chap-3 consumption saving and investment

8/2/2019 Chap-3 Consumption Saving and Investment

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Consumption Saving and

Investment


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Consumption Saving and Investment

John Maynard Keynes : British economist (1883-1946) who offered an explanation of the GreatDepression of the 1930s.

The General Theory of Employment Interestand Money

Keynes - The economy could tend towards aless than full employment equilibrium.

Classical economist (Prior to the 1930s) - Theeconomy is always tending toward a fullemployment equilibrium


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J. B. Say (Says law) : Supply creates its owndemand.

Keynes believed that Demand can be foreverinadequate for an economy to achieve full

employment. What determines demand for goods and services -

Disposable income

Consumption Function: shows the householdspending for goods and services at different levels ofdisposable income.


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Consumption function Relationship between consumption and

disposable income

Positive slope Autonomous consumption spending

Part of consumption spending

Independent of income Vertical intercept - consumption function

Saving: Money earned but not spent.


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Dis-saving - The amount personal spendingexceeds disposable income.

By taking money from personal savings.

Autonomous Consumption: Consumption that is

independent of the level of disposable income What happens when disposable income is zero?

Spending will be equal to autonomous consumption

because households will dissave for basic needs.


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Consumption Spending

Consumption spending increases when:

Disposable income rises

Wealth rises

Interest rate falls

Optimistic about the future


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Consumption and DisposableIncome

Marginal propensity to consume (MPC)

Slope of the consumption function

Amount by which consumption spending riseswhen disposable income rises.

1MPC0incomeeDisposabl

onConsumptiMPC


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Consumption and DisposableIncome

Representing the consumption with anequation

C = consumption spending

a = autonomous consumption spending

b = MPC

Income)e(DisposablbaC+=


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The Consumption Function

Consumption

Function

1,000

600

The consumption function shows the(linear) relationship between consumptionspending and disposable income

and the slope of the line(0.6) is the marginal

propensity to consume.

Consumptio

nSpending

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

Disposable Income

1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000

The vertical intercept (2,000)

is autonomous consumptionspending


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Consumption and Income

Consumptionincome line

Aggregate consumption spending at eachlevel of income or GDP

Slope = MPC

If Tax is fixed, it shifts downward by

MPCTax


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The Consumption-Income Line

1. To draw the consumption-

income line, we measurereal income (instead of realdisposable income) on thehorizontal axis.

Consumption-Income Line

600

A

B

Real ConsumptionSpending

1,000

2,000

3,000

4,000

5,0005,600

Real Income

2,000 4,000 6,000 8,000

1,000

2. The slope of theconsumption function

3. but a differentvertical intercept.


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Shifts in the Consumption-Income Line

Move along

Change in income - changes consumptionspending

Shift Change in anything else except income

changes consumption spending

lineincome-nconsumptiothealongrightward

MovementspendingnConsumptio

incomeDisposableIncome


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Shifts in the Consumption-Income Line


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Shift the Consumption-IncomeLine

Consumption-Income Line WhenNet Taxes = 500 billion

Consumption-Income Line WhenNet Taxes = 2,000 billion

RealConsumption

Spending

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

Real Income

2,000 4,000 6,000 8,000


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Getting to Total Spending

Investment Spending

Given

Government purchases Given

Net exports = Total exports - Total imports

Given


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Income and AggregateExpenditure

Aggregate expenditure=C+Ip +G+NX

Income increases

Aggregate expenditure increases

GDPMPCAE =


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Deriving the AggregateExpenditure Line

C + IP + G

C + IP + G + NX

C + IP

C

2. then add planned investment (IP)

1. Start with theconsumption-income line,

5. to get the aggregate expenditure line.

3. government purchases (G) . . .

4. and net exports (NX)

RealAggregate

Expenditure

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

Real GDP

2,000 4,000 6,000 8,000


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Finding Equilibrium GDP

Equilibrium GDP in the short run

Output = aggregate expenditure

Change in inventory

Inventories = GDP - AE

GDPinchangeNo0sInventorieGDPAE

GDP0sInventorieGDPAE

GDP0sInventorieGDPAE

==

> potential output Unusually low unemployment


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AELOWAggregateProduction Function

45

Equilibrium GDP and FullEmployment

8,000

10,000

10,000

E

F

100

10,000

150

A

B

8,000

and equilibrium employmentis less than full employment.

Full EmploymentPotential GDP

cyclicalunemployment= 50

AggregateExpenditure

Real GDP

Real GDP

Number ofWorkers

equilibrium output(8,000) is less thanpotential output,

When the aggregateexpenditure line islow . . .


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Equilibrium GDP andEmployment

12,000

12,000

H

10,000

10,000

10,000 B

Potential GDP

AggregateExpenditure

Real GDP

AEHIGH

Real GDP

Number ofWorkers

Aggregate

Production Function

150

Full Employment200

When the aggregateexpenditure line is high . . . and equilibrium employment is

greater than full employment.

equilibrium output (12,000) isgreater than potential output,

F

E'


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A Change in InvestmentSpending

Increase investment spending

Sales revenue increases

Income/disposable income increases

Consumption spending increases

Expenditure multiplier

Change in equilibrium real GDP

For 1 change in C, IP, G, or NX

MPC)(1

1Multiplier

=


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1,600

1,960

2,1762,306

2,500

1,000

InitialRise in

IP

AfterRound

2

AfterRound

3

AfterRound

4

AfterRound

5

Increase inAnnual GDP

AfterAll

Rounds


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Increase investment spending

GDP increases by morethan the initialincrease in investment

Decrease investment spending

GDP falls by more than the change inspending

PIMPC)(1

1GDP

=


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A Graphical View of theMultiplier

An increase in C, IP, G, or NX

Shift the AE line upward by the initial increasein spending

Equilibrium GDP rises:

SpendingMPC)(1

1GDP

=


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A Graphical View of theMultiplier

F

E

2,500

4,000 8,000 12,000

4,000

8,000

12,000

Real GDP

Real AggregateExpenditure

45

AE2

AE1

Increase inEquilibrium GDP

$1,000


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Automatic Stabilizers and theMultiplier

Automatic stabilizers

Reduce the size of the multiplier

Diminish the impact of spending changes Taxes.

Transfer payments

Interest rates

Imports Forward-looking behavior

Long-run: Multiplier = 0


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Appendix 1

Finding Equilibrium GDP Algebraically

b1

NXGIbTaY

AEY

NXGICAE

bY)bTa(C

)TY(baCTYY

bYaC

PP

D

D

+++=

=

+++=

+=

+=

=

+=


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Appendix 2: Tax Multiplier

Tax multiplier = -(Spending multiplier-1)

TMPC-1

MPC-GDP

MPC-1

MPC-MultiplierTax

=

=

chap-3 consumption saving and investment

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