Income and Expenditure
Chapter 11
The Multiplier Effect
A closer examination of C + I + G reveals
an interesting phenomena:
Increases in spending (C + I + G) lead to
an increase in GDP that is greater than the
original spending increase!
Why does this happen?
The Multiplier Effect
Suppose a business invests $1 million in
new capital (capital investment)
That $1 million turns into $1 million in
income for the workers that produce the
capital investment
Those workers then spend that income, or
at least a percentage of that income
The Multiplier Effect
Whatever percentage they spend,
becomes income for other workers.
Who, in turn, spend a percentage of that
income.
And so on
And so on
And so on…to a certain point
The Multiplier Effect
Thus, there is a MULTIPLIER
EFFECT that ripples throughout the
economy.
An original business investment of $1
million has brought about a much
greater increase in Real GDP
The Multiplier Effect
How large is the total affect?
What percentage of total disposable income is likely to
be consumed (spent?)
The AVERAGE PROPENSITY TO CONSUME (APC)
What percentage of total disposable income is likely to
be saved?
The AVERAGE PROPENSITY TO SAVE (APS)
The Multiplier Effect
The Marginal Propensity to Consume (MPC)


The increase in consumer spending when
disposable income rises by $1
MPC = ∆ Consumer Spending
∆ Disposable Income
The Marginal Propensity to Save (MPS)

The increase in savings when disposable income
rises by $1
MPS =
∆ Consumer Savings
∆ Disposable Income
MPC and MPS
Because you must either spend or save
additional income, MPC + MPS = 1
The Spending Multiplier =

1
(1-MPC)
OR
1
MPS
The Multiplier Effect
An autonomous change in aggregate spending
is an initial change in the desired level of
spending by firms, households, or government
at a given level of real GDP.
The multiplier 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.
Multiplier = 1
(1-MPC)
Multiplier = 1
MPS
∆Y = Multiplier X ∆S
The Spending Multiplier
What is the multiplier if MPC is .9?
10
What is the multiplier if MPS is .25
4
So, a $1 million increase in capital
investment spending, with an MPC of .8,
would result in how much of an increase in
GDP?
$5 Million
MPC = __∆ Spending____
∆ Disposable Income
∆Y = Multiplier X ∆S
Practice
Multiplier = 1___
(1-MPC)
Multiplier = 1__
MPS
1.
If you disposable income increases from $10,000 to $15,000, and
your consumption increases from $9,000 to $12,000, what is your
MPC?
2.
If disposable incomes increases by $5 billion and consumer
spending increases by $4 billion, what is the MPC?
3.
If the MPC is 0.9 and investment spending increases by $50
billion, what will be the change in GDP (assume no taxes or
trade)?
4.
Suppose investment spending increases by 50 billion and as a
result the equilibrium income increases by $200 billion. What is
the investment multiplier?
Increase Government Spending
OR Cut Taxes?
With an MPC of .75, which would
provide a greater impact on the
economy:


A $100 billion increase in Government
spending or
A $100 billion tax cut?
A $100 billion increase in G…Why?
Increase Government Spending
OR Cut Taxes?
The initial impact of the Government
spending will be $100 billion in
Consumption by Government.
Followed by .75 of the income earned
being consumed (.25 saved).
The tax cut will initially lead to 75% of the
$100 billion being “consumed” and 25%
saved.
Increase Government Spending
OR Cut Taxes?
So, it actually takes a LARGER tax
cut to bring about the same impact as
an increase in government spending.
Disposable Income and Consumer
Spending, 2003
The Consumption Function Graph
Shows the relationship between
CONSUMPTION and DISPOSABLE
INCOME (Personal Income – taxes).
Shows SAVINGS and DISSAVINGS
The Consumption Function Graph
Aggregate Consumption Function,
2003
Aggregate Consumption Function,
2009
Autonomous
Consumer
Spending is
$17,594.
MPC =
0.52
Comparison 2003 to 2009
2003
Autonomous
Consumer Spending
is $14,184.
MPC = 0.6
2009
Autonomous
Consumer Spending
is $$17,594.
MPC = 0.52
Shifts in the Aggregate
Consumption Function
Changes in Expected Future Disposable
Income

Expect increase in future DI – Shifts
Consumption Function up (increases)
Changes in Aggregate Wealth (The Wealth
Effect)

Greater wealth (overall assets, including the
value of stocks, not just income) leads to greater
consumption
Shifts in Aggregate Consumption
Function
Shifts in Aggregate Consumption
Function
Practice
Check Your Understanding 11-2.
Investment Spending
Business spending on capital goods
Includes changes in inventory
Includes all construction: business
and home
Investment Spending
Vital to economic growth
Consumer spending is larger than
investment spending.
Investment spending drives the business
cycle.
Most recessions originate with a fall in
investment.
Investment Change During Six
Recessions
Investment Spending
Planned investment spending is the
investment spending that business intend
to undertake during a given period.
Most dependant on the cost of borrowing
(INTEREST RATES)


Higher interest rates = higher costs = lower
Investment
Lower interest rates = lower costs = greater
Investment
Investment Spending
According to the accelerator principle, a higher growth
rate of real GDP leads to higher planned investment
spending, but a lower growth rate of real GDP leads to a
lower planned investment spending.
In 2006, when real GDP growth turned negative,
planned investment spending especially in residential
investment spending—plunged, accelerating the
economy’s slide into recession.
Investment Spending and Inventory
Inventories are stocks of goods held to satisfy
future sales.
Inventory investment is the value of the change
in total inventories held in the economy during a
given period.
Unplanned inventory investment occurs when
actual sales are more or less than businesses
expected, leading to unplanned changes in
inventories.
Actual investment spending is the sum of
planned investment spending and unplanned
inventory investment.
I = Iunplanned + Iplanned
Income-Expenditure Model and
Assumptions
Income-Expenditure model shows how changes in
spending including investment spending lead to changes
in real GDP through the actions of the multiplier.
Assumption: Changes in overall spending lead to
changes in aggregate output.
Assumption: The interest rate is fixed.
Assumption: Taxes, government transfers, and
government purchases are all zero.
Assumption: Exports and imports are both zero.
Planned Aggregate Spending and
Real GDP
GDP = C + I
YD = GDP
C = A + MPC *YD
AEPlanned = C + IPlanned
Planned aggregate spending is the total
amount of planned spending in the economy.
Planned Aggregate Spending and
Real GDP AE = C + I
planned
The level of planned
aggregate spending in a
given year depends on the
level of real GDP in that year.
Assume C = 300 + 0.6 x YD,
Iplanned =500
If GDP = 500, YD = 500,
C=300+ 0.6x500=600, and
AEplanned = 1100
planned
Aggregate Consumption Function
and Planned Aggregate Spending
Income-Expenditure Equilibrium
The economy is in income–
expenditure equilibrium
when GDP is equal to planned
aggregate spending.
Income–expenditure
equilibrium GDP is the level
of GDP at which GDP equals
planned aggregate spending.
Income-Expenditure Equilibrium
Keynesian Cross
The Keynesian cross
diagram identifies
income-expenditure
equilibrium as the point
where the planned
aggregate spending line
crosses the 45-degree
line.
Developed by Paul
Samuelson.
Multiplier Process and Inventory
Adjustment
When planned spending by
households and firms does not
equal the current aggregate
output by firms, this difference
shows up in changes in
inventories.
Over time, the firms’ response to
inventory changes moves real
GDP to equilibrium.
Changes in inventories are
considered a leading indicator of
future economic activity.
Multiplier Process and Inventory
Adjustment
The Paradox of Thrift
In the Paradox of Thrift, households and
producers cut their spending in anticipation of
future tough economic times.
It is called a paradox because what’s usually
“good” (saving to provide for your family in
hard times) is “bad” (because it can make
everyone worse off).