Durable Coins, but not tomatoes or cigarettesDivisible Coins and paper money, but not diamondsTHE ROLE OF THE TREASURY DEPARTMENT1SECTION 15: THE CONSUMPTION FUNCTIONTHE CONSUMPTION FUNCTIONThree things to do with income (Y)1. Spend it (Consumption = C)2. Save it (Saving = S)3. Pay taxes (Taxes = T)Y = C + S + TDISPOSABLE INCOME: Yd= Income available after paying taxesYd = Y - T = C + SThere are only two things to do with disposable income1. Spend it (consumption = C)2. Save it (saving = S)Yd = C + SCONSUMPTION FUNCTION- Expresses consumption spending as a function of disposable income- Holding all other variables constantOther variables also influence the level of consumption- Wealth- Expected future income- Expected inflation rates- Level of interest ratesWEALTH VERSUS INCOMEWEALTH (OR NET WORTH): Value of what you own minus what you owe-what you have saved over your lifetimeINCOME: Amount you earn in a given time period*An old person could be extremely wealthy and have almost no incomeCONSUMPTION FUNCTION FOR A HOUSEHOLD-Consumption spending increases as income increasesC = f(Y)OrC = f(Yd)*The relationship between consumption and income is close to linear*Slope of function decreases as income increases.CONSUMPTION FUNCTION FOR THE U.S. ECONOMYConsumption spending (C) increases as GDP increases.C = f(GDP) = f(Y)12OrC = f(Yd)where aggregate income (Y) = GDP CONSUMPTION FUNCTION FOR THE U.S. ECONOMY-Historically, the relationship has been almost exactly linear.-Frequently, we express C as a function of Y, rather than YdPLOTTING THE CONSUMPTION FUNCTIONExample: C = 6 + .7 YdPlot C on the vertical axisPlot Y or Yd on the horizontal axisIntercept = 6 = Value of C when Yd = 0= Autonomous consumptionSlope = .7= (Change in C) / (Change in Yd)= Marginal Propensity to ConsumeSlope = MPC = amount spent/ disposable incomeAn easy way to plot the consumption function is to select some values of Y and find the corresponding values of C.Plot these points and draw a line through them.PLOTTING THE CONSUMPTION FUNCTIONExample: C = 6 + .7 YdValue of Y 0 10 20 30 40Value of C 6 13 20 27 34Plot the points (C, Y): (6, 0); (13, 10); (20, 20), etc.These points fall on a straight lineINTERCEPT= AUTONOMOUS CONSUMPTIONThe intercept on the vertical axis is C = 6AUTONOMOUS CONSUMPTION-Consumption spending that does not depend on the level of income (or GDP)AUTONOMOUS SPENDING:-Any spending that does not depend on the level of income or GDPConsumptionInvestmentGovernmentForeign spending23SLOPE = MARGINAL PROPENSITY TO CONSUMEIf Y increases by 10, C increases by 7Slope = (Change in C)/(Change in Y) = 7/10 = .7Amount that C increases when Yd increases by 1 unitThe proportion of an increase in income that is spent by consumersMPC = (Change in C) / (Change in Yd)=  C /  YdINDUCED CONSUMPTION= the increase in consumption spending caused (or induced) by an increase in incomeSuppose MPC = .7Example: C = 6 + .7 YdIf income increases by $10,000, consumption will increase by $7,000Yd = 10,000C = 7,000MPC = 7000/ 10,000 = .7PARALLEL SHIFTS IN THE CONSUMPTION FUNCTION-A change in the intercept causes the consumption function to shift parallel to itself with no change in the slope.Some factors which can cause the consumption function to shift upward1. An increase in wealth, such as a rise in the stock market2. A decrease in interest rates which makes borrowing less expensive3. An increase in expected future income such as a job promotionExample: C = 6 + .7 YdC = 10 + .7 Yd34CHANGING THE SLOPE OF THE CONSUMPTION FUNCTION-An increase or decrease in the slope causes the consumption function to become steeper or flatter (with no change in theintercept).-higher percentage of disposable incomeExample: C = 6 + .7 YdC = 6 + .8 YdThe MPC takes a value between 0 and 1.0 < MPC < 1MARGINAL PROPENSITY TO CONSUME (MPC)VS. THE AVERAGE PROPENSITY TO CONSUME (APC)APC = Total consumption spending/ Total incomeAPC = C/ YdMPC = C / YdThe APC tells us the proportion of our entire disposable income that has been spent on consumption.The MPC tells us the proportion of any increase in our disposable income that will be spent on consumptionIF THE CONSUMPTION FUNCTION IS A STRAIGHT LINE, THE APC DECREASES AS Yd INCREASES.Example: C = 6 + .7 YdC Y APC13 10 1.320 20 1.027 30 0.934 40 .85DRAW A 45 DEGREE LINE ON THE GRAPH WITH THE CONSUMPTION FUNCTIONThe 45 degree line is the locus of all points such that the value on the vertical axis equals the value on the horizontal axis.The line representing the consumption function shows the amount of desired consumption spending associated with any level ofdisposable income.Suppose a point on the consumption function lies ABOVE the 45 degree line.45Then C > Yd.This means that consumption exceeds income.Suppose C exceeds disposable incomeThis tends to occur when income is low.These families dissave. Suppose a point on the consumption function lies BELOW the 45 degree line.Then C < Yd.Thus, income exceeds consumption.This tends to occur when income is high.Suppose a point on the consumption function lies ON the 45 degree line.Then C = YdThis means that income equals consumption.These families just BREAK EVEN.IF THE CONSUMPTION FUNCTION IS A STRAIGHT LINE, THE MPC IS CONSTANTC = 6 + .7 YdC Y APC6 0 13 10 1.3 C/Y = 7/10 = .720 20 1.0 C/Y = 7/10 = .727 30 0.9 C/Y = 7/10 = .734 40 .85 C/Y = 7/10 = .7SECTION 16:GROSS PRIVATE DOMESTIC INVESTMENTAUTONOMOUS INVESTMENTInvestment spending that does not depend on the level of GDP.-cocaineINDUCED INVESTMENT= Investment spending that increases or decreases as GDP increases of decreases-prostitutesTHREE CATEGORIES OF INVESTMENT SPENDINGPLANT AND EQUIPMENT SPENDINGInfluenced by state of the economy and by level of interest ratesNEW RESIDENTIAL CONSTRUCTIONInfluenced by level of interest ratesCHANGE IN INVENTORIESThe desired change in inventories does not necessarily equal the actual change in inventories.56The level of inventory cannot be completely determined by a business firmConsumers may buy more or less than the firm expected.DESIRED INVESTMENT SPENDING= the amount business wish to spend on new plant and equipment+ the amount contractors wish to spend on new residential construction+ the amount that businesses wish to spend to add to their stock of inventoryACTUAL INVESTMENT SPENDINGDesired investment will not necessarily equal actual investment spending.Businesses cannot necessarily achieve their desired