CHAPTER 12- CONSUMPTION, REAL
GDP, MULTIPLIER
CONSUMPTION FUNCTION I


The consumption function is the relationship
between consumption (household sector spending)
and disposable income.
In the consumption function, consumption is
directly related to disposable income and is positive
even at zero disposable income:


The 45-Degree Line
The 45-degree line represents all points where
consumption and income are exactly equal.
C = YD
CONSUMPTION (billions of dollars per year)
U.S. Consumption and Income
$7000
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
6000
C = YD
5000
4000
3000
2000
1000
45°
0
$1000
Actual consumer spending
2000
3000
4000
5000
DISPOSABLE INCOME (billions of dollars per year)
6000
7000
AUTONOMOUS INCOME
Have you ever known people who spend
money with out any income?
2. When disposable income is 0 and
consumption still exists (food, clothing,
shelter- basics) this is autonomous
consumption
3. Whether one has to dig into one’s
savings, go on welfare, or else beg,
borrow or steal, or call mom, one will
spend that minimum amount
HOW DOES THIS WORK?
Income is low- households tend to Dissave..(borrow
from savings or borrow from other sources)
 Income increases- household aggregate income
eventually equals and exceeds current consumption


The Keynesian model assumes that there is a positive
relationship between consumption and income.
Planned Consumption
Expenditures
(trillions of dollars)
45º Line
12
Saving
C
9
6
Dis-saving
3
45º
3
6
9
12
Real
Disposable Income
(trillions of dollars)
•However, as income increases, consumption increases by a smaller amount.
• Thus, the slope of the consumption function (line C) is less than 1
• (less than the slope of the 45° line).



Disposable Income
Yd= C+S
If we spend… cannot save.
If we spend… more activity (production)
takes place in the economy… potential to
increase GDP
What happens if we do not save at all?
WHAT IS THE DECIDING FACTOR ON
WHETHER YOU SPEND OR NOT?
 Income
 Keynes
felt we could learn a lot
about consumption by focusing on
the relationship between income
and spending.
 He said income and consumer
spending rise in tandem..
 If you know how much income
consumers have to spend (Yd), you
can predict what they will spend
KEYNE’S CONSUMPTION FUNCTION
Keynes referred to this as “fundamental
law” that men are disposed as a rule
and on the average, to increase their
consumption as their income
increases, but not by as much as the
increase in their income.
*1)At low levels of aggregate income, the
consumption expenditures of
households will exceed their
disposable income (when household
income is low, households dissave- they
either borrow or draw from past savings
to purchase consumption goods
45 Degree Line
45 Degree Line
C = YD
E
D
Saving
C
Dissaving
Consumption Function
C = $50 + 0.75YD
B
G
A
$50
100
150
200
250
300
350
400

Keynes Cont.
As with most theories, Keynes asks us to
assume away a lot of the problem.
 We will assume there is a specific
employment level of output. NARU
is present when full-employment
capacity is attained.
 Wages and prices are completely
inflexible until full employment is
reached
 Government’s taxing, spending and
monetary policies are constant.
Keynes said that the economy needs to be
directed to full-employment through
aggregate expenditures.
(C + I + G + X-M )
A
sluggish economy
There are a number of ways to jump-start the
economy…
Fiscally: taxing & spending. Affects on AD
Should the classical or Keynesian approach
be used…. Or should an eclectic approach
be used?
KEYNESIAN ECONOMICS
Works only on the AD curve
 Assumes AS is stationary
 Critics of Keynes:

…But this will cause deficits!
 …But the government can’t spend that much!

KEYNES’ MULTIPLIER EFFECT


Any new spending (G) becomes new income (Y) to
someone.
New income (Y) after taxes (T), called disposable
income (Yd), is divided into new spending (C) and
new saving (S).
Y=C+S+T
 Yd = Y – T = C + S
 ΔYd = ΔC + ΔS

WHAT DO YOU THINK MARGINAL
PROPENSITY TO CONSUME MEANS???
You get a “windfall.” How much of those $$ will
you spend… (marginally?) How much will you
save? (marginally?)
 Yd



=C+S
ΔYd = ΔC + ΔS
Divide through by ΔYd:
1 = ΔC/ΔYd + ΔS/ΔYd
 Define:
marginal propensity to consume (MPC)
MPC = ΔC / ΔYd
 marginal propensity to save (MPS)
MPS = ΔS / ΔYd
 1 = MPC + MPS, always

THE MULTIPLIER EFFECT
In each cycle, part of the new income is set aside
as saving (MPS).
 So, the next round of income-spending is smaller
than the previous round.
 As new income grows, it ultimately reaches its
maximum.
 The power of the multiplier effect is controlled by
the size of MPS.

THE MULTIPLIER EFFECT
 Spending
multiplier = 1/MPS
MPS
1/10
1/5
1/4
1/3
Spending
Multiplier
10
5
4
3
WHAT REALLY IS THE MULTIPLIER?
The multiplier is based on two concepts
already covered:
1. GDP is the nation’s expenditure on all the
final goods and services produced during the
year at market prices.
2. GDP=C+I+G+(X-M) = Aggregate Demand
SUMMARY
Y
=C+S+T
Y is national income
 Yd = Y – T = C + S
Yd is disposable
income
 MPC = ΔC / ΔYd
 MPS = ΔS / ΔYd
 MPC + MPS = 1, always
 spending multiplier = 1/MPS
 tax multiplier = - (spending multiplier – 1)
Obviously if C goes up the entire
GDP will go up also. When there
is any change in spending- it will
have a multiplied effect on GDP
*When money is spent by one
person, it becomes someone
else’s income.
When someone spends a dollar,
perhaps someone who received
that dollar would spend 80 cents
and of that 80 cents received by
the next person perhaps 64
cents…
If we add up all the spending
generated by that one dollar, it
will add up to four or five or six
times that dollar…
Hence, the name
“multiplier.”
$1.00
$.64
$.80
The multiplier tells us the extent to which the
rate of total spending will change in
response to an initial change in the flow of
expenditure.
1
Multiplier =
1 - MPC
Any change in spending (C, I, or G.) will set off a chain reaction,
Leading to a multiplied change in GDP. If $1 million investment
resulted in $4 million additional income, the multiplier would
be 4
THE MULTIPLIER PROCESS
3. Income reduced by $100 billion
4. Consumption reduced by $75 billion
Households
7. Income reduced by
$75 billion more
8. Consumption reduced
by $56.25 billion more
Factor
markets
Product
markets
6. Further cutbacks in
employment or wages
2. Cutbacks in employment or wages
9. And so on
Business
firms
5. Sales fall $75 billion
1. $100 billion in unsold goods appear
The Multiplier Principle
Expenditure
Stage
Additional
Income
Additional
Consumption
(Dollars)
(Dollars)
Marginal
Propensity
To Consume
Round 1
Round 2
Round 3
Round 4
Round 5
Round 6
Round 7
Round 8
Round 9
Round 10
All Others
1,000,000
750,000
562,500
421,875
316,406
237,305
177,979
133,484
100,113
75,085
225,253
750,000
562,500
421,875
316,406
237,305
177,979
133,484
100,113
75,085
56,314
168,939
3/4
3/4
3/4
3/4
3/4
3/4
3/4
3/4
3/4
3/4
3/4
Total
4,000,000
3,000,000
3/4
For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.
• The multiplier concept is fundamentally based upon the
proportion of additional income that households choose to spend
on consumption: the marginal propensity to consume (here
assumed to be 75%  3/4).
• Here, a $1,000,000 injection is spent, received as payment,
saved and spent, received as payment, saved and spent … etc.
…
until . . . $4 million is spent in the economy.
effectively,