National Income and
Price Determination
AP Economics
Mr. Bordelon
S
Spending Multiplier
S
In 2009, the Federal government passed the American Recovery and
Reinvestment Act, a stimulus package of $787 billion, with the intention of
encouraging job growth and reversing the recession. How?
S
The general idea of spending is that spending in one area of the economy
multiplies into more than $1 of spending throughout the economy.
S
Each dollar spent will cascade through the economy at each level.
S
S
S
I build a house. I spend money on construction materials, say lumber.
The lumber worker takes that money and spends it on groceries.
The grocery store uses that money to buy more groceries…and so on.
Spending Multiplier
S When we talk about spending, we’re talking about an
increase in aggregate output due to an increase in disposable
income. This disposable income leads to a rise in consumer
spending, which makes firms increase output again, and so
on.
S How large the effect is depends on the MPC and MPS.
MPC and MPS
S Marginal propensity to consume (MPC). Increase in consumer
spending when disposable income increases by $1.
DCONSUMERSPENDING
MPC =
DDISPOSABLEINCOME
S When consumer spending changes because of a rise or fall in
disposable income, MPC is the change in consumer spending
divided by the change in disposable income.
MPC and MPS
S
Marginal propensity to save (MPS). Increase in household savings when
disposable income increases by $1.
Dsavings
MPS =
Ddisposableincome
S
Consumers spend part, but not all of an additional dollar of disposable
income. MPC is a number between 0 and 1.
S
We’ll get back to these concepts when we talk about the spending multiplier
below.
Consumption Function
S Another way to look at this is through the consumption function:
S YD = C + S
S When you get more disposable income, YD, this increases both C
(consumption) and S (savings).
S MPC is the amount by which consumer spending rises if current
disposable income increases by $1. It is also the slope of the
consumption function.
S Because MPC is a number between 0 and 1,
MPC + MPS = 1.
Consumption Function
YD
C
S
MPC
MPS
0
5
-5
10
13
-3
0.8
0.2
20
21
-1
0.8
0.2
30
29
1
0.8
0.2
40
37
3
0.8
0.2
Looking at this consumption function table, we notice the following
1. Even when YD = 0, households consume as they draw down savings or borrow.
That $5 is called autonomous consumption. It’s the amount a household would
spend if no disposable income.
2. At every increase, we see a ration of 0.8:0.2.
MPC = ΔC/ΔDI = 8/10 = 0.8
MPS = ΔS/ΔDI = 2/10 = 0.2
This means that this household will consume 80 cents and save 20.
3. With this information, we can create the consumption function:
C = A + MPC x YD
Consumption
Function
C = A + MPC x YD
A: autonomous
consumption, $5 and
is the Y-intercept
MPC = 0.8 and is the
slope
C = 5 + 0.8YD
Consumption
Function
This is a general
breakdown of the
graph, showing slope
and the function
itself.
Spending Multiplier
S Sticking to this MPC of 0.8 for a moment, assume that
everyone spends 80% of every additional dollar of new
disposable income. What would happen if there is a new
amount of spending injected into the economy.
S Valentina is a chicken farmer in Orange City. Suppose she
decides to spend $1000 on chicken coups at Shane’s farm
supply shop. This money now starts circulation through the
economy. How?
Spending Multiplier
1.
Shane now has $1000 from the sale and spends 80% ($800)
(MPC!) on clothes at Dana’s boutique.
2.
Dana now has $800 from the sale and spends 80% ($640) at
Alex’s garage.
3.
Alex now has $640 from the sale and spends 80% ($512) at
Ashley’s grocery store.
4.
Ashley now has $512 from the sale and spends 80% ($409.60)
with Chantal’s vegetarian bakery! Where are our cookies,
Chantal?
Spending Multiplier
S After 5 rounds of spending, we’ve created $2,361.60, more
than double the original injection of spending by Valentina.
If we continued until someone spent 80% of nothing, Ted’s
initial $1,000 purchase would multiply to a total of $5000 in
income/spending. How, I hear you ask?
Spending Multiplier
S M = 1/(1 – MPC)
S M = 1/(1 - 0.8) = 1/0.2 = 5
S 5 x 1000 = $5,000
S Also, since MPC + MPS = 1  M = 1/MPS
Spending Multiplier
S On the macro scale, the multiplier is the ratio of the total
change in real GDP caused by an autonomous change in
aggregate spending (ΔAAS) to the size of the change (ΔY).
Mathematically if we were to work it out:
S ΔY = 1/(1 – MPC) x ΔAAS
S M = ΔY/ΔAAS = 1/(1 – MPC)
S M = 1/(1 – MPC) or 1/MPS
Consumer Spending
YD
C
S
MPC
MPS
0
5
-5
10
13
-3
0.8
0.2
20
21
-1
0.8
0.2
30
29
1
0.8
0.2
40
37
3
0.8
0.2
Let’s come back to this table, and look at what happens when YD increases from
$10 to $20. When that happens, C increases from $13 to $21. This is a movement
along the consumption function.
So the question is, what would cause C to increase, no matter the level of YD? In
other words, what would cause a shift of the consumption function?
Shifts of the Consumption Function
Changes in Expected Future Disposable Income. College senior graduates and has a job
lined up. She knows her current disposable income will increase. This would shift the
consumption function upwards.
Changes in Aggregate Wealth. Wealth is accumulated assets. The stock market takes a
dive and wealth declines. This would cause people to reduce consumption. Consumption
function shifts downward.
Investment Spending
S For a business to invest, they conduct a cost-benefit analysis
on what they will spend on.
S Expected Return on Investment (ROI) = (Total Revenue –
Total Cost)/Investment Cost
S The market interest rate is the cost of investment. Interest
rate is ultimately the cost of borrowed funds, and is also the
cost of investing your own funds since you’re forgoing that
income (opportunity cost!)
Investment Spending
S Investment will only occur if the firm expects a higher ROI
than the cost of the funds they would need to borrow to
finance the project.
S If the interest rate rises, fewer projects will be done.
S If the interest rate decreases, more projects will be done.
Expected Future Real GDP, Production
Capacity, and Investment Spending
S Expected Future Real GDP. Microsoft believes the economy will
expand next year. They might increase investment spending in
anticipation of increased sales. This is a “now” investment.
Microsoft must build a new factory now to take advantage of
customers next year. Firm increases investment.
S Production Capacity. Microsoft can produce 100,000 units if the
factory produces 24/7. The full capacity is 100,000 units.
Currently, Microsoft only has enough customers to produce only
50% (50,000) of full capacity. Firm does not increase investment.
S It can simply expand production.
S Best case scenario for new investment spending. At production
capacity with expectations of strong real GDP in the future.
Question #1
Income Range
MPC
$0-20,000
0.9
$20,001-$40,000
0.8
$40,001-$60,000
0.7
$60,001-$80,000
0.6
Above $80,000
0.5
The accompanying table shows how consumers’ MPC in a particular economy are
related to their level of income. Suppose the government engages in increased
purchases of goods and services. For each of the income groups in the
accompanying table, what is the value of the multiplier—that is, what is the
multiplier from each dollar the government spends on government purchases of
goods and services for each income group? Show your math. Citation from the text.
Question #2
Year
DI (millions)
C (millions
2003
$100
$180
2004
350
380
2005
300
340
2006
400
420
2007
375
400
2008
500
500
From 2003 to 2008, Eastlandia experienced large fluctuations in both
aggregate consumer spending and disposable income, but wealth, the interest
rate, and expected future disposable income did not change. This table shows
the level of aggregate consumer spending and disposable income in millions
of dollars for each of these years. Show your math. Use citations from text.
a. Plot the aggregate consumption function for Eastlandia.
b. What is the MPC? What is the MPS?
c. What is the aggregate consumption function?