Lec-10B & 11 - CH 12 - Consumption, Real GDP and Multiplier - Miller Edited

Chapter 12
Consumption,
Real GDP, and
the Multiplier
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 nationals real GDP.
Copyright 2014 Pearson Education, Inc. All rights reserved.
12-2
Some Simplifying Assumptions in a

Keynesian Model
To simplify the income determination
model, lets 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
12-3

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
households current income
Whatever is not consumed is saved
Consumption includes such things as buying
food and going to a concert
12-4

Saving
The act of not consuming all of ones 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
12-5

Consumption Goods
Goods bought by households to use up, such as
food and movies
12-6

Accounting identity:
Consumption + saving disposable income
Saving disposable income consumption
12-7

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
12-8

Capital Goods
Producer durables; nonconsumable goods that
firms use to make other goods
12-9
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
12-10
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 households real
disposable income.
Furthermore, a persons anticipation about
future flows of income influences how much of
current income is allocated to consumption and
how much is allocated to saving.
12-11

The Keynesian Theory of Consumption and

Saving
Keynes argued that real consumption and saving
decisions depend primarily on a households
current real disposable income.
12-12

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
12-13

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
12-14
Table 12-1 Real Consumption and Saving

Schedules: A Hypothetical Case
12-15

45-Degree Reference Line

The line along which planned real expenditures
equal real GDP per year
12-16
Figure 12-1
The Consumption
and Saving
Functions
12-17

Autonomous Consumption
The part of consumption that is independent of
the level of disposable income
Changes in autonomous consumption shift the
consumption function
12-18

Average Propensity to Consume (APC)

Real consumption divided by real disposable
income
The proportion of total disposable income that is
consumed
Real consumption
APC =
Real disposable income
12-19

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

Marginal Propensity to Consume (MPC)

The ratio of the change in real consumption to
the change in real disposable income
MPC =
Change in real consumption

Change in real disposable income
12-21

Marginal Propensity to Save (MPS)

The ratio of the change in saving to the change
in disposable income
MPS =
Change in real saving

Change in real disposable income
12-22

Example
Income = $54,000
C = $49,200
S = $4,800
What is the APC?
APC =
$49,200
= .911
$54,000
12-23

Example
Income increases by $6,000 to $60,000
C = $54,000
S = $6,000
What is the APC?
APC =
$54,000
= .90
$60,000
12-24

Some relationships
APC + APS 1
MPC + MPS 1
12-25

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
12-26
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
12-27
Figure 12-2 Planned Real Investment,

Panel (a)
12-28
Figure 12-2 Planned Real Investment,

Panel (b)
12-29
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
12-30
Figure 12-3 Consumption as a Function

of Real GDP
12-31

(cont'd)
Adding the investment function
AD = C + I + G + X
12-32
Figure 12-4 Combining Consumption

and Investment
12-33

(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
12-34
Figure 12-5 Planned and Actual Rates

of Saving and Investment
12-35

(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
12-36

(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
12-37
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
Lets think about what happens when we
add these elements
12-38

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
12-39

The Foreign Sector: C + I + G + X

Net exports (X) equals exports minus imports
Depends on international economic conditions
Autonomousindependent of real national
income
12-40
Table 12-2 The Determination of Equilibrium

Real GDP with Government and Net Exports Added
12-41
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
12-42
Figure 12-6 The Equilibrium Level of Real

GDP
12-43

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
12-44
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
12-45
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
12-46
Table 12-3 The Multiplier Process
12-47

The multiplier formula
1
1
Multiplier =
=
1 - MPC
MPS
12-48

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
12-49

Examples
MPC =
4
5
MPS =
1
5
Multiplier =
MPC =
3
5
MPS =
2
5
1
Multiplier =
= 2.5
2/5
1
=5
1/5
12-50

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

Multiplier x Change in autonomous spending
12-51

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
12-52
Figure 12-7 Effect of a Rise in Autonomous

Spending on Equilibrium Real GDP
12-53
Figure C-1 Graphing the Multiplier
12-54

Lec-10B & 11 - CH 12 - Consumption, Real GDP and Multiplier - Miller Edited

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Chapter 12

Did You Know That ...

In this chapter, you will learn how an

Copyright 2014 Pearson Education, Inc. All rights reserved.

Some Simplifying Assumptions in a

Copyright 2014 Pearson Education, Inc. All rights reserved.

Some Simplifying Assumptions in a

Copyright 2014 Pearson Education, Inc. All rights reserved.

Some Simplifying Assumptions in a

Copyright 2014 Pearson Education, Inc. All rights reserved.

Some Simplifying Assumptions in a

Copyright 2014 Pearson Education, Inc. All rights reserved.

Some Simplifying Assumptions in a

Saving disposable income consumption

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Some Simplifying Assumptions in a

Copyright 2014 Pearson Education, Inc. All rights reserved.

Some Simplifying Assumptions in a

Copyright 2014 Pearson Education, Inc. All rights reserved.

Determinants of Planned Consumption

Copyright 2014 Pearson Education, Inc. All rights reserved.

Determinants of Planned Consumption and

Keynes argued that:

Copyright 2014 Pearson Education, Inc. All rights reserved.

Determinants of Planned Consumption and

The Keynesian Theory of Consumption and

Copyright 2014 Pearson Education, Inc. All rights reserved.

Determinants of Planned Consumption and

Copyright 2014 Pearson Education, Inc. All rights reserved.

Determinants of Planned Consumption and

Copyright 2014 Pearson Education, Inc. All rights reserved.

Table 12-1 Real Consumption and Saving

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Determinants of Planned Consumption and

45-Degree Reference Line

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Copyright 2014 Pearson Education, Inc. All rights reserved.

Determinants of Planned Consumption and

Copyright 2014 Pearson Education, Inc. All rights reserved.

Determinants of Planned Consumption and

Average Propensity to Consume (APC)

Determinants of Planned Consumption and

Average Propensity to Save (APS)

Determinants of Planned Consumption and

Marginal Propensity to Consume (MPC)

Change in real consumption

Copyright 2014 Pearson Education, Inc. All rights reserved.

Determinants of Planned Consumption and

Marginal Propensity to Save (MPS)

Change in real saving

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Determinants of Planned Consumption and

What is the APC?

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Determinants of Planned Consumption and

What is the APC?

Determinants of Planned Consumption and

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Determinants of Planned Consumption and

Causes of shifts in the consumption function

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.