Transcript Chapter 12 - The Citadel

Chapter 12
Consumption,
Real GDP, and
the Multiplier
Introduction
In recent years, the federal government
has reported U.S. households save close
to 0% of their income.
Is the U.S. rate of saving really that low?
How does the share of income that goes
to saving matter for the U.S. economy?
You will find out in this chapter.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-2
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-3
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-4
Chapter Outline
• Some Simplifying Assumptions in a
Keynesian Model
• Determinants of Planned Consumption
and Planned Saving
• Determinants of Investment
• Determining Equilibrium Real GDP
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-5
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-6
Did You Know That...
• In the 1990s some posited new
information technologies made
recessions obsolete?
• By 2001, a drop in information
technology investment contributed to
a recession?
• Variations in household consumption
and business investment affect GDP?
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-7
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-8
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-9
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 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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-10
Some Simplifying Assumptions
in a Keynesian Model (cont'd)
• Consumption Goods
 Goods bought by households to use up,
such as food and movies
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-11
Some Simplifying Assumptions
in a Keynesian Model (cont'd)
• Consumption plus saving equals
disposable income.
• Saving equals disposable income
minus consumption.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-12
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-13
Some Simplifying Assumptions
in a Keynesian Model (cont'd)
• Capital Goods
 Producer durables; nonconsumable goods
that firms use to make other goods
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-14
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-15
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-16
Determinants of Planned Consumption
and Planned Saving (cont'd)
• Keynes argued that real saving and
consumption decisions depend
primarily on a household’s real
disposable income.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-17
Determinants of Planned Consumption
and Planned Saving (cont'd)
• Keynes was concerned with changes
in AD
AD = C + I + G + X
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-18
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-19
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-20
Table 12-1 Real Consumption and
Saving Schedules: A Hypothetical Case
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-21
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-22
Figure 12-1
The Consumption
and Saving
Functions
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-23
Figure 12-1 The Consumption
and Saving Functions (cont'd)
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-24
Figure 12-1 The Consumption
and Saving Functions (cont'd)
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-25
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-26
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-27
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-28
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-29
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-30
Determinants of Planned Consumption
and Planned Saving (cont'd)
• Example
 Income = $54,000
 C = $49,200
 S = $4,800
• What is the APC?
APC =
$49,200
= .911
$54,000
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-31
Determinants of Planned Consumption
and Planned Saving (cont'd)
• Example
 Income increases by $6,000 to $60,000
 C = $54,000
 S = $6,000
• What is the APC?
APC =
$54,000
= .90
$60,000
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-32
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.
 Marginal propensity to consume and
marginal propensity to save must sum
to 100% of the change in income.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-33
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 determinants of consumption
 Population
 Wealth
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-34
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-35
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-36
Figure 12-2
Planned Real Investment, Panel (a)
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-37
Figure 12-2
Planned Real Investment, Panel (b)
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-38
Example: Information-Technology
Investment Continues to Lag
• Business spending on IT accounts for about
40% of U.S. investment expenditures.
• Sometimes IT investment slows down due to
businesses cutting back on new IT.
• Some examples
 Reconfiguring existing servers (Vanguard Group)
 Firms using open-source software (Linux)
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-39
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-40
Figure 12-3 Consumption as
a Function of Real GDP
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-41
Determining Equilibrium
Real GDP (cont'd)
• Adding the investment function
AD = C + I + G + X
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-42
Figure 12-4 Combining
Consumption and Investment
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-43
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-44
Figure 12-5 Planned and Actual
Rates of Saving and Investment
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-45
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-46
Determining Equilibrium
Real GDP (cont'd)
• Unplanned decreases in business
inventories
 Business will increase production of goods
and services and increase employment
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-47
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-48
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-49
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-50
Table 12-2 The Determination
of Equilibrium Real GDP with
Government and Net Exports Added
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-51
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-52
Figure 12-6
The Equilibrium Level of Real GDP
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-53
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

Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-54
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-55
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-56
Table 12-3 The Multiplier Process
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-57
The Multiplier (cont'd)
• The multiplier formula
1
1
Multiplier =
=
1 - MPC
MPS
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-58
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-59
The Multiplier (cont'd)
• Examples
MPC =
4
5
MPS =
1
5
Mult. =
1
=5
1/5
MPC =
3
4
MPS =
1
4
Mult. =
1
=4
1/4
MPC =
2
3
MPS =
1
3
Mult. =
1
=3
1/3
MPC =
3
5
MPS =
2
5
Mult. =
1
= 2.5
2/5
MPC =
7
9
MPS =
2
9
1
Mult. =
= 4.5
2/9
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-60
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-61
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-62
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-63
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-64
Figure 12-7 Effect of a Rise
in Autonomous Spending on
Equilibrium Real GDP
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-65
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-66
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-67
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-68
The Relationship Between
Aggregate Demand and the
C + I + G + X Curve (cont'd)
• What are some of the effects of a price
level increase?
 Real balance effect
 Interest rate effect
 The open economy effect
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-69
Figure 12-8
The
Relationship
Between AD
and the C + I
+ G + X Curve
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-70
Issues and Applications:
Is the U.S. Propensity to Save
Really as Low as 0.01?
• Measures of U.S. saving have indicated
a big drop-off in personal saving during the
past 20 years.
• Some economists question whether the
saving rate really has fallen as much as
official figures indicate.
• “Are disposable income and saving correctly
measured?” these economists ask.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-71
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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-72
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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-73
Summary Discussion
of Learning Objectives (cont'd)
• The primary determinants of
planned investment
 The interest rate, business expectations,
productive technology, and business taxes
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-74
Summary Discussion
of Learning Objectives (cont'd)
• How equilibrium real GDP is
established in the Keynesian model
 Equilibrium national income occurs where
the C + I + G + X schedule crosses the 45degree line.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-75
Summary Discussion
of Learning Objectives (cont'd)
• 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.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-76
Summary Discussion
of Learning Objectives (cont'd)
• 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
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
12-77
End of
Chapter 12
Consumption,
Real GDP, and
the Multiplier