Module 16:
Income and Expenditure
1
The Multiplier:
An Informal Introduction
• 3 Simplifying Assumptions for this analysis
(i.e. ceteris paribus conditions):
1. We assume that changes in overall spending
(C and I) translate into changes in RGDP.
2. We assume there is no government spending
and no taxes (i.e. “private”).
3. We assume that net exports are zero (i.e. “closed”).
The Multiplier:
An Informal Introduction
$100 billion increase in investment spending
leads to increase in aggregate output (GDP)
leads to increase in disposable income
leads to a rise in consumer spending
Leads to an increase in aggregate output…
The Multiplier:
An Informal Introduction
• How large is the total effect on aggregate
output if we sum the effect from all these
rounds of spending increases?
• Marginal Propensity to Consume (MPC)
– The increase in consumer spending when
disposable income rises by $1
12-4
The Multiplier:
An Informal Introduction
• Recall that there are two things you can do
with disposable income…
• Marginal Propensity to Save (MPS)
– The increase in household savings when
disposable income rises by $1
MPS = 1 - MPC
12-5
The Multiplier:
An Informal Introduction
• Some relationships
– Marginal propensity to consume and marginal
propensity to save must sum to 100% of the
change in income (i.e. MPC + MPS = 1).
 Complete Activity 24: “What Is An MPC?”
12-6
The Multiplier:
An Informal Introduction
• Question
– So…How can a $100 billion increase in investment
generate a $500 billion increase in equilibrium
real GDP?
• Answer
– The multiplier process
The Multiplier:
An Informal Introduction
• It is possible that a relatively small change in investment
can trigger a much larger change in real GDP
The Multiplier:
An Informal Introduction
• The total effect of a $100 billion increase in investment
spending, I, taking into account all the subsequent
increases in consumer spending (and assuming no taxes
and no international trade), is given by:
• Let’s consider a numerical example where the marginal
propensity to consume is 0.6:
The Multiplier:
An Informal Introduction
• We’ve described the effects of a change in
investment spending, but the same analysis
can be applied to any other autonomous
change in aggregate spending.
• So the multiplier is:
The Multiplier:
An Informal Introduction
• 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
Consumer Spending
• Consumption
– Spending on new goods and services out of a
household’s current income
• Saving
– The act of not consuming all of one’s
current income
– Whatever is not consumed out of disposable
income is, by definition, saved.
Consumer Spending
• You can do only two things with income (in
absence of taxes): consume it or save it
Consumption + Saving = Disposable Income
and
Saving = Disposable Income – Consumption
Investment and Consumption explained
Consumer Spending
• Consumption choices have a
powerful effect on the economy.
• What determines how much
consumers spend?
Consumer Spending
• The most important factor affecting a family’s
consumer spending is disposable income (DI).
Consumer Spending
• 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.
– Let’s first recall our understanding of slope.
Consumption Function
 c = MPC x y + a
 Where c is individual household consumer
spending.
 y is individual household current disposable
income*.
 a is a constant term—individual household
autonomous consumer spending
 MPC for an individual household as :
 MPC = change in c / change in y
Consumption Function
Consumption Function
 In reality, the actual data never fit the
equation perfectly…
Aggregate Consumption Function
 Although Figure 16.3 shows a microeconomic
relationship, macroeconomists assume a similar
relationship holds for the economy as a whole:
 C = A + MPC x Y
 Where C is (aggregate) consumer spending.
 Y is (aggregate) disposable income*.
 A is aggregate autonomous consumer spending.
Shifts of the
Aggregate Consumption Function
• A change besides real disposable income will
cause the consumption function to shift.
• Changes in Population
• Changes in Expected Future Disposable Income
• Changes in Expected Future Prices
• Changes in Aggregate Wealth
12-21
Shifts of the
Aggregate Consumption Function
• Aggregate Wealth
– The stock 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.
– Those who have accumulated a lot of wealth will,
other things equal, spend more on goods and
services than those who still need to save…
12-22
Shifts of the
Aggregate Consumption Function
12-23
Investment Spending
• Although consumer spending is much greater than
investment spending, booms and busts in investment
spending tend to drive the business cycle.
Investment Spending
• Planned Investment Spending
– Amount firms intend to invest during a given period.
– Depends on three principal factors:
• the interest rate
• the expected future level of real GDP
• the current level of production capacity
The Interest Rate and
Investment Spending
• Planned Investment Spending is negatively
related to the interest rate—investment projects
are typically funded through borrowing.
• Higher interest rates will
discourage borrowing.
• Lower interest rates will
encourage borrowing.
Expected Future Real GDP and
Investment Spending
• Planned Investment Spending is positively
related to expected future real GDP.
– Higher expected real GDP and, in turn, expected
sales for firms, will encourage an increase in
planned investment spending.
– Lower expected real GDP and, in turn, expected
sales for firms, will encourage an decrease in
planned investment spending.
Current Production Capacity and
Investment Spending
• Planned Investment Spending is negatively
related to production capacity.
– Higher than necessary production capacity will
discourage planned investment spending.
– Lower than necessary production capacity will
encourage planned investment spending.
Inventories and
Investment Spending
• Inventories
– Stocks of goods held to satisfy future sales.
• Inventory Investment—Value of change in total
inventories held in the economy during a period.
– Firms, anticipating higher future sales, can increase
their inventories as a form of investment spending.
Inventories and
Unplanned Investment Spending
• Firms cannot always accurately predict sales
• Unplanned Inventory Investment
– Actual sales are more or less than expected,
leading to unplanned decreases or increases in
inventories.
Combining Consumption and Investment
• The equilibrium level of GDP is determined by the intersection of
the aggregate expenditures schedule and 45-degree line
• At this output ($11T), C is $9T and I is 2T
Inventories and
Unplanned Investment Spending
• No levels of GDP above the equilibrium level
are sustainable because C+I fall short.
• At the $12T GDP level, for example, C+I is only
$11.5T; this underspending causes inventories
to rise, prompting firms to readjust production
downward, in the direction of the $11T output