Chapter 12 Powerpoint

Chapter 12
Consumption,
Real GDP, and
the Multiplier

Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-2
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.

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

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

Chapter Outline
• Some Simplifying Assumptions in a
Keynesian Model
• Determinants of Planned Consumption and
Planned Saving
• Determinants of Investment
• Determining Equilibrium Real GDP

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

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.

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

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

• 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

• Consumption Goods
– Goods bought by households to use up, such as
food and movies

• Accounting identity:
Consumption + saving ≡ disposable income
Saving ≡ disposable income – consumption

• 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

• 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, and the less they wanted to consume

Determinants of Planned Consumption and
Planned Saving (cont'd)
• 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.

• 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.

• 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.

• 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.

• 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

Table 12-1 Real Consumption and Saving
Schedules: A Hypothetical Case

• 45-Degree Reference Line
– The line along which planned real expenditures
equal real GDP per year

Figure 12-1
The Consumption
and Saving
Functions

• Autonomous Consumption
– The part of consumption that is independent of
the level of disposable income
– Changes in autonomous consumption shift the
consumption function

• 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

MPC =
Change in real consumption
Change in real disposable income
• Marginal Propensity to Consume (MPC)
– The ratio of the change in real consumption to
the change in real disposable income

MPS =
Change in real saving
Change in real disposable income
• Marginal Propensity to Save (MPS)
– The ratio of the change in saving to the change
in disposable income

APC =
$49,200
$54,000
= .911
• Example
– Income = $54,000
– C= $49,200
– S = $4,800
• What is the APC?

APC =
$54,000
$60,000
= .90
• Example
– Income increases by $6,000 to $60,000
– C = $54,000
– S = $6,000
• What is the APC?

• Some relationships
APC + APS ≡ 1
MPC + MPS ≡ 1

• 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

• 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)

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.

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

Figure 12-2 Planned Real Investment,
Panel (a)

Figure 12-2 Planned Real Investment,
Panel (b)

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 three-
dimensional (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.

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

(cont'd)
• Adding the investment function
AD = C + I + G + X

Figure 12-4 Combining Consumption
and Investment

(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

(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

(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

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

• 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

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

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

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

• The multiplier formula
Multiplier =
1
1 - MPC
=
1
MPS

• 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

• Examples
MPC =
4
5
MPS =
1
5
Multiplier =
1
1/5
= 5
MPC =
3
5
MPS =
2
5
Multiplier =
1
2/5
= 2.5

Change in equilibrium real GDP =
Multiplier x Change in autonomous spending
• Measuring the change in equilibrium income
from a change in autonomous spending

• 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

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.

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

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

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 0.50.
• 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.

The Relationship Between Aggregate
Demand and the C + I + G + X Curve
• Aggregate demand consists of:
– Consumption
– Investment
– Government
– Foreign sector

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

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

Figure 12-8 The
Relationship Between
AD and the C + I + G
+ X Curve

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.

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.

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.

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.

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

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

Objectives (cont'd)
• The key determinants of planned
investment
– The interest rate, business expectations,
productive technology, and business taxes

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

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

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 C-1 Graphing the Multiplier

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