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

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1 Chapter 12 Consumption, Real GDP, and the Multiplier 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? You will find out in this chapter 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 12-3

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 12-4 Chapter Outline Some Simplifying Assumptions in a Keynesian Model and Planned Saving Determinants of Investment Determining Equilibrium Real GDP 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 12-6

3 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 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 12-8 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. 12-9

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

5 Some Simplifying Assumptions in a Keynesian Model (cont'd) 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, the less they wanted to consume 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

6 Keynes was concerned with changes in AD AD = C + I + G + X 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

7 Table 12-1 Real Consumption and Saving Schedules: A Hypothetical Case Degree Reference Line The line along which planned real expenditures equal real GDP per year Figure 12-1 The Consumption and Saving Functions 12-21

8 Figure 12-1 The Consumption and Saving Functions (cont'd) Figure 12-1 The Consumption and Saving Functions (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

9 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 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 12-27

10 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 Example Income = $54,000 C= $49,200 S = $4,800 What is the APC? APC = $49,200 $54,000 = Example Income increases by $6,000 to $60,000 C = $54,000 S = $6,000 What is the APC? APC = $54,000 $60,000 =

11 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

12 Example: Explaining the Low U.S. Saving Rate During the 1980s the measured U.S. saving rate averaged 9% so the average value of the APS was Since 2000 the savings rate has averaged 1.8%, implying an average APS value of Example: Explaining the Low U.S. Saving Rate (cont d) Why have the measured saving rate and the APS declined? 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 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

13 Figure 12-2 Planned Real Investment, Panel (a) Figure 12-2 Planned Real Investment, Panel (b) Example: The Rise and Decline of IT Investment s Share of Total Investment 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. The expected profitability of IT investments in the 2000s has remained high but not so high as during the 1990s. Thus, IT investment s share of total investment has dropped during the 2000s. What do you think would happen to IT investment s share of total business investment if the average price of IT goods began to rise each year? 12-39

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 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 12-42

15 Figure 12-4 Combining Consumption and Investment 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 Figure 12-5 Planned and Actual Rates of Saving and Investment 12-45

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 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 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

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 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 Table 12-2 The Determination of Equilibrium Real GDP with Government and Net Exports Added 12-51

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 Figure 12-6 The Equilibrium Level of Real GDP 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 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 12-54

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 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 12-57

20 The Multiplier (cont'd) The multiplier formula 1 Multiplier = 1 - MPC = 1 MPS 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 The Multiplier (cont'd) Examples MPC = 4 5 MPC = 3 4 MPC = 2 3 MPC = 3 5 MPC = 7 9 MPS = 1 5 MPS = 1 4 MPS = 1 3 MPS = 2 5 MPS = 2 9 Mult. = 1 1/5 = 5 Mult. = 1 1/4 = 4 Mult. = 1 1/3 = 3 Mult. = 1 2/5 = 2.5 Mult. = 1 2/9 =

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 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 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

22 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

23 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 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 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 12-69

24 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. (See Figure 12.9) One reason for this is 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 on Real U.S. Consumption Spending Since 1945 Source: Board of Governors of the Federal Reserve System

25 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 12-75

26 Summary Discussion of Learning Objectives (cont'd) The key determinants of planned investment The interest rate, business expectations, productive technology, and business taxes 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 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

27 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 Figure B-1 Graphing the Multiplier 12-80