Income and Expenditures

Module 16

Learning Objectives

1. The nature of the multiplier, which shows how initial changes in spending lead to further changes.

2. The meaning of the aggregate consumption function, which shows how current disposable income affects consumer spending

3. How expected future income and aggregate wealth affect consumer spending

4. The determinants of investment spending

5. Why investment spending is considered a leading indicator of the future state of the economy

Key Economic Concepts

1. An increase in spending multiplies throughout the economy, as that spending becomes another person’s income, part of which is spent, which becomes another person’s income, part of which is spent….

2. THE MPC = Δ Consumption / Δ DI. The MPC is the amount by which consumer spending rises if current disposable income rises by $1 (it is the slope of the consumption function).

3. MPS = Δ Saving / Δ DI

4. MPC + MPS = 1

Key Economic Concepts, cont.

5. The spending multiplier: M = 1 / (1-MPC) OR 1/MPS

6. Investment spending is negatively related to the interest rate

7. Autonomous changes in investment spending have the same multiplying impact on RGDP as changes in autonomous consumption

Common Student Difficulties

• It is unnecessary to know all the math behind the multiplier. Just be sure to understand an example with at least 4 rounds.

• It is easy to get confused by changes to investment spending, especially the difference between unplanned and planned inventories. You can save a lot of time and unnecessary confusion if you focus on the other factors that shift investment spending. After all, an increased in unplanned inventories is removed from investment spending through an accounting adjustment once those units are actually consumed.

• Let’s say you find a dollar in the street. You now have one dollar you did not have before. You now have an “income” of one dollar. What can you do with that dollar?? You can spend all of it, save all of it, or spend some of it and save some of it. You have options!

Let’s assume you decide to spend the WHOLE dollar. Your spending of that dollar is an

EXPENDITURE for you and INCOME for the person (entrepreneur) you traded with.

How much did GDP increase with this transaction?

$1.00

(you bought “stuff”)

• Now what happens to that dollar in the possession of the entrepreneur? They have the same options you had:

Spend it or Save it.

Let’s assume the entrepreneur spends the WHOLE dollar at another business.

This expenditure for the entrepreneur is now INCOME for another entrepreneur.

How much did GDP increase with this transaction?

$1.00

Does this sound familiar??

This “found” dollar has now purchased $2.00 worth of goods and/or services.

The original dollar appears to be cloning itself!!

If we repeat this pattern, it would go on FOREVER and GDP would increase INFINITLEY. Is this possible? Unlikely…Why?

People have a TENDENCY TO SAVE some portion of each dollar they receive.

Keynes had a fancy name for this: Marginal Propensity to Save (MPS). In layman’s terms this means people have a TENDENCY TO SAVE A PORTION OF EACH ADDITIONAL DOLLAR they receive.

The flip side of this is people have a TENDENCY TO SPEND (or CONSUME) some portion of each dollar they receive.

Keynes had a fancy name for this: Marginal Propensity to Consume (MPC). In layman’s terms this means people have a TENDENCY TO CONSUME A PORTION OF EACH ADDITIONAL DOLLAR they receive.

• Example: If I get an additional dollar I may consume .90 and save .10.

• My Marginal Propensity to Consume (MPC) that dollar is then: 90%.

• My Marginal Propensity to Save (MPS) that dollar is then: 10%.

Do you notice a pattern?

MPC + MPS = 1.00 (or 100%)

The Multiplier

• The federal government enacted the American Recovery and Reinvestment Act of 2009: “stimulus package” of $787 billion to spark job growth and reverse the worst recession since the Great Depression

Marginal Propensity to Consume

• Consumption is 2/3 of total spending in the economy.

• After a person pays his taxes, he is left with a Yd (disposable income) that can either be consumed or saved.

• Yd = C + S

• When a person gets more Yd, he will increase both C & S

MPC & MPS

• MPC = Δ Consumption / Δ Disposable Income • The amount by which spending rises if current

disposable income rises by $1

• MPS = Δ Savings/ Δ Disposable Income

• MPC + MPS = 1

Ex: Consumption Schedule for Household

Consumption Function

An equation showing how an individual household’s consumer Spending varies with the household’s current disposable income C = a + MPC * Yd

The Spending Multiplier

Ex: Ted is a chicken farmer in a local community. Supposed Ted decides to spend $1000 on some chicken coops at Anthony’s farm supply shop.

This money now gets circulated around the economy.

1. Anthony now has $1000 rom the sale and spends 80% ($800) on clothes at Marcia’s boutique.

2. Marcia now has $800 from the sale and spends 80% ($640) to fix her car at Pat’s garage.

3. Pat now $640 from the sale and spends 80% ($512) at Dianna’s grocery store.

4. Dianna now has $512 from the sale and spends 80% (409.60) with Catherine’s catering company.

• After 5 rounds of spending, how much money have we created??

$2, 361.60!!!

If we continued until someone was trying to spend 80% of nothing, Ted’s initial $1000 purchase would multiplied to a total of $5000 in spending.

• M = 1/(1-MPC)

• M = 1/(1-.8)

• M = 1/.2

• M = 5

Shifts of the Aggregate Consumption Function

1. Changes in expected future Yd

2. Changes in Aggregate wealth

Investment Spending

• Although consumer spending is much larger than investment spending, booms and busts in investment spending tend to drive the business cycle. • Most recessions originate as a fall in

investment spending

The Interest Rate and Investment Spending

Investment spending = a cost-benefit analysis

Ex: A firm is considering building a new factory.

• Will increase sales

• Will require borrowing to fund the investment

Expected return on the investment = expected economic profit from the factory

= (TR – TC/investment cost)

Market interest rate

Market interest rate = cost of the investment

• Interest rate is the cost of borrowed funds

• Interest rate is also the cost of investing your own funds (no borrowing), since it is income forgone.

Factors that increase investment spending at any interest rate

1. Expected Future RGDP

• increase investment spending b/c belief that the economy will take off next year • Anticipation of increased sales

2. Production capacity

• Best conditions for investment spending consist of firms that are near production capacity with expectations of strong RGDP in future