ECON 2105 1nd Edition Lecture 10 Outline of Last Lecture I. Why we measure inflation?II. CPI Formula III. CPI to Inflation RateIV. Inflation Adjustment V. Practice Outline of Current LectureI. Income and Expenditure II. MPC and MPS III. What determines consumer spendingIV. PracticeV. Aggregate Consumption VI. Multiplier Effect Current LectureModule 16Income and Expenditure !. Income and ExpenditureThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.- What would you do, if you check your mailbox today and find out that your Grandma sends you a $1000 check as a birthday gift? o Spend some, save some, buy food, gas- Assume you (say David) spend all of the gift money to buy a brand new laptop from Athens Techno-shop.o The spending of $1,000 iso an expenditure for Davido An income for the owner of Athens Techno-shop, say Sarah.o The impact on GDP? o GDP increases by $1000.- What would Sarah do with $1,000 income?- Assume that Sarah would spend this additional income of $1,000 to order a Mac computer for her personal use.o The spending of $1,000 iso an expenditure for Saraho An income for Apple.o The impact on GDP? o GDP increases by $1000.- The Grandma’s $1,000 gift has now purchased $2000 worth of goods andservices.o Spending on final goods and services will contribute to US GDP. - If we repeat this pattern, it would go on FOREVER and GDP would increase INFINITLEY.o Is it possible? Not really. People will save some moneyII. MPC and MPS - How much consumers spend when they receive more income?- Marginal propensity to consume, or MPC - MPC= ^ consumer spending/ ^ disposable income - Where ^= change - Disposable income= current income + transfer payments- tax payment - In this Module, we are assuming that the output (production) is determined by demand side of the economy. (we have an infinite supply)keep the prices constant. Demand determines the supply - The higher the demand, the higher the production, hence the higher the income (Production=income)- Aggregate spending in the economyo Closed: C(spending by household) + I (spending by firms) + G (spending by government) = GDP o Open: C + I +G + X-IM. =GDPo Y=C+I = aggregate demand Example - How much consumers spend when they receive more income o Assume Dave receives $1000 gift check, ^ disposable income= $1000.o If he consumes $600 of it, then he saves $400 o Private savings $400o MPS= $400/$1000= .4 o MPC+MPS= .6+.4=1 III. What determines consumer spending? - Households are constantly confronted with choices—not just about what to consume but also about how much to spend. And that depends mostly on income.- INCOME, savings, level of wealth, - Current disposable income: income after taxes are paid and government transfers are received.- The higher the disposable income the more they spend - The higher the stock prices the higher the consumer spending - Consumption function: an equation showing how an individual household’s consumer spending varies with the household’s disposable income.o c = a + MPC × ydo Where o c = a household’s consumer spending o yd = household disposable incomeo MPC = marginal propensity to consumeo a = a constant, autonomous consumer spending—what a family would spend even with zero incomeo MPC x yd =induced spending o MPC= ^c/^yd - MPC = Δc/Δyd- Multiplying both sides of the equation by Δyd, we get:o MPC × Δyd = Δc- In other words, when yd goes up by $1, c goes up by MPC.IV. Practice - Suppose when Sue’s disposable income is $10,000, she spends $8,000, and when her disposable income is $20,000, she spends $14,000. Sue’s autonomous consumer spending is equal to _$2000_ and her MPC is equal to _0.6_.o Equation: C= a + MPC x yd o MPC = ^ consumer spending / ^ in disposable income o MPC= ^c/ ^yd o MPC= 6000/10000 =0.6o MPC= 0.6o What is a??o C= a + 0.6 x yd o 8000= a + 0.6 x 10000o a= 2000o or 14000= a 0.6 x 20000o a= 2000- Autonomous spending is around $17,594 and MPC = 0.52.V. Aggregate Consumption- Aggregate consumption function: the relationship for the economy as a whole between aggregate disposable income and aggregate consumer spending.o C = A + MPC × YDo Same form as consumption function, just aggregate.- Assume aggregate consumer spending equals $5,000 when aggregate disposable income is zero, and when disposable income increases from $300 to $400, consumer spending increases by $70. What is the equation for the aggregate consumption function?o C= a + MPC x yd o Yd= 0 o MPC= 70 / 100 = 0.7o Answer: C= 5000 + 0.7 x yd - An upward shift of the aggregate consumption function- If consumers expect higher aggregate income or wealth, consumption increases at all income levels now. This will cause a shit upward on the aggregate consumption function. - A downward shift on the aggregate consumption function - If consumers expect lower aggregate income or wealth, Consumption decreases at all income levels now.- Lower consumer income = lower spending - What causes shifts?o changes in expected future disposable incomeo changes in aggregate wealthVI. Multiplier Effect - Assume that in the economy, MPC= 0.9 and MPS=0.1.- If construction spending rises by $100 billion, - What is the immediate impact of this constructing spending on GDP?- It increases by _100_ billion.- Now, GDP has increased by $_100___ billion, hence income has increasedby $__100___ billion.- People will spend 90% of this additional income in the second round.- Consumption increased by $_90__ billion- Savings increased by $_10__ billion. - The impact on GDP is now $__90_ billion in the second