Consumption
& Investment
The Multiplier and the MPC
Disposable Income (YD)
 What
consumers have left over to spend
or save once they have paid out their net
taxes

Net taxes = taxes paid – transfers received
 YD
= Gross Income – Net Taxes
 With no government transfers or taxation,
YD = Consumption + Savings
Consumption and Saving
Schedules
 Show
the direct relationship between Disposable
income, consumption, and savings
 As YD increases for a typical household, C and S
both increase
Disposable Income (YD )
Consumption (C)
Savings (S)
0
40
-40
100
120
-20
200
200
0
300
280
20
400
360
40
500
440
60
Consumption Function






A linear equation showing how an individual
household’s consumer spending varies with the
household’s current disposable income
C = a + MPC x YD
C = 40 + .80 x YD
The constant $40 is referred to as the autonomous
consumption because it does not change as YD
changes
The slope of the consumption function is .80
Autonomous Consumer Spending (a): the amount of
money a household would spend if it had no
disposable income
Consumption Function
C = 40 + .80 x YD
Saving Function
S = -40 + .20 x YD
Marginal Propensity to Consume
 Marginal
always means an incremental change
caused by an external force
 Marginal Propensity to Consume (MPC): the
change in consumption caused by a change in
disposable income
MPC = ∆ consumer spending (C)
∆ disposable income (YD)
 Because we are looking at the part of each
additional dollar that consumers will spend, the
MPC is a number between 0 and 1
Marginal Propensity to Save
 The
remainder (1 - MPC) is the Marginal
Propensity to Save
 MPS: the fraction of an additional dollar of
disposable income that is saved

A change in savings caused by a change
in disposable income
MPS = 1-MPC
* Note that MPC + MPS = 1
Multiplier in Recent History
Not too long ago, the federal government
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?
The short answer is that $1 of spending in one
area of the economy multiplies into more than
$1 of spending throughout the economy.
The Spending Multiplier
Class 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.
The Spending Multiplier


Multiplier: the ratio of total change in Real
GDP to the size of autonomous change in
spending (the cause of the chain reaction)
∆Y
-OR1
∆AAS
(1-MPC)
Size of the multiplier depends on MPC


Higher the MPC, the higher the multiplier!
So based off of the previous example…
M = 1__
M=5
(1-.80)
The Tax Multiplier
 Taxes,
foreign trade, etc. complicate the
model
 Taxes on disposable income reduce the
size of the spending multiplier
Tax Multiplier = - MPC/(1-MPC)
 The tax multiplier is always negative
Consumer Spending
 Consumer
spending accounts for 2/3 of the US
real GDP
 Let’s use our consumption function from the
earlier schedule
C = 40 + .80 x YD
 If YD increases from $200 to $300, C increases
from $200 to $280. This is seen as movement
upward along the fixed consumption function.
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.
Shifters of the Consumption
Function
 Two
1.
2.
factors will shift CF
Change in Expectations about future
disposable income – Expecting good times
will shift CF up, expecting hard times will shift it
down
Changes in aggregate wealth – Those with
the most savings (wealth) can afford to
spend more…a rise in aggregate wealth will
shift CF up, while a fall in aggregate wealth
will shift it down

Wealth is accumulated assets, and this is very different
from disposable income. If you own a house, a car, share
of stock or even a savings account, you have wealth.
And this is what
shifts of the aggregate
consumption function look like!
The Interest Rate and
Investment Spending
 Firms
analyze the benefits and costs in investment
spending
 Expected return on the investment must be
equivalent to the expected economic profit from
the investment
Return on Investment/Profit = (total revenue—total cost)
investment cost
 The
1.
2.
market interest rate is the cost of investment
Interest rate is cost of borrowed funds
Interest rate is also cost of investing your own
funds (no borrowing), since it is income forgone
Investment Demand Curve
 Investment
demand curve shows the
inverse relationship between interest rates
and investment demand
Expected Future
Real GDP & Production Capacity
on Investment Spending
 Various
factors can increase spending at any
interest rate
 Expected Future Real GDP


Low or no expectation of sales growth results in
minimal investment spending
High expectation of sales growth results in need to
expand production capacity
 Production

Capacity
If current capacity is higher than needed for current
sales, growing capacity is a lesser concern.
Inventories & Unplanned
Investment spending
 Businesses
maintain inventories to satisfy
future sales
 Inventory investment – Value of total
inventories in an economy over a period of
time. This can be a negative number when
inventories are reduced.
 If sales fall, businesses might end up with
larger inventories than expected (unplanned
inventory investment)
 Rising inventories signal economic slowdown
Investment Spending
 Actual
investment spending is equal to
planned investment spending plus
unplanned inventory investment.

I= IPlanned + I Unplanned
 Planned
Investment: Interest Rates,
Expected Future real GDP, Production
capacity
 Unplanned Inventory investment: when
actual sales are less than businesses
expected, leading to unplanned increases
in inventories
 Sales higher than expectations result in
negative unplanned inventory investment
 Sales lower than expectations result in
positive unplanned inventory investment