Chapter 12. Introduction. Learning Objectives. Consumption, Real GDP, and the Multiplier

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1 Chapter 12 Consumption, Real GDP, and the Multiplier Introduction Since the early 2000s, planned real investment spending has increased in most of the world s nations. As a percentage of global real GDP, however, planned real investment spending in the world s developed countries has declined. Yet, it has been rising in emerging-economy nations. These are countries transitioning to a developed status. How do changes in planned real investment spending affect a country s real GDP? Reading Chapter 12 will help you answer this question. Copyright 2014 Pearson Education, Inc. All rights reserved 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 2014 Pearson Education, Inc. All rights reserved

2 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 2014 Pearson Education, Inc. All rights reserved Chapter Outline Some Simplifying Assumptions in a Keynesian Model Determinants of Planned Consumption and Planned Saving Determinants of Investment Determining Equilibrium Real GDP Copyright 2014 Pearson Education, Inc. All rights reserved 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 2014 Pearson Education, Inc. All rights reserved

3 Did You Know That... The share of real GDP allocated to real consumption spending is: 66 percent in Germany 60 percent in the United Kingdom 70 percent in the United States Less than 41 percent in China? In this chapter, you will learn how an understanding of households real saving and real consumption spending can help you evaluate fluctuations in a national s real GDP. Copyright 2014 Pearson Education, Inc. All rights reserved Some Simplifying Assumptions in a Keynesian Model To simplify the income determination model, let s assume: 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 2014 Pearson Education, Inc. All rights reserved 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 2014 Pearson Education, Inc. All rights reserved

4 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 2014 Pearson Education, Inc. All rights reserved Some Simplifying Assumptions in a Keynesian Model (cont'd) Consumption Goods Goods bought by households to use up, such as food and movies Copyright 2014 Pearson Education, Inc. All rights reserved Some Simplifying Assumptions in a Keynesian Model (cont'd) Accounting identity: Consumption + saving disposable income Saving disposable income consumption Copyright 2014 Pearson Education, Inc. All rights reserved

5 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 2014 Pearson Education, Inc. All rights reserved Some Simplifying Assumptions in a Keynesian Model (cont'd) Capital Goods Producer durables; nonconsumable goods that firms use to make other goods Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved

6 Determinants of Planned Consumption and Keynes argued that: The interest rate is not the most important factor in saving and consumption decisions Rather, real saving and consumption decisions depend primarily on a household s real disposable income. Furthermore, a person s anticipation about future flows of income influences how much of current income is allocated to consumption and how much is allocated to saving. Copyright 2014 Pearson Education, Inc. All rights reserved Determinants of Planned Consumption and The Life-Cycle Theory of Consumption The most realistic and detailed theory of consumption, often called the life-cycle theory of consumption, considers how a person varies saving and consumption as income ebbs and flows throughout an entire life span. This theory predicts that when an individual anticipates a higher income in the future, he or she will tend to consume more and save less in the current period than would have been the case otherwise. Copyright 2014 Pearson Education, Inc. All rights reserved Determinants of Planned Consumption and The Permanent Income Hypothesis A related theory, called the permanent income hypothesis, suggests that the income level that matters for a person s decisions about current consumption and saving is permanent income, or expected average lifetime income. Thus, if a person s flow of income temporarily rises without an increase in average lifetime income, the person responds by saving more and leaving consumption unchanged. Copyright 2014 Pearson Education, Inc. All rights reserved

7 Determinants of Planned Consumption and The Keynesian Theory of Consumption and Saving Keynes argued that real consumption and saving decisions depend primarily on a household s current real disposable income. Copyright 2014 Pearson Education, Inc. All rights reserved Determinants of Planned Consumption and 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 2014 Pearson Education, Inc. All rights reserved Determinants of Planned Consumption and 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 2014 Pearson Education, Inc. All rights reserved

8 Table 12-1 Real Consumption and Saving Schedules: A Hypothetical Case Copyright 2014 Pearson Education, Inc. All rights reserved Determinants of Planned Consumption and 45-Degree Reference Line The line along which planned real expenditures equal real GDP per year Copyright 2014 Pearson Education, Inc. All rights reserved Figure 12-1 The Consumption and Saving Functions Copyright 2014 Pearson Education, Inc. All rights reserved

9 Determinants of Planned Consumption and Autonomous Consumption The part of consumption that is independent of the level of disposable income Changes in autonomous consumption shift the consumption function Copyright 2014 Pearson Education, Inc. All rights reserved Determinants of Planned Consumption and 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 Copyright 2014 Pearson Education, Inc. All rights reserved Determinants of Planned Consumption and Average Propensity to Save (APS) Real saving divided by real disposable income (DI) Saved proportion of real DI APS = Real saving Real disposable income Copyright 2014 Pearson Education, Inc. All rights reserved

10 Determinants of Planned Consumption and Marginal Propensity to Consume (MPC) The ratio of the change in real consumption to the change in real disposable income Change in real consumption MPC = Change in real disposable income Copyright 2014 Pearson Education, Inc. All rights reserved Determinants of Planned Consumption and 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 2014 Pearson Education, Inc. All rights reserved Determinants of Planned Consumption and Example Income = $54,000 C= $49,200 S = $4,800 What is the APC? APC = $49,200 $54,000 =.911 Copyright 2014 Pearson Education, Inc. All rights reserved

11 Determinants of Planned Consumption and Example Income increases by $6,000 to $60,000 C = $54,000 S = $6,000 What is the APC? APC = $54,000 $60,000 =.90 Copyright 2014 Pearson Education, Inc. All rights reserved Determinants of Planned Consumption and Some relationships APC + APS 1 MPC + MPS 1 Copyright 2014 Pearson Education, Inc. All rights reserved Determinants of Planned Consumption and 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 2014 Pearson Education, Inc. All rights reserved

12 Determinants of Planned Consumption and Net wealth The stock of assets owned by a person, household, firm or nation (net of any debts owed) For a household, wealth can consist of a house, cars, personal belongings, stocks, bonds, bank accounts, and cash (minus any debts owed) Copyright 2014 Pearson Education, Inc. All rights reserved Example: Lower Household Wealth and Subdued Growth in Consumption Between 2007 and 2009, there was a substantial decline in two key components of real household wealth. Inflation-adjusted wealth in housing fell by 25 percent Inflation-adjusted wealth in corporate stocks fell by 50 percent These wealth reductions shifted the U.S. consumption function downward. Real disposable income also fell, causing a leftward movement along the consumption function and a further drop in consumption. Copyright 2014 Pearson Education, Inc. All rights reserved 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 2014 Pearson Education, Inc. All rights reserved

13 Figure 12-2 Planned Real Investment, Panel (a) Copyright 2014 Pearson Education, Inc. All rights reserved Figure 12-2 Planned Real Investment, Panel (b) Copyright 2014 Pearson Education, Inc. All rights reserved Example: Adding a Third Dimension Requires New Investment Spending Of the approximately 40,000 movie screens in the United States, fewer than 8,000 are equipped with digital technology required for projection of threedimensional (3D) movies. Conversion to the 3D technology costs about $70,000. Major movie-theater chains are currently undertaking this investment for more than 1,000 theaters. This adds up to an aggregate investment expenditure of about $700 million. Copyright 2014 Pearson Education, Inc. All rights reserved

14 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 2014 Pearson Education, Inc. All rights reserved Figure 12-3 Consumption as a Function of Real GDP Copyright 2014 Pearson Education, Inc. All rights reserved Determining Equilibrium Real GDP (cont'd) Adding the investment function AD = C + I + G + X Copyright 2014 Pearson Education, Inc. All rights reserved

15 Figure 12-4 Combining Consumption and Investment Copyright 2014 Pearson Education, Inc. All rights reserved 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 2014 Pearson Education, Inc. All rights reserved Figure 12-5 Planned and Actual Rates of Saving and Investment Copyright 2014 Pearson Education, Inc. All rights reserved

16 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 and inventories will rise Businesses respond by cutting back production and reducing employment Copyright 2014 Pearson Education, Inc. All rights reserved Determining Equilibrium Real GDP (cont'd) 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 Copyright 2014 Pearson Education, Inc. All rights reserved 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 2014 Pearson Education, Inc. All rights reserved

17 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 2014 Pearson Education, Inc. All rights reserved 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 2014 Pearson Education, Inc. All rights reserved Table 12-2 The Determination of Equilibrium Real GDP with Government and Net Exports Added Copyright 2014 Pearson Education, Inc. All rights reserved

18 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 2014 Pearson Education, Inc. All rights reserved Figure 12-6 The Equilibrium Level of Real GDP Copyright 2014 Pearson Education, Inc. All rights reserved Keynesian Equilibrium with Government and the Foreign Sector Added (cont'd) The Equilibrium Level of Real GDP Observations If C + I + G + X = Y Equilibrium GDP If C + I + G + X > Y Unplanned decrease in inventories Businesses raise output Y returns to equilibrium If C + I + G + X < Y Unplanned increase in inventories Businesses reduce output Y returns to equilibrium Copyright 2014 Pearson Education, Inc. All rights reserved

19 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 2014 Pearson Education, Inc. All rights reserved 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 2014 Pearson Education, Inc. All rights reserved Table 12-3 The Multiplier Process Copyright 2014 Pearson Education, Inc. All rights reserved

20 The Multiplier (cont'd) The multiplier formula 1 Multiplier = 1 - MPC = 1 MPS Copyright 2014 Pearson Education, Inc. All rights reserved 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 2014 Pearson Education, Inc. All rights reserved The Multiplier (cont'd) Examples MPC = 4 5 MPS = 1 5 Multiplier = 1 1/5 = 5 MPC = 3 5 MPS = 2 5 Multiplier = 1 2/5 = 2.5 Copyright 2014 Pearson Education, Inc. All rights reserved

21 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 2014 Pearson Education, Inc. All rights reserved 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 2014 Pearson Education, Inc. All rights reserved What If... The government seeks a larger multiplier effect by funding private spending on certain items rather than buying them directly? Whether the government gives funds to households and firms for purchasing goods or whether the government makes the purchases directly, the resulting increase in total autonomous expenditure is the same. Thus, the overall multiplier effect on equilibrium real GDP would also be the same. So, providing grants of public funds to be spent by households and firms rather than having government purchase the same items will not enlarge the overall theoretical multiplier effect. Copyright 2014 Pearson Education, Inc. All rights reserved

22 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 2014 Pearson Education, Inc. All rights reserved 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 2014 Pearson Education, Inc. All rights reserved Figure 12-7 Effect of a Rise in Autonomous Spending on Equilibrium Real GDP Copyright 2014 Pearson Education, Inc. All rights reserved

23 International Example: The Effect of Higher Autonomous Spending on China s Real GDP Most estimates indicate that the marginal propensity to consume in China is about So, assuming no change in the price level, the multiplier would be about 2. However, economists have estimated that the short-run effect of an initial increase in real autonomous spending on China s real GDP is only about 1.1. Therefore, once the higher price level is taken into account, an additional one-unit increase in real autonomous expenditure causes a 1.1 unit increase in China s annual real GDP. Copyright 2014 Pearson Education, Inc. All rights reserved The Relationship Between Aggregate Demand and the C + I + G + X Curve Aggregate demand consists of: Consumption Investment Government Foreign sector Copyright 2014 Pearson Education, Inc. All rights reserved 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 Copyright 2014 Pearson Education, Inc. All rights reserved

24 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 2014 Pearson Education, Inc. All rights reserved Figure 12-8 The Relationship Between AD and the C + I + G + X Curve Copyright 2014 Pearson Education, Inc. All rights reserved You Are There: Evaluating the Effects of Declining Real Disposable Income Mark Vitner, an economist with Wells Fargo bank, examines the latest monthly economic data. Real disposable income fell by 0.3 percent during the month. Real consumption spending and real saving dipped as well, consistent with the theory. Vitner summarizes the situation by saying that household budgets are getting tighter and consumers are having difficulty maintaining their standard of living. Copyright 2014 Pearson Education, Inc. All rights reserved

25 Issues & Applications: A Global Reversal in Planned Investment Spending In the past, developed countries have displayed the largest upward shifts in their planned investment functions. Recently, however, larger upward shifts have occurred among the emerging-economy nations, such as China, India, South Korea, and Singapore. Figure 12-9 on the next slide displays real investment spending as a percentage of global real GDP for developed and emerging nations. Copyright 2014 Pearson Education, Inc. All rights reserved Figure 12-9 Real Investment Spending as a Percentage of Global Real GDP in Two Groups of Nations since 1995 Sources: International Monetary Fund; author s estimates. Copyright 2014 Pearson Education, Inc. All rights reserved Issues & Applications: A Global Reversal in Planned Investment Spending (cont d) Variations in planned real investment spending operate through the multiplier to bring about changes in equilibrium real GDP. Therefore, a country that experiences a larger upward shift in its planned investment function will observe a greater increase in its equilibrium real GDP. This explains why countries such as China, India, South Korea, and Singapore are emerging to take a place alongside developed nations. Copyright 2014 Pearson Education, Inc. All rights reserved

26 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 2014 Pearson Education, Inc. All rights reserved 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 2014 Pearson Education, Inc. All rights reserved Summary Discussion of Learning Objectives (cont'd) The key determinants of planned investment The interest rate, business expectations, productive technology, and business taxes Copyright 2014 Pearson Education, Inc. All rights reserved

27 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 45-degree line Copyright 2014 Pearson Education, Inc. All rights reserved 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 2014 Pearson Education, Inc. All rights reserved 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 2014 Pearson Education, Inc. All rights reserved

28 Figure C-1 Graphing the Multiplier Copyright 2014 Pearson Education, Inc. All rights reserved