DETERMINATION OF

NATIONAL INCOME

Consumption (C) function

Investment (I) function

Government (G) function

Marginal propensity to consume/save

Multipliers (I, G, Tax)

Effects of multipliers on GDP

RECAP!
Gross Domestic Product (GDP) is the most
comprehensive measure of the overall performance of an
economy or the nations total output of goods and services.
GDP using Expenditures Approach:
GDP = C + I + G + NX
Where:
C Consumption expenditures
I Investment expenditures
G Government expenditures
NX
Net exports of a nation during the year

INTRODUCTION
CONSUMPTION, INCOME AND SAVING
Consumption
- is usually the largest single component of GDP

which are mostly comprised by housing, motor

vehicles, food, clothing, and medical care.
- has three categories:
Durable goods
Nondurable goods
Services
Personal Saving
- is that part of disposable income that is not consumed.

Disposable Income
- is the amount of money that households have available
for spending and saving afterincome taxeshave been
accounted for.

Example:

In 2016, personal income amounted to $9,275 billion which

is comprised by wages, interest, rents, dividends, transfer
payments, etc. In the same year, 12.5% of personal taxes were
paid. Household outlays for consumption (inc. interest)
amounted to 96.3% of disposable income. How much is the
personal savings in dollars and in rate?
Amount, 2016
($, billion)

Personal income
9,275
Less: Personal taxes ($9,275 * 12.5%)
(1,160)
Disposable Personal Income
8,115
Less: Personal Outlays (C + Int.)
(7,815)
Personal Savings (amt.)
300

Personal Savings Rate =

Personal
Savings (amt.)
Disposable Income
Personal Savings (rate) = $300 / $8,115 = 3.7%

Income is the primary determinant of consumption and

saving.
A Break-even Point happens when the representative
household neither saves nor dissaves but consumes all its
income.
Illustration:

Savings : Income > Consumption

Dissaving : Income < Consumption
Break-even : Income = Consumption

CONSUMPTION FUNCTION
This function shows the relationship between the level of
consumption expenditures and the level of disposable
income.
C = a + b (Y)
Where:
C = Consumer Spending
a = Autonomous Consumption
b = Marginal Propensity to Consume
Y = Disposable Income
This suggests consumption is primarily determined by the
level of disposable income.
If income is low, people will have to spend a high
proportion of their income. If income is high, people will
have the luxury to save.

Illustration:
C

Savings

28,000

Consumer Spending ($)

26,000

Break-even point

24,000

22,000

Consumption

20,000

18,000

45
20,000

22,000 24,000 26,000

Disposable Income ($)

28,000 30,000

DETERMINANTS OF CONSUMPTION
1. Consumer Disposable Income
C = a + b (Y)
2. Permanent Income and the Life-Cycle Model of
Consumption
Permanent Income is the income after removing
temporary or transient influences due to the weather
or windfall gains or losses.
Permanent-income theory states that consumption
responds primarily to permanent income.
Life-cycle hypothesis assumes that people save in order
to smooth their consumption over their life-time.
3. Wealth and Other Influences
Wealth effect higher wealth
consumption.

leads

to

higher

INVESTMENT FUNCTION
Investments two (2) important role in Macroeconomics:
Affects short-run output through its impact on
aggregate demand.
Affects long-run output growth through the impact of
capital formation on potential output and aggregate
supply.
Capital or real investments refer to additions to the
stock of productive assets or capital goods like computers
or trucks.
Financial investments refer to buying shares, stocks,
bonds and securities which already exist in stock market.
Why do people invest?
They expect a profit.
Revenues > Costs

TWO TYPES OF INVESTMENT

Induced Investment

- is profit or income motivated.

- is income-elastic.
I = f(Y)

Autonomous Investment
- is independent of the level of income and is thus
income inelastic.
- is affected by factors like innovations, inventions,
growth of population and labor force, researches, social
and legal institutions, weather changes, war, revolution,
etc.
- regarded as public investment.

1,000

G
F

Net Savings ($)

800
E

600
D

400
C

200
B

0
-200

Savings

20,000 22,000 24,000 26,000 28,000 30,000

Disposable Income ($)

GOVERNMENT
FUNCTION

GOVERNMENT CONSUMPTIONS
EXPENDITURES AND GROSS
INVESTMENT

 In

measuring governments contribution to

GDP, we simply add all these government
purchases to flow of consumption,
investment, and as well as net exports. Hence
all the government payroll expenditures on
its employee plus the costs of goods it buys
from private industry are included in this 3rd
category of flow of products, called the
government expenditures and gross
Investment.

Government consumption expenditures

and gross investment averages between
9-10% percent of gross domestic
product. 2

GOVERNMENT TIMES THREE

Government consumption expenditures and gross
investment is one of three related terms reflecting spending
activities by the government sector. Government
expenditures and government purchases are the other two
terms. They range from the broadest (government
expenditures) to the official measurement (government
consumption expenditures and gross investment). Here is an
overview of all three:

Government Expenditures: This is the term for ALL

spending by the government sector. It includes spending
for the purchase of goods and services which falls under
the title of government purchases. It also includes
expenditures that are NOT for goods and services, which
are termedtransfer payments.

Government Purchases: This is the specific

term referring to actual expenditures on final
goods and services, or gross domestic product, by
the government sector. It specifically excludes
transfer payments.

Government Consumption Expenditures

and Gross Investment:
This is the official measure of the government
purchases component ofaggregate
expendituresused in the calculation of gross
domestic product. This term reflects the fact that
the government sector purchases both consumption
goods and capital goods.

EXCLUSION OF TRANSFER
PAYMENTS
Government transfer payments are government
payment to individuals that are not made in
exchange for goods and services supplied..
these payments meet important social purposes but,
since they are not purchases of current goods or
services they are omitted from GDP
One peculiar government transfer payment is the
interest on the government debt. Interest is treated
as a payment for debt incurred to pay for past wars
or government programs and is not considered to be
purchase of a current good or service. Government
interest payments are considered transfers and are
therefore ommited from GDP..

TAXES
Wherever the dollars came from, the statistician
computes the governmental component of GDP as
the actual cost to the government of the goods and
services.
While it is fine to ignore taxes I the flow of product
approach, however we must account for taxes in
the earnings or COST APPROACH to GDP.

NET EXPORTS
Exports-Imports= Net Exports
The Phil. GDP represents all goods and
services within the boundaries of the Philippines.
Production differs from sale in the Philippines in
two aspects:
Some of our production (agricultural piroducts)
is bought by foreigners and shipped abroad and
these items constitute our EXPORTS
Some of what we consume is produced abroad
and shipped to the Philippines and these items
constitute our IMPORTS

EXAMPLE:
Suppose that Philippines produces 100 bushels of
corn and 7 bushels are imported. Of these, 87
bushels are consumed (C), 10 go for government
purchases to feed the army (G) ang 6 go into
domestic investment as increases in inventories (I).
In addition, 4 bushels are exported.
Net exports= -3.
GDP= 87 (C) + 10 (G) + 6 (I) -3 (NE)

AUTONOMOUS EXPENDITURE

Autonomous expenditure is a macroeconomic

term used to describe the components of an
economy's aggregate expenditure that are not
impacted by that same economy's real level of
income. This type of spending is considered
automatic and necessary, whether occurring at
the government level or the individual level.

Governments and Autonomous

Expenditures

The vast majority of government spending

qualifies as autonomous expenditures. This is
due to the fact that the spending often relates
strongly to the efficient running of a nation,
making some of the expenditures required in
order to maintain minimum standards.

THE PURPOSE OF GOVERNMENT

EXPENDITURE
Governmentspends money for a variety of reasons,
including:
To supply goods and services that the private sector
would fail to do, such aspublic goods, including
defence, roads and bridges;merit goods, such as
hospitals and schools; and welfare payments and
benefits, including unemployment and disability benefit.
To achieve supply-side improvements in the macroeconomy, such as spending oneducationand training
to improve labour productivity.
To reduce the negative effects ofexternalities, such as
pollution controls.

AUTONOMOUS GOVERNMENT
PURCHASES
-Government purchases by the government
sector that do not depend on income or production
(especially national income or gross domestic
product). That is, changes in income do not
generate changes in government purchases.
-are government purchases by thegovernment
sectorthat are unrelated to and unaffected by the
level of income or production.
1

AUTONOMOUS: AN EQUATION
One way to provide an illustration of autonomous
government purchases (and the relation to induced
government purchases) is with a general linear
government purchases equation, such as the one
presented here:
G = g + hY
where: G is government purchases, Y is income
(or aggregate production), g is the intercept, and
h is the slope.

INDUCED GOVERNMENT
PURCHASES,
-government purchases that are based on the level
income or production
An Autonomous Intercept: The intercept of the
government purchases equation (g) measures the
amount of government purchases undertaken if
income is zero. If income is zero, then
government purchases is $g. The intercept is
generally assumed and empirically documented
to be positive (0 <g).

Marginal
Propensit
y to
Consume

WHAT IS MARGINAL PROPENSITY

TO CONSUME?
It is the extra amount that people consume when
they receive an extra dollar of disposable income.
The word Marginal means extra or additional.
Propensity to Consume designates the desired
level of consumption.

TO COMPUTE THE MPC:

MPC =

Change in real consumption

Change in real disposable income

Consumptio
n
Expenditur
e

MPC

Net
Saving

A 24000

24200

800/1000= 0.8

-200

200/1000=0.
2

B 25000

25000

800/1000= 0.8

200/1000=0.
2

C 26000

25800

800/1000=0.8

200

200/1000=0.
2

D 27000

26600

800/1000=0.8

400

200/1000=0.
2

E 28000

27400

800/1000=0.8

600

200/1000=0.
2

F 29000

28200

800/1000=0.8

800

200/1000=0.
2

G 30000

29000

800/1000=0.8

1000

200/1000=0.

Disposabl
e Income

MPS

KEY POINTS:
The MPC is always less than 1.
If a consumer receives a dollar of income,
consumer will spend some of it and save the
rest.
The fraction that the consumer spends is
determined by the MPC
The fraction of income that the consumer
saves is determined by the marginal
propensity to save (MPS)
The sum of the MPC and MPS is always 1

MARGINAL PROPERTY TO
CONSUME AS GEOMETRICAL SLOPE

FACTORS THAT DETERMINE

THE MARGINAL PROPENSITY
TO CONSUME:
1. Income levels
At low income levels, an increase in income
is likely to see a high marginal propensity to
consume; this is because people on low
incomes have many goods / services they need
to buy. However, at higher income levels,
people tend to have a greater preference to
save because they have most goods they need
already.

FACTORS THAT DETERMINE

THE MARGINAL PROPENSITY
TO CONSUME:
2. Temporary / permanent.
If people receive a bonus, then they may be
more inclined to save this temporary rise in
income. However, if they gain a permanent
increase in income, they may have greater
confidence to spend it.

FACTORS THAT DETERMINE

THE MARGINAL PROPENSITY
TO CONSUME:
3. Interest rates. A higher interest rate may
encourage saving rather than consumption,
however the effect is fairly limited because
higher interest rates also increase income from
saving, reducing the need to save.
4. Consumer confidence. If confidence is high,
this will encourage people to spend. If people are
pessimistic (e.g. expect unemployment /
recession) then they will tend to delay spending
decisions and there will be a low MPC.

MARGINAL PROPENSITY TO
SAVE
It is defined as the fraction of an extra dollar of
disposable income that goes to extra saving.
It indicates the change in saving resulting from
a change in income. In fact, if the MPC and
MPS are calculated based on after-tax
disposable income, then the two marginals
sum to one:
MPC + MPS = 1.

TO COMPUTE THE MPS:

MPS =

Change in real saving

Change in real disposable income

DEFINITION OF
TERMS::
Consumption Function- relates the level of
consumption to the level of disposable income
Saving Function- relates saving to disposable ;
what is saved equals what is not consumed,
saving and consumption schedules are mirror
images

The Multiplier

WHAT IS A MULTIPLIER?
A

multiplier is the factor by which

gains in total output are greater than
the change in spending that caused it.
It is usually used in reference to the
relationship between investment and
total national income.
The multiplier theory and its equations
are created by John Maynard Keynes

INVESTMENT
The value of an investment multiplier is a
function of several factors , including the
marginal propensity to save (MPS) and
marginal propensity to consume (MPC) of the
people whose payment for labor constitutes the
investments expenditure.

EXAMPLE:
If the marginal propensity to consume of a project's
workers is 0.75, then 75% of the workers' income is
spent on goods and services that produce income for
another individual or business, and 25% of their
income is withdrawn from circulation by means of
savings, taxation or expenditures on foreign goods
and services. This same project has an investment
multiplier of 4, which means that for every $1 spent
on investment, another $4 of income is generated.
The investment multiplier is calculated as 1/(1MPC), or 1/(1-0.75), in the example.

TAX MULTIPLIER

It is assumed that an increase or (decrease) in

tax affects consumption only (and has no effect on
investment , government expenditures, etc.,)

EXAMPLE:
Simple Tax Multiplier = MPC/MPS = MPC / (1 MPC)
Where,
MPSstands for marginal propensity to save (MPS); and
MPCis marginal propensity to consume
MPS equals 1 MPC
Given the same value of marginal propensity to consume,
simple tax multiplier will be lower than the spending
multiplier. This is because in the first round of increase
in government expenditures, consumption increases by
100%, while in case of a decrease in taxes of the same
amount, consumption increase by a factor of MPC.

Increasing
government
expenditures
and
investment is more effective than decreasing
taxes in increasing the GDP because it requires
lower increase in budget deficit. The target
increase in GDP of $40 billion can be achieved by
increasing
government
expenditures
and
investment by $10 billion. $13.3B of tax reduction
would be needed if the country decides to achieve
the target growth in GDP by decreasing taxes.
This is because spending multiplier is higher
than the tax multiplier. Relevant calculations are
shown below.

Spending multiplier in Herzoslovakia = 1/MPS

= 1/0.25 = 4
Tax multiplier in Herzoslovakia = MPC/(1 MPC)
= 0.75/0.25 = 3
Increase in government expenditures needed =
target change in GDP/spending multiplier
= $40B/4 = $10B
Decrease in taxes needed = target change in
GDP/tax multiplier
= $40B/3 = $13.3B

GOVERNMENT EXPENDITUES

An increase in government spending results in

an increase in national income.

Thus, its effect on national income is

expansionary . There is a limit to private
investment. Thus , to stimulate income the gap
has to be filled up by government expenditure.

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