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Chapter 10
I. Consumption Function (CF)
A. With Y (GDP) on the horizontal axis, and C (Consumption Spending) on the
vertical, the curve representing the relationship between the level of spending at
various income levels is called the Consumption Function. For comparison, a line
is also drawn at a 45 degree angle, starting at the origin. This line shows a 1:1
ratio of Consumption: Income, which only actually exists when the Consumption
Function crosses the 45 degree line.
B. At points to the left of this intersection, Consumption exceeds income (through
borrowing). This region is called “dissavings” where the savings are a negative
number. To the right of the intersection, income exceeds consumption spending.
Graphically this is due to the slope of the CF being less than 45 degrees; the ratio
of C/Y is less than 1:1. If it is 0.8/1 that means people spend 80 cents for every
dollar of increased income.
C. Change in output consumed, represented by movement along the CF, can only be
caused by a change in Y (income). CF can shift (up or down) dependent on (note
these are essentially demand –AD- shifters for the macroeconomy) :
1. Attitudes towards saving – influenced by religious and cultural customs,
as well as concrete factors like the existence of pensions and insurance.
2. Assets – while income is measured on a yearly basis, assets are the
accumulated, year after year, total worth of individuals. It often includes
the inherited assets of previous generations as well. Assets take three
forms:
i. Liquid assets: money or close to money, such as bonds and
savings accounts that can be quickly turned into cash.
ii. Debt: accumulating debt enables C to increase (CF shifts up)
while paying down debt causes CF to shift down. The interest rate
and leniency or rigidity of the terms of lending also will influence
the CF.
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iii. Ownership of durable goods: if individuals purchase a variety of
durable goods, their CF can shift down because they will not need
to spend at that level again for some time.
3. Expectations, particularly about future income, the health of the economy,
and the security of their employment
4.Taxes- directly influence C, therefore CF shifts if taxes fluctuate.
5.Distribution of income – if income is distributed away from the rich and
towards the poor, overall spending will increase (CF shifts up) since the
wealthier individuals are able to save more while the poor are more inclined to
spend additional income.
6.Demographics – the makeup of society in terms of age, number of people in
the population, and the percentage of the population in the workforce will all
influence the CF.
Factors like taxes, assets, distribution of income or demographics are
called “objective” or economic factors while attitudes towards savings and
expectations are “psychological” factors.
II.
Keynesian Multiplier and Propensities to Consume/Save
For usefulness in equations/concepts, MPC is most important
A. APC: Average Propensity to Consume, the fraction of Disposable Income
(DI) that is Consumed (C). APC= C/DI
B. APS: Average Propensity to Save, the fraction of DI that is saved (S).
APS=S/DI
C. APC+APS=1 (after taxes, people can either spend or save)
D. MPC: Marginal Propensity to Consume.
Marginal: Additional unit of (Disposable income)
Propensity: Tendency
Consume: Spend
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MPC is the amount of Consumption spending people will tend to make for an
additional unit of income. If the MPC is .75, 75 cents of an additional dollar
will be spent and 25 cents saved (MPS=.25). Of an additional 400M in
Disposable Income, 300M would be spent.
MPC+MPS=1
The book refers to MPC as MPE (marginal propensity to expend)
E. The Multiplier effect refers to the impact on Income of a given change in
Consumption. The cumulative impact is greater than the initial change in
consumption. Logically this is due to the fact that any new spending,
whether it comes from taxes falling, an upswing in CC or stocks, or new,
independent investment projects, that money gets spent. The proportion of
new income that is spent is equal to the MPC. But that is just the first
stage of spending really, since wherever that money was spent, it is now in
the pockets of different consumers who will spend a proportion of their
new income, also equal to the MPC. This process continues until the
values in the rounds of spending become too small to count. If you were to
add up these values (tedious, unnecessary) you would get the same
number (total new level of spending) as simply multiplying the initial new
spending amount by the multiplier. Mathematically, the multiplier = 1/(1MPC)
F. For convenience it is assumed in the shifting of the CF and the resulting
increase in income that the multiplier (M) is instantaneous. Of course, in
reality the rounds of spending take time and the multiplier effect takes up
to a few years to completely work itself through the economy. The
alternative to an “Instantaneous Multiplier”is a “Periodic Multiplier”that
has a diminishing impact on income in each of several successive periods.
We will depict these changes, graphically, as instantaneous.
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G. To summarize, the multiplier equals:
The total change in Income (after all “rounds of spending”are complete) / a
given change in AE (the exogenous shock).
On Page 249: In figures 10-10 a. and b., what government policy could close each gap.
(hint: use the multiplier process)
III. Investment and Government Spending
A. The amount of autonomous Investment (II) has been drawn as a straight
line (constant for all income levels), with a dollar value measured from the horizontal
axis. To get the CF+II combined function, CF was simply shifted up by the value of II. G
can be included in the same way, beginning with a function of II+G, which will shift II
up by the amount of Government Spending (G).
B. Government Spending can shift up or down for political or other noneconomic reasons while II shifts in response to autonomous Investment shifters (like
taxes, technology, expectations, productivity, interest rate).
IV. Savings
A. The argument that a society that saves more in a recession will lead to reduced
output, and ultimately less savings, is called the “Paradox of Thrift.” The increase in
savings must equal a decrease in spending, which signals to firms to decrease their usage
of resources, causing unemployment and less overall saving.
V. Completing the Aggregate Demand–Income Model
A. As covered previously, G can be added to II by shifting Intended
Investment by the value of G. An economy in balance has not only S=I but G=T, so the
element that needs to be added to the analysis is T (Taxes). The CF will shift down by
MPC*(amount of taxes). This is because taxes decrease both Consumption and Saving.
B. Equilibrium: Adjust the initial CF line up for II and G, and then down for
taxes. The new intersection with the 45 degree line now determines equilibrium income,
measured on the horizontal axis.
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D. The Keynesian contention that an economy very often operated at
temporary equilibrium points of unemployment or inflation (i.e. divergences from fullemployment income levels) is evident on the AE-Income graph. In full-employment
equilibrium, Potential Income= Potential Output (PO) and is the vertical line on p. 249.
When potential output is to the right of equilibrium income, output is less than potential,
which is called a “Recessionary gap.” The value of the difference between current
income/output and potential output/income is the dollar value of the recessionary gap, or
the amount AE would have to increase to attain capacity GDP.
When potential output is to the left of equilibrium income, AE is more than
income, which is called an “Inflationary gap.” Output exceeds potential, which will be
inflationary unless AE can be decreased (through decreases G, for example, or Tax or
Interest rate increases). The value of the difference between current income/output and
potential output/income is the dollar value of the inflationary gap, or the amount AE
would have to decrease to attain capacity GDP.
VI. Balanced-Budget Multiplier
A. Recall that the “rounds of spending” that follow an initial increase in AD
cause the total change in Income to ultimately be greater than the initial
increase in AD. If G increase by 100M (Million dollars), then the total
change in Income (based on a MPC=.75) is 100*{1/(1-.75)}=400 million.
B. If this government is to pursue a balanced budget policy, it will have to
change taxes by an equal amount – in this case, positive 100M. Taxes also
affect AD, but not as directly as G. When G increases, all that new money
is spent. When taxes increase, Consumption does fall but only by an
amount=MPC*T. This is because some of the new tax is paid for by a
reduction in saving. In this example, the initial shock to AD will be
0.75*100=75. In the long term, this amount goes through the multiplier
process 75*{1/(1-.75)}=300.
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C. In summary, the increase in G of 100M caused Y to eventually increase
400M, while the taxes of 100M decreased Y by 300M. 400M300M=100M; the income level rises by a net of 100M when the change in
G and T are both 100M. In this case, there was a positive increase in G
and T, so the change in Income is positive. Another way to say this is the
balanced-budget multiplier=1.
VII. In an open economy (one that trades with foreign nations) Y=C+G+I+Xn
A. Xn = X-M and can be assumed constant, shifting the CF+I+G (AD) function up,
assuming of course that Xn is a positive number. If there is a trade deficit, the AD shifts
down to adjust for foreign trade in an open economy. Exports increase AD and imports
decrease it. Be able to use the change in imports or exports (e.g. $100 Billion) just as you
would a change in consumption or government spending in the multiplier equation.
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