Carlos Andres Rodriguez Herrera 2 1 23 Principles of Macroeconomics ECON 2002 01 Chapter 12 Consumption Real GDP and the Multiplier Introduction Since the early 200s 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 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 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 Chapter Outline Some Simplifying Assumptions in a Keynesian Model Determinants of Planned Consumption and Planned Saving Determinants of Investment Determining Equilibrium Real GDP How a Change in Real Autonomous Spending Affects Real GDP When the Price Level Keynesian Equilibrium with Government and the Foreign Sector Added The Multiplier Can Change The Relationship Between Aggregate Demand and the C I G X Curve Some Simplifying Assumptions in a Keynesian Model To simplify the income determination model let s assume 1 Business pay no indirect taxes sales tax 2 Business 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 The Ohio State University 1 Consumption Saving 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 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 Goods bought by households to use up such as food and movies Consumption Goods Accounting identity Investment Consumption saving disposable income Saving disposable income consumption 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 Producer durables non consumable goods that firms use to make other goods Capital 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 from 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 Carlos Andres Rodriguez Herrera 2 1 23 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 The line along which planned real expenditures equal real GDP per year 45 Degree Reference Line 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 Realdisposable income Average Propensity to Save APS Real saving divided by real disposable income DI Saved proportion of real DI APS Real saving Realdisposableincome 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 disposableincome Marginal Propensity to Save MPS The ratio of the change in saving to the change in disposable income MPS Change realsaving Change real disposableincome Relationships between Marginal and Average Propensity Formulas APC APS 1 MPC MPS 1 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 a Population b Wealth Net wealth The stock of assets owned by a person household firm or nation net of any debts owned Net wealth assets liabilities For a household wealth can consist of a house cars personal belongings stocks bonds bank accounts and cash minus any debts owned The Ohio State University 3 Determinants of Investment Investment you will remember consists of expenditures on new buildings and equipment Gross private