CHAPTER 12 CONSUMPTION, INCOME, AND THE MULTIPLIER

CHAPTER OVERVIEW The main objective of this chapter is to indicate how macroeconomic equilibrium is attained in a Keynesian framework. The income-expenditure model is developed. In the process the concepts of consumption, savin , investment and net exports are developed and used to derive macroeconomic equilibrium. !nother important objective is to derive and explain the si nificance of the multiplier both in the fixed price model and in the !"-!# model. $inally the chapter shows how %&I&'&( is related to a re ate demand. CHAPTER OBJECTIVES !fter studyin ). *. ,. -. .. this chapter students should be able to

#istin uish between savin and savin s and explain how savin and consumption are related. +xplain the key determinants of consumption and savin in the Keynesian model. Identify the primary determinants of planned investment. #escribe how equilibrium national income is established in the Keynesian model. +valuate why autonomous chan es in total planned expenditures have a multiplier effect on equilibrium national income 0nderstand the relationship between total planned expenditures and the a re ate demand curve.

/. VOCABULARY

%onsumption "avin s

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Investment %apital oods %onsumption function #issavin s !utonomous consumption !vera e propensity to consume !vera e propensity to 1ropensity 2ar inal propensity to consume 2ar inal propensity to 1ropensity 2ultiplier CHAPTER OUTLINE I. SOME SIMPLIFYING ASSUMPTIONS IN A KEYNESIAN MODEL: 3)4 5usinesses pay no indirect taxes, such as sales taxes. 3*4 5usinesses distribute all of their profits to shareholders. 3,4 There is no depreciation, or capital consumption allowances, so ross private domestic investment equals net investment. 3-4 The economy is closed. 'iven all these simplifyin assumptions, real disposable income will be equal to real national income minus taxes. A. Anot !" Loo# $t D!%&n&t&on' $n( R!)$t&on' &*': %onsumption is the act of usin income for the purchase of consumption oods. %onsumption oods are oods purchased by households for immediate satisfaction. 5y definition, whatever is not consumed is saved. 1. Sto+#' $n( F)o,': S$-&n. $n( S$-&n.': It is important to distin uish between savin and savin s. "avin is an action that occurs at a particular rate. This rate is a flow. It is expressed per unit of time. "avin s, by contrast, is a stock measured at a certain point or instant in time. 2. R!)$t&n. In+o/! to S$-&n. $n( Con'0/*t&on: %onsumption & savin 6 disposable income. This is called an accountin identity. It has to hold true at every moment in time. $rom it the definition of savin is7 "avin 6 disposable income - consumption. 1. In-!'t/!nt: ! flow concept that includes expenditures on new machines, buildin s and

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equipment, i.e. capital business inventories. II.

oods, and chan es in

DETERMINANTS OF PLANNED CONSUMPTION AND PLANNED SAVING: The consumption function shows the relationship between planned consumption and various levels of disposable income. !s real disposable income oes up, planned consumption rises also, but by less than does income. The savin function shows that planned savin also increases with disposable income. 2S!! T$3)! 12415 A. B. G"$* &n. t ! N0/3!"': 2S!! F&.0"! 12415

D&''$-&n. $n( A0tono/o0' Con'0/*t&on: The amount of planned consumption, which does not depend at all on disposable income, is called autonomous consumption. #issavin is ne ative savin 7 it is a situation where spendin exceeds income. #issavin can occur when a household is able to borrow or use up existin owned assets. A-!"$.! P"o*!n'&t6 to Con'0/! $n( to S$-!: 1. A-!"$.! P"o*!n'&t6 to Con'0/! 2APC5: %onsumption divided by disposable income8 the proportion of total disposable income that is consumed. A-!"$.! P"o*!n'&t6 to S$-! 2APS5: "avin divided by disposable income8 the proportion of total disposable income that is saved.

C.

2.

D.

M$".&n$) P"o*!n'&t6 to Con'0/! $n( to S$-! 1. M$".&n$) P"o*!n'&t6 to Con'0/! 2MPC5: The chan e in consumption divided by the chan e in disposable income. M$".&n$) P"o*!n'&t6 to S$-! 2MPS5: The chan e in savin divided by the chan e in disposable income.

2. E.

So/! R!)$t&on' &*' 1. !1% & !1" 6 ) 3)99 percent of total income4. 3)99 percent of the chan e in in-

2. 21% & 21" 6 ) come4

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F. T ! C$0'!' o% S &%t' &n t ! Con'0/*t&on F0n+t&on: :henever there is a chan e in non-income determinants of consumption, the consumption curve shifts upward or downward. ! chan e in population up or down, a chan e in expectations, or a chan e in real household wealth will cause the consumption function to shift. 2S!! LOTM 12475 III. DETERMINANTS OF INVESTMENT: Investment is defined as expenditures on new plant, capital equipment, and chan es in business inventories. ;eal ross private domestic investment in the 0nited "tates has been volatile compared to real consumption, because investment decisions of business people are based on hi hly variable, subjective expectations of the economic future. A. T ! P)$nn!( In-!'t/!nt F0n+t&on: !t all times businesses perceive an array of investment opportunities. "ince each project is profitable only if its rate of return exceeds the rate of interest8 it follows that as the interest rate falls, planned investment spendin increases, and vice versa. The investment function is represented as an inverse relationship between the rate of interest and the quantity of planned investment. 2S!! F&.0"! 12425 W $t C$0'!' t ! In-!'t/!nt F0n+t&on to S &%t: If noninterest rate determinants of investment chan e, the investment schedule will shift. +xpectations of business people, chan es in productive technolo y, and chan es in business taxes cause a shift in the investment function.

B.

IV.

CONSUMPTION AS A FUNCTION OF REAL NATIONAL INCOME: <et taxes avera e about ). percent of national income. $or this reason, real national income can be substituted for real disposable income in the consumption function. 2S!! F&.0"! 12415 A. T ! 894D!."!! R!%!"!n+! L&n!: The line alon which planned expenditures are equal to real national income per year. A((&n. t ! In-!'t/!nt F0n+t&on: In the simplified Keynesian model it is assumed that real investment per year is autonomous with respect to real national income. 2S!! F&.0"! 12485

B.

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V.

SAVINGS AND INVESTMENT: PLANNED VERSUS ACTUAL: +quilibrium occurs at the intersection of the planned savin and planned investment schedules. There is no tendency for businesses to alter the rate of production or the level of employment because they are neither increasin nor decreasin their inventories in an unplanned way. :hen the savin rate planned by households differs from the investment rate planned by businesses, there will be an increase or decrease in real national income in the form of unplanned inventory chan es. ;eal national income and employment will chan e until unplanned inventory chan es are a ain =ero. 2S!! F&.0"! 12495 KEYNESIAN E:UILIBRIUM WITH GOVERNMENT AND THE FOREIGN SEC4 TOR ADDED: 2S!! T$3)! 12425 A. Go-!"n/!nt: ;esource-usin federal, state, and local overnment purchases are politically determined and can thus be considered autonomous. T ! Fo"!&.n S!+to": The level of exports depends on international economic conditions in the countries that buy 0.". products. Imports depend on economic conditions in the 0nited "tates The difference between imports and exports is net exports. C. D!t!"/&n&n. t ! E;0&)&3"&0/ L!-!) o% R!$) N$t&on$) In+o/! *!" Y!$": The equilibrium level of real national income exists whenever total planned expenditures equal total production, iven a constant price level. 2S!! F&.0"! 124<5

VI.

B.

VII. THE MULTIPLIER: The multiplier is the number by which a permanent chan e in autonomous spendin such as autonomous investment or autonomous consumption is multiplied to et the chan e in the equilibrium level of real national income. !ny permanent increase in autonomous spendin will cause a more than proportional increase in real national income. 2S!! T$3)! 12415 A. T ! M0)t&*)&!" Fo"/0)$: The autonomous spendin multiplier is equal to the reciprocal of the mar inal propensity to save, i.e., the /0)t&*)&!" = 1 > 21 4 MPC5 = 1 > MPS. The multiplier is directly related to the 21% and inversely related to the 21". The chan e in the equilibrium level of real national income due

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to a chan e in autonomous spendin is the /0)t&*)&!" t&/!' t ! + $n.! &n $0tono/o0' '*!n(&n.. B. T ! S&.n&%&+$n+! o% t ! M0)t&*)&!": The multiplier ma nifies chan es in equilibrium real national income caused by chan es in autonomous spendin .

VIII. THE MULTIPLIER WHEN THE PRICE LEVEL CAN CHANGE: The multiplier effect on equilibrium overall level of real nation income will be smaller if part of the increase in nominal national income occurs because the price level increases. The price level does not stay fixed because ";!" normally is positively sloped. The multiplier is smaller because part of the additional income is used to pay hi her prices8 not all is spent on increased output as is the case when the price level is fixed. 2S!! F&.0"! 124 ?5 I@. THE RELATIONSHIP BETWEEN AGGREGATE DEMAND AND THE CAIAGA@ CURVE: The %&I&'&( curve is drawn assumin a iven price level. If the price level oes up, the real balance effect, increased borrowin with a resultin increase in the interest rate, and a decline in net exports will cause the %&I&'&( curve to shift downward. ;eal national income will fall. 2S!! F&.0"! 124B5

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SELECTED REFERENCES !ckley, 'ardner, Macroeconomics: Theory and Policy, <ew >ork7 2acmillan, )?@A. !ndo, !. and $. 2odi liani, BCelocity and the Investment 2ultiplier,B American Economic Review, Col. DC, <o. -, "eptember )?/., pp. /?,-@*A, @A/-@?9. 5arret, %harles 1. and !.!. :alters, BThe "tability of Keynesian and 2onetary 2ultipliers in the 0nited "tates,B Review of Economics and Statistics, <ovember )?//, pp. ,?.--9.. %ampa na, !nthony, Macroeconomics, <ew >ork7 "t. 2artinEs 1ress, )?A). $riedman, 2. and #. 2eiselman, B;eply to !ndo and 2odi liani and to #e1rano and 2ayer,B American Economic Review, Col. .., <o. -, "eptember I?/., pp. @.,-@A.. 'ordon, ;obert F., Macroeconomics, -th ed., 5oston7 Dittle, 5rown, and %ompany, )?A@. Keynes, Fohn 2., The General Theory of Employment, Interest, and Money, Interest and 2oney, <ew >ork7 Garcourt, )?/,. Klein, Dawrence, The Keynesian Revol tion, <ew >ork7 2acmillan, )?/). 2iller, ;o er D. and ;obert :. 1ulsinelli, Macroeconomics, <ew >ork7 Garper and ;ow, )?A/.