Name ___________________________
Section 4
Module 16: Income and Expenditure
Lecture Notes
Pump Primer:
List the formulas for MPC, MPS, and the multiplier.
Student learning objectives:
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The nature of the multiplier, which shows how initial changes in spending lead to further
changes.
The meaning of the aggregate consumption function, which shows how current disposable
income affects consumer spending.
How expected future income and aggregate wealth affect consumer spending
The determinants of investment spending.
Why investment spending is considered a leading indicator of the future state of the economy.
Key Economic Concepts for This Module:
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An increase in spending multiplies throughout the economy as that spending becomes another
person’s income, part of which is spent, which becomes another person’s income, part of which is
spent…
The marginal propensity to consume (MPC) = (Δ Consumption/Δ Disposable Income). The
MPC is the amount by which consumer spending rises if current disposable income rises by $1
and is the slope of the consumption function.
The marginal propensity to save (MPS) = (Δ Saving/Δ Disposable Income).
MPC + MPS = 1
The spending multiplier M= 1/(1-MPC) = 1/MPS.
If aggregate autonomous spending changes by (ΔAAS) dollars, the multiplier effect will change
real GDP (it is common in macroeconomics to label real GDP with Y) by a greater amount
ΔY = M x ( ΔAAS).
Investment spending is negatively related to the interest rate.
Autonomous changes in investment spending have the same multiplying impact on real GDP as
changes in autonomous consumption.
Introduction:
The purpose of this module is to introduce the idea that consumption increases with disposable
income. When consumption increases, it multiplies throughout the economy, creating more income
and more spending. Another key component of national income is investment spending and this is
often a good predictor of where the economy is headed. (It should be noted that the Keynesian cross
model (or 45-degree diagram) is no longer tested and does not appear in the revised AP curriculum.)
The Multiplier: An Informal Introduction

The federal government recently enacted the American Recovery and Reinvestment Act of
2009. This “stimulus package” of $787 billion was intended to spark job growth to reverse
the worst recession since the Great Depression.

How was this supposed to work?
o The short answer is that $1 of spending in one area of the economy multiplies into
more than $1 of spending throughout the economy.
(Note: The Circular Flow diagram showed that money spent by one person is received as income by
another person.)
Thinking bank to this diagram will help to understand the spending multiplier.
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(For now, we will ignore the government (or public sector) and we will ignore net exports (or foreign
sector) in the economy.)
Marginal Propensity to Consume
 ____________________ is a huge fraction (more than 2/3) of total spending in the economy.
 After a person pays his taxes, he is left with ________________ ____________ (Yd) that can
either be consumed or saved.
Yd = C + S


When a person gets more disposable income, Yd, he will increase both C and S.
o
The _____________________ _________________ ___ ______________ MPC =
(Δ Consumption/Δ Disposable Income). The MPC is the amount by which consumer
spending rises if current disposable income rises by $1 and is the slope of the
consumption function.
o
The _______________________ ____________________ ___ ___________ MPS =
(Δ Saving/Δ Disposable Income).
o
Formula: ________________________
The following table shows a hypothetical consumption schedule for a household.
Notice that even when Yd=0, a household will still consume as they draw down savings or
borrow. The $5 of consumption when Yd=0 is called “_____________________
________________________.”
Yd
Consumption
(C)
Savings
(S)
0
10
20
30
40
5
13
21
29
37
-5
-3
-1
1
3
MPC (Δ C/Δ DI)
MPS = (Δ S/Δ DI)
We can see in the table that when Yd increases by $10, C increases by $8 and S increases by
$2.
Thus, the MPC = (Δ C/Δ Yd) = _____.
The MPS = (Δ S/Δ Yd) = _____.
If this household receives $1 of additional Yd, they will consume 80 cents and save 20 cents
of it. With the above information, we can create a consumption function.
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
The _______________________ __________________ is an equation showing how an
individual household’s consumer spending varies with the household’s current disposable
income.

The simplest version of a consumption function is a linear equation:
c = a + MPC × yd
Notes:
“a” represents autonomous consumption or the
vertical intercept of the function ($5).
MPC is the marginal propensity to consume, or the
slope of the function (.80).
c = 5 + .80Yd
The Multiplier: An Informal Introduction
Let’s assume that everyone in the economy spends 80% of every additional dollar of new disposable
income. What would happen if there were an injection of new spending into the economy?
Example Ted is a chicken farmer in the local community.
Suppose Ted decides to spend $1000 on some chicken coops at Anthony’s farm supply shop.
This money now starts to be circulated around the economy.
1. Anthony now has $1000 from the sale and spends 80% ($800) on clothes at Marcia‘s boutique.
2. Marcia now has $800 from the sale and spends 80% ($640) to fix her car at Pat’s garage.
3. Pat now has $640 from the sale and spends 80% ($512) at Dianna’s grocery store.
4. Dianna now has $512 from the sale and spends 80% ($409.60) with Catherine’s catering
company.
After 5 rounds of spending, we’ve created $2,361.60, more than DOUBLE the original injection of
spending!!! If we had continued until someone was trying to spend 80% of nothing, Ted’s initial
$1000 purchase would have multiplied to a total of $5000 in income/spending.
The spending multiplier can be shown to be equal to:
M = 1/(1-MPC) = 1/(1-.80) = 1/.2 = 5
Since, MPC + MPS = 1, we can also say that M=1/MPS
In the macroeconomy:
 The ____________________ is the ratio of the total change in real GDP caused by an
autonomous change in aggregate spending to the size of that autonomous change.
ΔAAS is the autonomous change in aggregate spending
ΔY is the total change in real GDP.
Multiplier is equal to ΔY/ΔAAS.
ΔY =
1x ΔAAS
1 MPC
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So, the multiplier is:
M=
ΔY
Δ AAS
=
1
MPC - 1
Current Disposable Income and Consumer Spending

At about 2/3 of total spending in the U.S., consumer spending is a critical driver of the
macroeconomy.

As we have already seen, we can model consumer spending with a consumption function that
is positively related to disposable income.
Current Disposable Income and Consumer Spending
Generally, the consumption function is modeled:
c = a + MPC × yd
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Using the hypothetical information from the table above:
c = 5 + .80Yd
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If Yd increases from $10 to $20, C increases from $13 to $21. This is seen as a movement
upward along the fixed consumption function.
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What would cause C to increase, no matter the level of Yd? There are several factors that will
shift the consumption function upward or downward.
Shifts of the Aggregate Consumption Function
(Note: Remember the demand and supply “shifters” from
earlier in the course. These are similar by increasing or
decreasing consumption at all levels of current disposable
income.)
1. Changes in Expected Future Disposable Income
Suppose a college senior was about to graduate
and already had a job lined up. In other words,
she knows that her current disposable income is
going to rise. This expectation of more income in the future shifts the consumption function
upward.
2. Changes in Aggregate Wealth
Wealth is accumulated assets, and this is very different from disposable income. If you own a
house, a car, shares of stock or even a savings account, you have wealth.
Suppose that the stock market has a bad year and the value of your wealth substantially
declines. This lost wealth, even if it is only on paper, usually causes people to reduce their
consumption. The consumption function shifts downward.
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Investment Spending
Although consumer spending is much larger than investment spending, booms and busts in
investment spending tend to drive the business cycle. In fact, most recessions originate as a fall in
investment spending.
The Interest Rate and Investment Spending
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When a firm considers investment spending, they are really doing a little benefit-cost analysis
on the dollars they are about to spend.
Example: A firm is considering building a new factory. This will increase sales, but it will
also require borrowing to fund the investment.
Expected return on the investment = expected economic profit from the factory = (total
revenue minus total cost)/investment cost.
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The market interest rate is the cost of investment.
1. Interest rate is cost of borrowed funds.
2. Interest rate is also cost of investing your own funds (no borrowing), since it is income
forgone.
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The factory will only go ahead if the firm expects a rate of return higher than the cost of the
funds they would have to borrow to finance that project. If the interest rate rises, fewer
projects will pass that test, and as a result investment spending will be lower.
Thus, there is a ______________ relationship between the interest rate and dollars of
investment spending.
Expected Future Real GDP, Production Capacity, and Investment Spending

There are some factors that would increase investment spending at any interest rate.
• Expected __________________ Real GDP
Suppose a firm believed that the economy was really going to take off next year. This
firm might __________________ investment spending in anticipation of increased
sales. After all, you can’t build a factory overnight; the firm must begin the factory now
to take advantage of more customers in the coming year.
• Production Capacity
Suppose a firm can produce 100,000 units if the factory is producing 24/7. The firm’s
full capacity is 100,000 units. Right now, the firm has enough customers to produce
only 50%, or 50,000 units, of full capacity.

A firm in this situation would not likely be looking to increase investment. After all, if orders
from customers were to increase, it would be easy to satisfy those orders without increasing
the size of the factory.
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The best conditions for new investment spending consist of firms that are near production
capacity with expectations of strong real GDP in the future.
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Common Student Difficulties:
• It is unnecessary for you to know all of the math behind the spending multiplier. An example with
about four rounds of spending can help you understand the role of the MPC.
• The intuition behind changes to the consumption function is fairly well understood by most
students. However, many students become easily confused by changes to investment spending,
especially the difference between unplanned and planned inventories. You can save a lot of time
and unnecessary confusion if you focus on the other factors that shift investment spending. After
all, an increase in unplanned inventories is removed from investment spending through an
accounting adjustment once those units are actually consumed.
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