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  • 1. Chapter 12 Consumption, Real GDP, and the Multiplier
  • 2. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-2 Introduction Since the early 2000s, planned real investment spending has increased in most of the world’s nations. As a percentage of global real GDP, however, planned real investment spending in the world’s developed countries has declined. Yet, it has been rising in emerging-economy nations. These are countries transitioning to a developed status. How do changes in planned real investment spending affect a country’s real GDP? Reading Chapter 12 will help you answer this question.
  • 3. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-3 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
  • 4. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-4 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
  • 5. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-5 Chapter Outline • Some Simplifying Assumptions in a Keynesian Model • Determinants of Planned Consumption and Planned Saving • Determinants of Investment • Determining Equilibrium Real GDP
  • 6. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-6 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
  • 7. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-7 Did You Know That ... • The share of real GDP allocated to real consumption spending is: – 66 percent in Germany – 60 percent in the United Kingdom – 70 percent in the United States – Less than 41 percent in China? • 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.
  • 8. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-8 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
  • 9. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-9 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
  • 10. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-10 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
  • 11. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-11 Some Simplifying Assumptions in a Keynesian Model (cont'd) • Consumption Goods – Goods bought by households to use up, such as food and movies
  • 12. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-12 Some Simplifying Assumptions in a Keynesian Model (cont'd) • Accounting identity: Consumption + saving disposable income Saving disposable income – consumption
  • 13. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-13 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
  • 14. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-14 Some Simplifying Assumptions in a Keynesian Model (cont'd) • Capital Goods – Producer durables; nonconsumable goods that firms use to make other goods
  • 15. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-15 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
  • 16. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-16 Determinants of Planned Consumption and Planned Saving (cont'd) • Keynes argued that: – The interest rate is not the most important factor in saving and consumption decisions – Rather, real saving and consumption decisions depend primarily on a household’s real disposable income. – Furthermore, a person’s anticipation about future flows of income influences how much of current income is allocated to consumption and how much is allocated to saving.
  • 17. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-17 Determinants of Planned Consumption and Planned Saving (cont'd) • The Life-Cycle Theory of Consumption – The most realistic and detailed theory of consumption, often called the life-cycle theory of consumption, considers how a person varies saving and consumption as income ebbs and flows throughout an entire life span. • This theory predicts that when an individual anticipates a higher income in the future, he or she will tend to consume more and save less in the current period than would have been the case otherwise.
  • 18. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-18 Determinants of Planned Consumption and Planned Saving (cont'd) • The Permanent Income Hypothesis – A related theory, called the permanent income hypothesis, suggests that the income level that matters for a person’s decisions about current consumption and saving is permanent income, or expected average lifetime income. • Thus, if a person’s flow of income temporarily rises without an increase in average lifetime income, the person responds by saving more and leaving consumption unchanged.
  • 19. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-19 Determinants of Planned Consumption and Planned Saving (cont'd) • The Keynesian Theory of Consumption and Saving – Keynes argued that real consumption and saving decisions depend primarily on a household’s current real disposable income.
  • 20. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-20 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
  • 21. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-21 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
  • 22. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-22 Table 12-1 Real Consumption and Saving Schedules: A Hypothetical Case
  • 23. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-23 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
  • 24. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-24 Figure 12-1 The Consumption and Saving Functions
  • 25. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-25 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
  • 26. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-26 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 APC = Real consumption Real disposable income
  • 27. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-27 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 APS = Real saving Real disposable income
  • 28. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-28 MPC = Change in real consumption Change in 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
  • 29. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-29 MPS = Change in real saving 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
  • 30. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-30 APC = $49,200 $54,000 = .911 Determinants of Planned Consumption and Planned Saving (cont'd) • Example – Income = $54,000 – C = $49,200 – S = $4,800 • What is the APC?
  • 31. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-31 APC = $54,000 $60,000 = .90 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?
  • 32. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-32 Determinants of Planned Consumption and Planned Saving (cont'd) • Some relationships APC + APS 1 MPC + MPS 1
  • 33. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-33 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
  • 34. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-34 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)
  • 35. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-35 Example: Lower Household Wealth and Subdued Growth in Consumption • Between 2007 and 2009, there was a substantial decline in two key components of real household wealth. – Inflation-adjusted wealth in housing fell by 25 percent – Inflation-adjusted wealth in corporate stocks fell by 50 percent • These wealth reductions shifted the U.S. consumption function downward. • Real disposable income also fell, causing a leftward movement along the consumption function and a further drop in consumption.
  • 36. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-36 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
  • 37. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-37 Figure 12-2 Planned Real Investment, Panel (a)
  • 38. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-38 Figure 12-2 Planned Real Investment, Panel (b)
  • 39. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-39 Example: Adding a Third Dimension Requires New Investment Spending • Of the approximately 40,000 movie screens in the United States, fewer than 8,000 are equipped with digital technology required for projection of three- dimensional (3D) movies. • Conversion to the 3D technology costs about $70,000. • Major movie-theater chains are currently undertaking this investment for more than 1,000 theaters. • This adds up to an aggregate investment expenditure of about $700 million.
  • 40. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-40 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
  • 41. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-41 Figure 12-3 Consumption as a Function of Real GDP
  • 42. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-42 Determining Equilibrium Real GDP (cont'd) • Adding the investment function AD = C + I + G + X
  • 43. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-43 Figure 12-4 Combining Consumption and Investment
  • 44. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-44 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
  • 45. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-45 Figure 12-5 Planned and Actual Rates of Saving and Investment
  • 46. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-46 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
  • 47. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-47 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
  • 48. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-48 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
  • 49. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-49 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
  • 50. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-50 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
  • 51. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-51 Table 12-2 The Determination of Equilibrium Real GDP with Government and Net Exports Added
  • 52. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-52 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
  • 53. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-53 Figure 12-6 The Equilibrium Level of Real GDP
  • 54. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-54 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
  • 55. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-55 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
  • 56. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-56 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
  • 57. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-57 Table 12-3 The Multiplier Process
  • 58. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-58 The Multiplier (cont'd) • The multiplier formula Multiplier = 1 1 - MPC = 1 MPS
  • 59. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-59 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
  • 60. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-60 The Multiplier (cont'd) • Examples MPC = 4 5 MPS = 1 5 Multiplier = 1 1/5 = 5 MPC = 3 5 MPS = 2 5 Multiplier = 1 2/5 = 2.5
  • 61. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-61 Change in equilibrium real GDP = Multiplier x Change in autonomous spending The Multiplier (cont'd) • Measuring the change in equilibrium income from a change in autonomous spending
  • 62. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-62 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
  • 63. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-63 What If . . . The government seeks a larger multiplier effect by funding private spending on certain items rather than buying them directly? • Whether the government gives funds to households and firms for purchasing goods or whether the government makes the purchases directly, the resulting increase in total autonomous expenditure is the same. – Thus, the overall multiplier effect on equilibrium real GDP would also be the same. – So, providing grants of public funds to be spent by households and firms rather than having government purchase the same items will not enlarge the overall theoretical multiplier effect.
  • 64. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-64 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
  • 65. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-65 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
  • 66. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-66 Figure 12-7 Effect of a Rise in Autonomous Spending on Equilibrium Real GDP
  • 67. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-67 International Example: The Effect of Higher Autonomous Spending on China’s Real GDP • Most estimates indicate that the marginal propensity to consume in China is about 0.50. • So, assuming no change in the price level, the multiplier would be about 2. • However, economists have estimated that the short-run effect of an initial increase in real autonomous spending on China’s real GDP is only about 1.1. • Therefore, once the higher price level is taken into account, an additional one-unit increase in real autonomous expenditure causes a 1.1 unit increase in China’s annual real GDP.
  • 68. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-68 The Relationship Between Aggregate Demand and the C + I + G + X Curve • Aggregate demand consists of: – Consumption – Investment – Government – Foreign sector
  • 69. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-69 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
  • 70. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-70 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
  • 71. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-71 Figure 12-8 The Relationship Between AD and the C + I + G + X Curve
  • 72. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-72 You Are There: Evaluating the Effects of Declining Real Disposable Income • Mark Vitner, an economist with Wells Fargo bank, examines the latest monthly economic data. • Real disposable income fell by 0.3 percent during the month. • Real consumption spending and real saving dipped as well, consistent with the theory. • Vitner summarizes the situation by saying that household budgets are getting tighter and consumers are having difficulty maintaining their standard of living.
  • 73. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-73 Issues & Applications: A Global Reversal in Planned Investment Spending • In the past, developed countries have displayed the largest upward shifts in their planned investment functions. • Recently, however, larger upward shifts have occurred among the emerging-economy nations, such as China, India, South Korea, and Singapore. • Figure 12-9 on the next slide displays real investment spending as a percentage of global real GDP for developed and emerging nations.
  • 74. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-74 Figure 12-9 Real Investment Spending as a Percentage of Global Real GDP in Two Groups of Nations since 1995 Sources: International Monetary Fund; author’s estimates.
  • 75. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-75 Issues & Applications: A Global Reversal in Planned Investment Spending (cont’d) • Variations in planned real investment spending operate through the multiplier to bring about changes in equilibrium real GDP. • Therefore, a country that experiences a larger upward shift in its planned investment function will observe a greater increase in its equilibrium real GDP. • This explains why countries such as China, India, South Korea, and Singapore are emerging to take a place alongside developed nations.
  • 76. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-76 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
  • 77. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-77 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
  • 78. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-78 Summary Discussion of Learning Objectives (cont'd) • The key determinants of planned investment – The interest rate, business expectations, productive technology, and business taxes
  • 79. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-79 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
  • 80. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-80 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
  • 81. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-81 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
  • 82. Copyright ©2014 Pearson Education, Inc. All rights reserved. 12-82 Figure C-1 Graphing the Multiplier