Microeconomics Notes 4 Chapter 12 Consumption Real GDP and the Multiplier 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 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 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 Consumption Goods Goods bought by households to use up such as food and movies Accounting Identity Consumption Saving Disposable Income 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 Capital Goods Producer durables non consumable goods that firms use to make other goods 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 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 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 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 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 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 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 45 Degree Reference Line The line along which planned real expenditures equal real GDP per year Autonomous Consumption The part of consumption that is independent of the level of disposable income Changes in autonomous consumption shift the consumption function 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 D isposable Income Average Propensity to Save APS Real saving divided by real disposable income DI Saved proportion of real DI APS Real Saving Real Disposable Income Marginal Propensity to Consume MPC The ratio of the change in real consumption to the change in real disposable income MPC Change Real Consumption Change Real Disposable Income Marginal Propensity to Save MPS MPS Change Real Saving Change Real Disposable Income The ratio of the change in saving to the change in disposable income 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 Relationships APC APS 1 MPC MPS 1 Population Wealth 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 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 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 Saving and investment Planned versus Actual Only at equilibrium real GDP will planned saving equal actual saving Hence planned saving is equal to planned investment Planned investment equals actual investment 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 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 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 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 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 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