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Chapter 12

Consumption,
Real GDP, and
the Multiplier

Did You Know That ...


The share of real GDP allocated to real
consumption spending is:

66 percent in Germany
60 percent in the United Kingdom
70 percent in the United States
Less than 41 percent in China?

In this chapter, you will learn how an


understanding of households real saving and real
consumption spending can help you evaluate
fluctuations in a nationals real GDP.

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12-2

Some Simplifying Assumptions in a


Keynesian Model
To simplify the income determination
model, lets assume:
1. Businesses pay no indirect taxes (sales tax)
2. Businesses distribute all profits to shareholders
3. There is no depreciation
4. The economy is closed; no foreign trade

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12-3

Some Simplifying Assumptions in a


Keynesian Model (cont'd)
Real Disposable Income
Real GDP minus net taxes, or after-tax real
income

Consumption
Spending on new goods and services out of a
households current income
Whatever is not consumed is saved
Consumption includes such things as buying
food and going to a concert

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12-4

Some Simplifying Assumptions in a


Keynesian Model (cont'd)
Saving
The act of not consuming all of ones 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

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12-5

Some Simplifying Assumptions in a


Keynesian Model (cont'd)
Consumption Goods
Goods bought by households to use up, such as
food and movies

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Some Simplifying Assumptions in a


Keynesian Model (cont'd)
Accounting identity:
Consumption + saving disposable income

Saving disposable income consumption

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12-7

Some Simplifying Assumptions in a


Keynesian Model (cont'd)
Investment
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

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12-8

Some Simplifying Assumptions in a


Keynesian Model (cont'd)
Capital Goods
Producer durables; nonconsumable goods that
firms use to make other goods

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12-9

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

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12-10

Determinants of Planned Consumption and


Planned Saving (cont'd)

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 households real
disposable income.
Furthermore, a persons anticipation about
future flows of income influences how much of
current income is allocated to consumption and
how much is allocated to saving.

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12-11

Determinants of Planned Consumption and


Planned Saving (cont'd)

The Keynesian Theory of Consumption and


Saving
Keynes argued that real consumption and saving
decisions depend primarily on a households
current real disposable income.

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12-12

Determinants of Planned Consumption and


Planned Saving (cont'd)

Consumption Function
The relationship between amount consumed and
disposable income
A consumption function tells us how much
people plan to consume at various levels of
disposable income

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12-13

Determinants of Planned Consumption and


Planned Saving (cont'd)

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

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12-14

Table 12-1 Real Consumption and Saving


Schedules: A Hypothetical Case

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12-15

Determinants of Planned Consumption and


Planned Saving (cont'd)

45-Degree Reference Line


The line along which planned real expenditures
equal real GDP per year

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12-16

Figure 12-1
The Consumption
and Saving
Functions

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12-17

Determinants of Planned Consumption and


Planned Saving (cont'd)

Autonomous Consumption
The part of consumption that is independent of
the level of disposable income
Changes in autonomous consumption shift the
consumption function

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Determinants of Planned Consumption and


Planned Saving (cont'd)

Average Propensity to Consume (APC)


Real consumption divided by real disposable
income
The proportion of total disposable income that is
consumed

Real consumption
APC =
Real disposable income
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12-19

Determinants of Planned Consumption and


Planned Saving (cont'd)

Average Propensity to Save (APS)


Real saving divided by real disposable income
(DI)
Saved proportion of real DI

Real saving
APS =
Real disposable income
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12-20

Determinants of Planned Consumption and


Planned Saving (cont'd)

Marginal Propensity to Consume (MPC)


The ratio of the change in real consumption to
the change in real disposable income

MPC =

Change in real consumption


Change in real disposable income

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12-21

Determinants of Planned Consumption and


Planned Saving (cont'd)

Marginal Propensity to Save (MPS)


The ratio of the change in saving to the change
in disposable income

MPS =

Change in real saving


Change in real disposable income

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Determinants of Planned Consumption and


Planned Saving (cont'd)

Example
Income = $54,000
C = $49,200
S = $4,800

What is the APC?

APC =

$49,200
= .911
$54,000

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12-23

Determinants of Planned Consumption and


Planned Saving (cont'd)

Example
Income increases by $6,000 to $60,000
C = $54,000
S = $6,000

What is the APC?

APC =
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$54,000
= .90
$60,000
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Determinants of Planned Consumption and


Planned Saving (cont'd)

Some relationships
APC + APS 1

MPC + MPS 1

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12-25

Determinants of Planned Consumption and


Planned Saving (cont'd)

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
Population
Wealth

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Determinants of Investment
Investment, you will remember, consists of
expenditures on new buildings and
equipment
Gross private domestic investment has been
volatile
Consider the planned investment function, and
shifts in the function

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12-27

Figure 12-2 Planned Real Investment,


Panel (a)

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12-28

Figure 12-2 Planned Real Investment,


Panel (b)

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12-29

Determining Equilibrium Real GDP


We are interested in determining the
equilibrium level of real GDP per year
Consumption as a function of real GDP
The 45-degree reference line

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12-30

Figure 12-3 Consumption as a Function


of Real GDP

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12-31

Determining Equilibrium Real GDP


(cont'd)
Adding the investment function

AD = C + I + G + X

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12-32

Figure 12-4 Combining Consumption


and Investment

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12-33

Determining Equilibrium Real GDP


(cont'd)
Saving and investment: Planned versus
Actual
Only at equilibrium real GDP will planned saving
equal actual saving
Planned investment equals actual investment
Hence planned saving is equal to planned
investment

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Figure 12-5 Planned and Actual Rates


of Saving and Investment

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Determining Equilibrium Real GDP


(cont'd)
Unplanned increases in business inventories
Consumers purchase fewer goods and services
than anticipated
This leaves firms with unsold products and
inventories will rise
Businesses respond by cutting back production
and reducing employment

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12-36

Determining Equilibrium Real GDP


(cont'd)
Unplanned decreases in business
inventories
Business will increase production of goods and
services and increase employment
Ultimately there will be an increase in real GDP

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12-37

Keynesian Equilibrium with Government and


the Foreign Sector Added

To this point we have ignored the role of


government in our model
We also left out the foreign sector of the
economy in our model
Lets think about what happens when we
add these elements

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12-38

Keynesian Equilibrium with Government and


the Foreign Sector Added (cont'd)

Government (G): C + I + G
Federal, state, and local
Does not include transfer payments
Is autonomous
Lump-sum taxes = G

Lump-Sum Tax
A tax that does not depend on income or the
circumstances of the taxpayer

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12-39

Keynesian Equilibrium with Government and


the Foreign Sector Added (cont'd)

The Foreign Sector: C + I + G + X


Net exports (X) equals exports minus imports
Depends on international economic conditions
Autonomousindependent of real national
income

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12-40

Table 12-2 The Determination of Equilibrium


Real GDP with Government and Net Exports Added

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12-41

Keynesian Equilibrium with Government and the


Foreign Sector Added (cont'd)

Determining the equilibrium level of GDP


per year
We are now in a position to determine the
equilibrium level of real GDP per year
Remember that equilibrium always occurs when
total planned real expenditures equal real GDP

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12-42

Figure 12-6 The Equilibrium Level of Real


GDP

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12-43

Keynesian Equilibrium with Government and


the Foreign Sector Added (cont'd)
The Equilibrium Level of Real GDP
Observations
If C + I + G + X = Y
Equilibrium GDP

If C + I + G + X > Y

Unplanned decrease in inventories


Businesses raise output
Y returns to equilibrium

If C + I + G + X < Y

Unplanned increase in inventories


Businesses reduce output
Y returns to equilibrium

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The Multiplier
Multiplier
The ratio of the change in the equilibrium level
of real national income to the change in
autonomous expenditures
The number by which a change in autonomous
real investment or autonomous real
consumption is multiplied to get the change in
equilibrium real GDP

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12-45

The Multiplier (cont'd)


Question
How can a $100 billion increase in investment
generate a $500 billion increase in equilibrium
real GDP?

Answer
The multiplier process

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12-46

Table 12-3 The Multiplier Process

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12-47

The Multiplier (cont'd)


The multiplier formula

1
1
Multiplier =
=
1 - MPC
MPS

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The Multiplier (cont'd)


By taking a few numerical examples, you
can demonstrate to yourself an important
property of the multiplier
The smaller the MPS, the larger the multiplier
The larger the MPC, the larger the multiplier

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12-49

The Multiplier (cont'd)


Examples

MPC =

4
5

MPS =

1
5

Multiplier =

MPC =

3
5

MPS =

2
5

1
Multiplier =
= 2.5
2/5

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1
=5
1/5

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The Multiplier (cont'd)


Measuring the change in equilibrium income
from a change in autonomous spending

Change in equilibrium real GDP =


Multiplier x Change in autonomous spending

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The Multiplier (cont'd)


Significance of the multiplier
It is possible that a relatively small change in
consumption or investment can trigger a much
larger change in real GDP

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Figure 12-7 Effect of a Rise in Autonomous


Spending on Equilibrium Real GDP

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Figure C-1 Graphing the Multiplier

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