving Functions (cont'd)
12-17
Figure 12-1 The Consumption
and Saving Functions (cont'd)
12-18
Determinants of Planned Consumption and
Planned Saving (cont'd)

Average Propensity to Consume (APC)
 Real
consumption divided by real disposable
income
 The
proportion of total disposable income that
is consumed
Real consumption
APC =
Real disposable income
12-19
Determinants of Planned Consumption and
Planned Saving (cont'd)

Average Propensity to Save (APS)
 Real
saving divided by real disposable
income (DI)
 Saved
proportion of real DI
Real saving
APS =
Real disposable income
12-20
Determinants of Planned Consumption and
Planned Saving (cont'd)

Marginal Propensity to Consume (MPC)
 The
ratio of the change in real consumption to
the change in real disposable income
MPC =
Change in real consumption
Change in real disposable income
12-21
Determinants of Planned Consumption and
Planned Saving (cont'd)

Marginal Propensity to Save (MPS)
 The
ratio of the change in saving to the
change in disposable income
MPS =
Change in real saving
Change in real disposable income
12-22
Determinants of Planned Consumption and
Planned Saving (cont'd)

Some relationships
 Average
propensity to consume and average
propensity to save must sum to 100% of total
income. (APC + APS = 1)
 Marginal
propensity to consume and marginal
propensity to save must sum to 100% of the
change in income. (MPC + MPS = 1)
12-23
Determinants of Planned Consumption and
Planned Saving (cont'd)

Causes of shifts in the consumption
function
A
change besides real disposable income will
cause the consumption function
to shift.
 Non-income

Population

Wealth
determinants of consumption
12-24
Determinants of Planned Consumption and
Planned Saving (cont'd)

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.
12-25
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.
12-26
Figure 12-2
Planned Real Investment, Panel (a)
12-27
Figure 12-2
Planned Real Investment, Panel (b)
12-28
Determining Equilibrium
Real GDP (cont'd)

Adding the investment function
AD = C + I + G + X
12-29
Figure 12-4 Combining
Consumption and Investment
12-30
Determining Equilibrium
Real GDP (cont'd)

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.
12-31
Figure 12-5 Planned and Actual Rates of
Saving and Investment
12-32
Determining Equilibrium Real GDP (cont'd)

Unplanned increases in business inventories
 Consumers
purchase fewer goods and services
than anticipated
 This

leaves firms with unsold products
Unplanned decreases in business inventories
 Business
will increase production of goods and
services and increase employment
12-33
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.
12-34
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
12-35
Keynesian Equilibrium with Government and
the Foreign Sector Added (cont'd)

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
12-36
Table 12-2 The Determination
of Equilibrium Real GDP with Government and
Net Exports Added
12-37
Keynesian Equilibrium with Government and
the Foreign Sector Added (cont'd)

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.
12-38
Figure 12-6
The Equilibrium Level of Real GDP
Recall that planned AD
=C+I+G+X
Although not identified
as such by Keynes, the
45-degree reference
line can be thought of
as actual expenditures
or AS.
Equilibrium will occur
where AD = AS.
12-39
The Equilibrium Level of Real
GDP

Observations
 If
C+I+G+X=Y

 If
C+I+G+X>Y



 If
Equilibrium GDP
Unplanned drop in inventories
Businesses increase output
Y returns to equilibrium
C+I+G+X<Y



Unplanned rise in inventories
Businesses cut output
Y returns to equilibrium
12-40
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
12-41
Table 12-3 The Multiplier
Process
12-42
The Multiplier (cont'd)

The multiplier formula
1
1
Multiplier =
=
1 - MPC
MPS
12-43
The Multiplier (cont'd)

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.
12-44
The Multiplier (cont'd)

Measuring the change in
equilibrium income from a
change in autonomous spending
Change in equilibrium real GDP =
Multiplier x Change in autonomous spending
12-45
The Multiplier (cont'd)

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.
12-46
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 autonomous
consumption, investment, government spending,
net exports.
12-47
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.
12-48
Figure 12-7 Effect of a Rise
in Autonomous Spending on
Equilibrium Real GDP
12-49
The Relationship Between Aggregate
Demand and the C + I + G + X Curve

There is clearly a relationship; aggregate
demand consists of consumption,
investment, government, and the foreign
sector.
12-50
The Relationship Between
Aggregate Demand and the
C + I + G + X Curve (cont'd)

There is a major difference
C
+ I + G + X curve drawn with price
level constant
 AD
curve drawn with the price
level changing
12-51
The Relationship Between Aggregate Demand
and the C + I + G + X Curve (cont'd)



To derive the aggregate demand curve from the
C + I + G + X curve, we must now allow the
price level to change.
Since we know that at higher prices, real
spending is diminished, we can show two
C + I + G + X curves at different price levels.
We can then plot the equilibrium outcomes of
each as AD at the two price levels as reflected
on the AS-AD model graph.
12-52
Figure 12-8
The
Relationship
Between AD
and the C + I +
G + X Curve
12-53
End of
ECON 151 – PRINCIPLES
OF MACROECONOMICS
Chapter
10
Chapter 12: Consumption, Real
GDP, and the Multiplier
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
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