End of

Chapter 10
ECON 151 – PRINCIPLES OF MACROECONOMICS

Chapter 12: Consumption, Real

GDP, and the Multiplier

Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
1
1
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

12-2
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.

12-3
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 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.
 Dissaving
 Negative saving; a situation in which spending exceeds
income

12-4
Some Simplifying Assumptions
in a Keynesian Model (cont'd)
 Consumption plus saving equals
disposable income.
 Saving equals disposable income minus
consumption.

12-5
Some Simplifying Assumptions
in a Keynesian Model (cont'd)
 Consumption Goods
 Goods bought by households to use up, such
as food and movies

 Capital Goods
 Producer durables; nonconsumable goods
that firms use to make other goods

12-6
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.

12-7
Spending on Human Capital:
Investment or Consumption?
 Economists define human capital as the accumulation
of investments and training
in education.
 From this perspective, educational
expenses should be regarded as a form
of investment spending.
 Nevertheless, in official U.S. government statistics,
household spending on education is classified as
consumption.

12-8
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 real saving and consumption
decisions depend primarily on a household’s real
disposable income.

12-9
Determinants of Planned Consumption and
Planned Saving (cont'd)

 Keynes was concerned with changes

in AD as reflected in planned expenditures.
 His initial focus was on Consumption.

AD = C + I + G + X

12-10
Determinants of Planned Consumption and
Planned Saving (cont'd)

 Consumption Function
 Therelationship between amount consumed
and disposable income
A consumption function tells us how much
people plan to consume at various levels of
disposable income.

12-11
Determinants of Planned Consumption and
Planned Saving (cont'd)

 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.

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

12-13
Determinants of Planned Consumption and
Planned Saving (cont'd)

 45-Degree Reference Line

 The line along which planned real
expenditures equal real GDP per year
 On the following graph, DPI is labeled as YD.
However, under the Keynesian simplifying
assumptions, when all components of AD are
reflected, the label becomes Y for real GDP.

12-14
Determinants of Planned Consumption and
Planned Saving (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.

12-15
Figure 12-1
The Consumption
and Saving
Functions

12-16
Figure 12-1 The Consumption
and Saving Functions (cont'd)

12-17
Figure 12-1 The Consumption
and Saving Functions (cont'd)

12-18
Determinants of Planned Consumption and
Planned Saving (cont'd)

 Average Propensity to Consume (APC)

 Realconsumption divided by real disposable
income
 The proportion of total disposable income that
is consumed
Real consumption
APC =
Real disposable income
12-19
Determinants of Planned Consumption and
Planned Saving (cont'd)

 Average Propensity to Save (APS)

 Real saving divided by real disposable
income (DI)
 Saved proportion of real DI

Real saving
APS =
Real disposable income
12-20
Determinants of Planned Consumption and
Planned Saving (cont'd)

 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

12-21
Determinants of Planned Consumption and
Planned Saving (cont'd)

 Marginal Propensity to Save (MPS)

 The ratio of the change in saving to the
change in disposable income

Change in real saving

MPS =
Change in real disposable income

12-22
Determinants of Planned Consumption and
Planned Saving (cont'd)

 Some relationships
 Average propensity to consume and average
propensity to save must sum to 100% of total
income. (APC + APS = 1)
 Marginal propensity to consume and marginal
propensity to save must sum to 100% of the
change in income. (MPC + MPS = 1)

12-23
Determinants of Planned Consumption and
Planned Saving (cont'd)

 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

12-24
Determinants of Planned Consumption and
Planned Saving (cont'd)

 Wealth
 Thestock 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.

12-25
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.

12-26
Figure 12-2
Planned Real Investment, Panel (a)

12-27
Figure 12-2
Planned Real Investment, Panel (b)

12-28
Determining Equilibrium
Real GDP (cont'd)
 Adding the investment function

AD = C + I + G + X

12-29
Figure 12-4 Combining
Consumption and Investment

12-30
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.

12-31
Figure 12-5 Planned and Actual Rates of
Saving and Investment

12-32
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
 Unplanned decreases in business inventories
 Business will increase production of goods and
services and increase employment

12-33
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.

12-34
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

12-35
Keynesian Equilibrium with Government and
the Foreign Sector Added (cont'd)

 The Foreign Sector: C + I + G + X

 Netexports (X) equals exports
minus imports
 Depends on international economic conditions
 Autonomous—independent of real
national income

12-36
Table 12-2 The Determination
of Equilibrium Real GDP with Government and
Net Exports Added

12-37
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.

12-38
Figure 12-6
The Equilibrium Level of Real GDP

Recall that planned AD

=C+I+G+X
Although not identified
as such by Keynes, the
45-degree reference
line can be thought of
as actual expenditures
or AS.
Equilibrium will occur
where AD = AS.

12-39
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

12-40
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

12-41
Table 12-3 The Multiplier
Process

12-42
The Multiplier (cont'd)
 The multiplier formula

1 1
Multiplier = =
1 - MPC MPS

12-43
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.

12-44
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

12-45
 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.

12-46
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 autonomous
consumption, investment, government spending,
net exports.

12-47
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.

12-48
Figure 12-7 Effect of a Rise
in Autonomous Spending on
Equilibrium Real GDP

12-49
The Relationship Between Aggregate
Demand and the C + I + G + X Curve

 There is clearly a relationship; aggregate

demand consists of consumption,
investment, government, and the foreign
sector.

12-50
The Relationship Between
Aggregate Demand and the
C + I + G + X Curve (cont'd)
 There is a major difference
C + I + G + X curve drawn with price
level constant
 AD curve drawn with the price
level changing

12-51
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.
 Since we know that at higher prices, real
spending is diminished, we can show two
C + I + G + X curves at different price levels.
 We can then plot the equilibrium outcomes of
each as AD at the two price levels as reflected
on the AS-AD model graph.
12-52
Figure 12-8
The
Relationship
Between AD
and the C + I +
G + X Curve

12-53
 End of
Chapter 10
ECON 151 – PRINCIPLES OF MACROECONOMICS

Chapter 12: Consumption, Real

GDP, and the Multiplier

Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
54
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