Consumption, Real GDP and
Multiplier
Chapter 12
Consumption
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
Saving
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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
Consumption Goods
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Goods bought by households to
use up, such as food and movies
Consumption plus saving equals
disposable income
Saving equals disposable income
minus consumption
Investment
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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
Producer durables; nonconsumable
goods that firms use to make other
goods
Classical Model
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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
Keynesian View
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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
Keynesian
Consumption function
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Keynes was concerned with changes in
AD (AD= C +I+G+NX)
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
Autonomous Consumption
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The part of consumption that is
independent of the level of disposable
income
Changes in autonomous consumption
shift the consumption function
45-Degree Reference Line - The line
along which planned real expenditures
equal real GDP per year
Dissaving
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Negative saving; a situation in
which spending exceeds income
Dissaving can occur when a
household is able to borrow or use
up existing assets
Average Propensity to
Consume
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Average Propensity to Consume
(APC) Real consumption divided by
real disposable income
The proportion of total disposable
income that is consumed
Average Propensity to Save
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Average Propensity to Save (APS)
Real saving divided by real
disposable income(DI)
Saved proportion of real DI
Example of APC
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Income increases by $6,000 to
$60,000
C = $54,000
S = $6,000
Marginal Propensity to
Consume
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Marginal Propensity to Consume
(MPC) The ratio of the change in
real consumption to the change in
real disposable income
Marginal Propensity to Save

Marginal Propensity to Save (MPS)
The ratio of the change in saving
to the change in disposable income
The Multiplier
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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
Multiplier Formula
It is possible that a relatively small
change in consumption or
investment can trigger a much
larger change in real GDP
Multiplier example
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MPC = .9 and MPS =.1
1/1-.9=1/.1= 10
If 50 billion dollars is invested then it will
become 500 billion dollars in real GDP
growth due to the Multiplier
Your turn to use multiplier
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MPC =.8 MPS=.2
50 billion is invested
1/1-.8 = 1/.2 = 5
5x50= 250 billion
Now make a multiplier problem for a
friend.
Investment
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Investment is new expenditures on
buildings and equipments.
It also includes changes in inventories,
or items produced but not sold by
businesses
Investment Decisions
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Businesses have an array of investment
choices with varying rates of return (profit)
Keynes believed that when interest rates
increase in the credit market planned
investment decreased
Conversely, when interest rates decrease
then planned investment increases
Therefore, there is a downward sloping
investment curve
Investment shifts
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Investments may also shift due to:
1. Future expectations of future sales by
business people
2. Changes in productive technology
3. Increases or decreases in taxes
Adding investment
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Investment, or what is called autonomous
investment, is added to the Keynesian
Income Model
It is parallel and above the consumption
function line
It is labeled C + I
The addition of Investment to Consumption
raises the level of RGDP or National Income
at the equilibrium point of the 45 degree
angle
The increases in Inventories
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If consumers purchase fewer goods and
services than anticipated this leaves
firms with unsold products and
inventories will rise
Businesses respond by cutting back
production, to reduce unplanned
business inventories, thus reducing
RGDP
Decreases in Inventories
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If there are unplanned decreases
in business inventories then
business will increase production
of goods and services and increase
employment
Ultimately there will be an increase
in real GDP
Government Spending
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Government spending, like investment
is considered autonomous (not
determined by levels of disposable
income)
G in the model includes federal, state
and local government spending.
However, transfer payments, like social
security are not included in G.
Government spending
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It is estimated that government expenditures
account for about 20% of GDP
The Keynesian model assumes a lump sum
tax, which means that real GDP will be
reduced by the amount of the lump sum tax.
(This tax decreases C and I)
Foreign Sector
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The Foreign sector is determined by net
exports (exports - imports).
Trade surpluses will increase the real GDP,
and trade deficits will decrease the RGDP
The Foreign sector is also autonomous.
Together C+I+G+NX are often given the
notation AE (All Expenditures) on the macro
model.
Relationship between models
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The C+I+G+NX curve you studied in
Chapters 10 and 11 is directly related to
the AE curve in the Keynesian income
model
The major difference is that the
Keynesian income model does not
include price level changes of the first
Macro model we learned.
Keynesian Assumptions
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