What is Propensity to Consumer
When do we spend more?
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
By definition: all disposable income is either
spent or saved
Yd = C + S
Why would we calculate or even consider savings as
important?
A low savings rate leads to a low productivity rate?
Why
Because****without savings to invest in new and better capital,
we can’t raise our productivity very quickly.
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
Keynes said that the economy needs to be
directed to full-employment through
aggregate expenditures.
(C + I + G + X-M )
Keynes Said:
He believed that SPENDING induced business firms
to supply g & s.
He said if spending FELL then business firms would
respond by cutting back production.
LESS SPENDING… LEADS TO LESS OUTPUT.
He said prices and wages were not flexible.
He said- Equilibrium occurs when the level of total
spending is equal to current output.
When this happens producers have no reason to
expand or contract output
Consumer’s Behavior
• We expect that even with an income level
of zero, there will be some consumption.
• This is the autonomous consumption.
• We expect consumption to rise with
income based on the consumer’s MPC.
• Dissaving occurs when current
consumption exceeds current income – a
negative saving flow.
The Multiplier
• The decline in spending will be much larger
than the initial (autonomous) spending
decrease.
• The multiplier is the multiple by which an
initial change in aggregate spending will
alter total expenditure after an infinite
number of spending cycles.
1
Multiplier =
1 - MPC
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
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
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.”
$.64
$1.00
$.80
The multiplier principle applies in reverse also.
(decrease, yields reduction) (money in shoe box)
Marginal Propensity to Consume is the key
The multiplier builds on the principle that one
individual’s expenditure becomes the income of
another.
*Income increases- we spend some on “more
stuff” In turn consumption expenditures on
“stuff” will generate additional income for
others who will spend part of their income on
“stuff” also.
There is a direct correlation between expenditure
multiplier and MPC.
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,