Chapter 12
Consumption,
Real GDP, and
the Multiplier
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Introduction
During the Great Recession of the late 2000s, inflation
adjusted spending on goods and services by U.S.
household declined by 2 percent, while the levels of
wealth, indebtedness and income of households fell
significantly.
Why and how was the decrease in U.S. consumption
spending related to the declines in household wealth,
debts and income?
Reading this chapter will help you answer this question.
Learning Objectives
• Distinguish between saving and savings and
explain how consumption and saving are
related
• Explain the key determinants of consumption
and saving in the Keynesian model
• Identify the primary determinants of planned
investment
Learning Objectives (cont'd)
• Describe how equilibrium real GDP is
established in the Keynesian model
• Evaluate why autonomous changes in total
planned expenditures have a multiplier effect
on equilibrium real GDP
• Understand the relationship between total
planned expenditures and the aggregate
demand curve
Chapter Outline
• Some Simplifying Assumptions in a Keynesian
Model
• Determinants of Planned Consumption and
Planned Saving
• Determinants of Investment
• Determining Equilibrium Real GDP
Chapter Outline (cont'd)
• Keynesian Equilibrium with Government and
the Foreign Sector Added
• The Multiplier
• How a Change in Real Autonomous Spending
Affects Real GDP When the Price Level Can
Change
• The Relationship Between Aggregate Demand
and the C + I + G + X Curve
Did You Know That ...
• At various times from the late 1990s through the mid-2000s,
the U.S. saving rate—the ratio of the flow of real, inflationadjusted saving to real GDP—was negative?
• In this chapter, you will learn how an understanding of
households’ real saving and real consumption spending can
help you evaluate fluctuations in a national’s real GDP.
Some Simplifying Assumptions in a
Keynesian Model
• To simplify the income determination model,
let’s 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
Some Simplifying Assumptions in a
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
household’s current income
– Whatever is not consumed is saved
– Consumption includes such things as buying food
and going to a concert
Some Simplifying Assumptions in a
Keynesian Model (cont'd)
• Saving
– The act of not consuming all of one’s 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
Some Simplifying Assumptions in a
Keynesian Model (cont'd)
• Consumption Goods
– Goods bought by households to use up, such as
food and movies
Some Simplifying Assumptions in a
Keynesian Model (cont'd)
• Accounting identity:
Consumption + saving  disposable income
Saving  disposable income – consumption
Some Simplifying Assumptions in a
Keynesian Model (cont'd)
• 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
Some Simplifying Assumptions in a
Keynesian Model (cont'd)
• Capital Goods
– Producer durables; nonconsumable goods that
firms use to make other goods
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
Determinants of Planned Consumption and Planned Saving
(cont'd)
• Keynes argued that:
– The interest rate is not the most important
determinant of individual’s real saving and
consumption decisions
– Real saving and consumption decisions depend
primarily on a household’s real disposable income
Determinants of Planned Consumption and Planned Saving
(cont'd)
• Keynes was concerned with changes in AD
AD = C + I + G + X
Determinants of Planned Consumption and Planned Saving
(cont'd)
• 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
Determinants of Planned Consumption and Planned Saving
(cont'd)
• 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
Table 12-1 Real Consumption and Saving Schedules: A
Hypothetical Case
Determinants of Planned Consumption and Planned Saving
(cont'd)
• 45-Degree Reference Line
– The line along which planned real expenditures
equal real GDP per year
Figure 12-1
The Consumption and
Saving Functions
Determinants of Planned Consumption and Planned Saving
(cont'd)
• Autonomous Consumption
– The part of consumption that is independent of
the level of disposable income
– Changes in autonomous consumption shift the
consumption function
Policy Example: Why Knowing Consumer Sentiment Aids
Consumption Forecasts
• Government economists use the University of Michigan’s
Index of Consumer Sentiment to help forecast total U.S.
consumption spending over the coming weeks and months.
• That Index is based on answers to questions about how
confident people are about their future disposable income.
• Household’s confidence about future disposable income
affects their autonomous consumption.
Determinants of Planned Consumption and Planned Saving
(cont'd)
• 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
Determinants of Planned Consumption and Planned Saving
(cont'd)
• Average Propensity to Save (APS)
– Real saving divided by real disposable income (DI)
– Saved proportion of real DI
Real saving
APS =
Real disposable income
Determinants of Planned Consumption and Planned Saving
(cont'd)
• 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
Determinants of Planned Consumption and Planned Saving
(cont'd)
• 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
Determinants of Planned Consumption and Planned Saving
(cont'd)
• Example
– Income = $54,000
– C = $49,200
– S = $4,800
• What is the APC?
APC =
$49,200
= .911
$54,000
Determinants of Planned Consumption and Planned Saving
(cont'd)
• 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
Determinants of Planned Consumption and Planned Saving
(cont'd)
• Some relationships
APC + APS  1
MPC + MPS  1
Determinants of Planned Consumption and Planned Saving
(cont'd)
• 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
Determinants of Planned Consumption and Planned Saving
(cont'd)
• Net wealth
– The stock of assets owned by a person,
household, firm or nation (net of any debts owed)
– For a household, wealth can consist of a house,
cars, personal belongings, stocks, bonds, bank
accounts, and cash (minus any debts owed)
Why Not … help the economy by taking from the rich and
giving to the poor?
• Redistributing wealth from high-income households to lowerincome households would cause the autonomous
consumption of lower-income households to rise but the
autonomous consumption of high-income households to fall.
• On net, total household wealth would be unaffected by the
redistribution and thus aggregate autonomous consumption
would be almost unchanged.
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
Figure 12-2 Planned Real Investment,
Panel (a)
Figure 12-2 Planned Real Investment,
Panel (b)
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
Figure 12-3 Consumption as a
Function of Real GDP
Determining Equilibrium Real GDP
(cont'd)
• Adding the investment function
AD = C + I + G + X
Figure 12-4 Combining Consumption
and Investment
Determining Equilibrium Real GDP
(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
Figure 12-5 Planned and Actual Rates
of Saving and Investment
Determining Equilibrium Real GDP
(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
Determining Equilibrium Real GDP
(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
Example: A Great Inventory Buildup During the Great Recession
• For 10 months following the officially designated start of the
Great Recession in December 2007, business inventories
shrank as U.S. firms managed inventories at relatively low
levels.
• During the last few weeks of 2008, however, unsold business
inventories suddenly jumped by nearly $70 billion because of
a decline in household spending by a similar amount.
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
• Let’s think about what happens when we add
these elements
Keynesian Equilibrium with Government and 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
Keynesian Equilibrium with Government and the Foreign
Sector Added (cont'd)
• The Foreign Sector: C + I + G + X
– Net exports (X) equals exports minus imports
– Depends on international economic conditions
– Autonomous—independent of real national
income
Table 12-2 The Determination of Equilibrium Real GDP with
Government and Net Exports Added
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
Figure 12-6 The Equilibrium Level of Real GDP
Keynesian Equilibrium with Government and the Foreign
Sector Added (cont'd)
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
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
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
Table 12-3 The Multiplier Process
The Multiplier (cont'd)
• The multiplier formula
1
1
Multiplier =
=
1 - MPC
MPS
The Multiplier (cont'd)
• 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
The Multiplier (cont'd)
• Examples
MPC =
4
5
MPS =
1
5
Multiplier =
1
=5
1/5
MPC =
3
5
MPS =
2
5
Multiplier =
1
= 2.5
2/5
The Multiplier (cont'd)
• Measuring the change in equilibrium income
from a change in autonomous spending
Change in equilibrium real GDP =
Multiplier x Change in autonomous spending
The Multiplier (cont'd)
• 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
How a Change in Real Autonomous Spending Affects Real GDP
When
the Price Level Can Change
• So far our examination of how changes in real autonomous
spending affects equilibrium real GDP has considered a
situation in which the price level remains unchanged
• Our equilibrium analysis has only considered how AD shifts in
response to investment, government spending, net exports
How a Change in Real Autonomous Spending Affects Real
GDP When the Price Level Can Change (cont'd)
• When we take into account the aggregate supply curve, we
must also consider responses of the equilibrium price level to
a multiplier-induced change in AD
Figure 12-7 Effect of a Rise in Autonomous Spending on
Equilibrium Real GDP
The Relationship Between Aggregate Demand and the
C + I + G + X Curve
• Aggregate demand consists of:
– Consumption
– Investment
– Government
– Foreign sector
The Relationship Between Aggregate Demand and the C + I
+ G + X Curve (cont'd)
• There is a major difference between the two:
– C + I + G + X curve drawn with price level constant
– AD curve drawn with the price level changing
• To derive the aggregate demand curve from
the C + I + G + X curve, we must now allow the
price level to change
The Relationship Between Aggregate Demand and the C + I
+ G + X Curve (cont'd)
• What are some of the effects of a price level
increase?
– Real balance effect
– Interest rate effect
– The open economy effect
Figure 12-8
The Relationship
Between AD and the C +
I + G + X Curve
You Are There: In Boise, Idaho, Inventories Accumulate as
Desired Saving Rises
• In the late 2008 and early 2009, Noreen and Rick Capp of
Boise, Idaho, began to consume less and save more in order to
pay off their credit card debt.
• The decisions of the Capps and other Boise families to increase
planned saving were transmitted to businesses as unplanned
inventory buildups.
Issues & Applications: Why U.S. Consumption Spending Dropped in the
Late 2000s
• Between the end of 2007 and mid-2009, aggregate U.S. real
consumption spending declined by about $175 billion.
• Figure 12-9 shows that declines in real disposable income and
real household wealth led to a drop in real consumption
expenditures.
Figure 12-9 Real Household Debt, Housing Wealth, Disposable
Income, and Stock Wealth Indexes Since 1960
Summary Discussion of Learning
Objectives
• The difference between saving and savings
and the relationship between saving and
consumption
– Saving is a flow over time while savings is a stock
– Consumption plus saving equals disposable
income
Summary Discussion of Learning
Objectives (cont'd)
• Key determinants of consumption and saving
in the Keynesian model
– In the classical model, the interest rate is the
fundamental determinant of saving
– In the Keynesian model, the primary determinant
is disposable income
– DI increases, so does C
Summary Discussion of Learning
Objectives (cont'd)
• The key determinants of planned investment
– The interest rate, business expectations,
productive technology, and business taxes
Summary Discussion of Learning
Objectives (cont'd)
• How equilibrium real GDP is established in the
Keynesian model
– Equilibrium national income occurs where the C +
I + G + X schedule crosses the 45-degree line
Summary Discussion of Learning
Objectives (cont'd)
• Why autonomous changes in total planned
expenditures have a multiplier effect on
equilibrium real GDP
– As consumption increases, so does real GDP,
which induces further consumption spending
– The ultimate expansion of real GDP is equal to
the multiplier times the increase in autonomous
expenditures
Summary Discussion of Learning
Objectives (cont'd)
• The relationship between total planned
expenditures and the aggregate demand curve
– AD consists of consumption, investment, and
government purchases, plus the foreign sector
– Difference
• C + I + G + X curve drawn with price level constant
• AD with the price level changing
Figure C-1 Graphing the Multiplier