Download Module 16

Module 16
Apr 2015

In the short term – we can assume the
following:
◦ Producers are willing to supply additional output at
a fixed price
◦ The interest rate is a given
◦ There is no government spending and no taxes
◦ Export and imports are zero
Ex: if there is a change in investment spending, say
$100B on home construction, the direct effect will be
to increase income and the value of aggregate output
by the same amt.





Marginal Propensity to Consume – the
increase in consumer spending when
disposable income rises by $1
MPC = △consumer spending
△ disposable income
Marginal Propensity to Save – the increase in
household savings when disposable income
rises by $1
MPS = 1-MPC

With no taxes and no international trade,
each $1 increase in spending raises both the
real GDP and disposable income by $1.
$100B increase raises GDP by $100B and
raises disposable income by $100B which
leads to consumer spending which increases
real GDP MPCx100B. Then, that is more
money to spend and it becomes
MPCxMPCx$100B, etc.
The $100B in investment spending sets off a
chain reaction in the economy. The net result
of this chain is that an increase in investment
spending leads to change in the real GDP that
is a multiple of the size of that initial change.
Total increase in real GDP from $100B rise in I:
____1____ x $100B
(1-MPC)







If the MPC = .6, each additional $1in
additional disposable income causes a $0.6
rise in consumer spending. So,
1st round:
$100B
2nd round:
$100B + $60B
3rd round:
$100B + $60B + $36B
(1/1-0.6)x$100B=2.5x$100B=$250B
There is a limit because at each stage, some
money “leaks out”




Autonomous Change in Aggregate Spending –
is an initial rise or fall in aggregate spending
that is the cause, not the result, or a series of
income and spending changes.
Multiplier – the ratio of the total change in
real GDP caused by an autonomous change in
aggregate spending to the size of the
autonomous change.
∆AAS (change in autonomous change in
aggregate spending)
∆Y (change in real GDP)



Multiplier:
__∆Y__ = ____1____
∆AAS
(1-MPC)




Consumption Function – an equation showing
how an individual household’s consumer
spending varies with the household’s current
disposable income.
𝑐 = 𝑎 + 𝑀𝑃𝐶 × 𝑦𝑑
Autonomous consumer spending – the
amount of money a household would spend if
it had no disposable income. This is the a in
the equation
Income is expressed with the y


MPC is the ration of the change in consumer
spending to the change in current disposable
income 𝑀𝑃𝐶 = ∆𝑐/∆𝑦 𝑑
Multiplying both sides of the equation by ∆𝑦𝑑
we get 𝑀𝑃𝐶 × ∆𝑦𝑑 = ∆𝑐


This figure shows the consumption function
with 𝑦𝑑 on the horizontal axis and 𝑐 on the
vertical axis. Individual household
autonomous consumer spending 𝑎 is the
value of 𝑐 when 𝑦𝑑 is zero – it is the vertical
intercept of the consumption function 𝑐𝑓.
𝑀𝑃𝐶 is the slope of the line, measured by rise
over run
The data doesn’t always fit perfectly, but it’s
usually close.
Consumer Spending
Household Current Disposable
Income
$20,000
$22,500
$40,000
$51,000
$60,000
$70,000
$80,000
$95,000
What is the MPC?
What is 𝑎?
Consumer Spending
Disposable Income
$25,000
$30,000
$45,000
$55,000
$65,000
$75,000
What is the MPC?
What is 𝑎?
𝑐=
+
× 𝑦𝑑



If the MPC = .53, then the MPS is .47 (1-MPC)
and the multiplier is 1/(1 − 𝑀𝑃𝐶) or 1/𝑀𝑃𝑆 or
1/.47 or 2.13.
While this is a micro concept, it can be
applied to macro – and is known as the
aggregate consumption function – the
relationship for the economy as a whole
between aggregate current disposable
income and aggregate consumer spending
𝐶 = 𝐴 + 𝑀𝑃𝐶 × 𝑌𝐷

There are two principal causes of shifts of the
aggregate consumption functions:
◦ Changes in expected future disposable income
 Suppose you get a job, but it hasn’t started yet. You
will start to spend as if it already has OR you know
your hours are going to be cut, so you spend less in
anticipation
◦ Changes in aggregate wealth
 People with more money (other things being equal) will
spend more on goods and services (their example is 2
people make same $, but 1 has saved $200,000, and
will therefore spend more – but ??? She’s saving???


Planned investment spending – is the
investment spending that businesses intend
to undertake during a given period
It depends on 3 factors: the interest rate, the
expected future level of real GDP, and the
current level of production capacity.





Interest rate – most obvious with home construction –
interest rate on $150,000 is 7.5% pmt of $1048/mo;
rate of 5.5% pmt of $851/mo.
Firms with investment spending projects will go
ahead with a project only if they expect a rate of
return higher than the project’s cost
Past profits used to finance investments are called
retained earnings.
Planned investment spending, spending on
investment projects that firms voluntarily decide
whether or not to undertake, is negatively related to
the interest rate.
Other things equal, a higher interest rate leads to
lower level of planning investment spending.


Other things equal, firms will undertake more
investment spending when they expect their
sales to grow.
The higher the current capacity, the lower the
investment spending




Inventories – stocks of goods held to satisfy
future sales
Inventory Investment – the value of the change in
total inventories held in the economy during a
given period. – Can be negative
Unplanned inventory investment – occurs when
actual sales are less than businesses expected,
leading to unplanned increases in inventories.
Sales in excess of expectations result in negative
unplanned inventory investment.
Actual investment spending-the sum of planned
and unplanned investment spending



1. Explain why a decline in investment
spending caused by a change in business
expectations leads to a fall in consumer
spending.
2. What is the multiplier if the MPC is 0.5?
What is it when the multiplier is 0.8?
Suppose a crisis in the capital markets makes
consumers unable to borrow and unable to
save money. What implication does this have
for the effects of expected future disposable
income on consumer spending?

4. For each event, explain whether the initial
effect is a change in planned investment
spending or a change in unplanned inventory
investment, and indicate the direction of the
change:
◦ A. an unexpected increase in consumer spending
◦ B. a sharp rise in the cost of business borrowing
◦ C. a sharp increase in the economy’s growth rate of
real GDP
◦ D. an unanticipated fall in sales

1. changes in which of the following leads to
a shift of the aggregate consumption
function:
◦ I. expected future disposable income
◦ II. Aggregate wealth
◦ III. Current disposable income
a. I only
b. II only
c. III only
d. I and II only
e. I, II, and III

2. The slope of a family’s consumption
function is equal to:
◦
◦
◦
◦
◦
A. the real interest rate
B. the inflation rate
C. the marginal propensity to consume
D. the rate of increase in household 𝑦𝑑
E. the tax rate

3. Given the consumption function 𝑐 =
$16,000 + 0.5𝑦𝑑 if individual household current
disposable income is $20,000, individual
household consumer spending will equal:
◦
◦
◦
◦
◦
A. $36,000
B. $26,000
C. $20,000
D. $16,000
E. $6,000

4. The level of planned investment spending
is negatively related to the:
◦
◦
◦
◦
◦
A. rate of return on investment
B. level of consumer spending
C. Level of actual investment spending
D. interest rate
E. all of the above

5. Actual investment spending in any period
is equal to:
◦ A. planned investment spending + unplanned
inventory investment
◦ B. planned investment spending – unplanned
inventory investment
◦ C. planned investment spending + inventory
decreases
◦ D. unplanned inventory investment + investment
increases
◦ E. unplanned inventory investment – inventory
increases







6. Use the consumption function provided to
answer the following questions:
𝑐 = $15𝑚000 + 0.8 × 𝑦𝑑
A. What is the value of the MPC?
B. If ind. Household current disposable income is
$40,000, ind. Household consumer spending will
equal how much?
C. Draw a correctly labeled graph showing this
consumption function.
D. What is the slope of this consumption
function?
E. On your graph from part c, show what would
happen if expected future incomes decreased.