Module 16

Income and Expenditure

KRUGMAN'S
MACROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• The nature of the multiplier, which shows how initial
changes in spending lead to further changes

• The meaning of the aggregate consumption function,

which shows how current disposable income affects
consumer spending

• How expected future income and aggregate wealth

affect consumer spending

• The determinants of investment spending

• Why investment spending is considered a leading

indicator of the future state of the economy
 MPC & MPS AND DISPOSABLE
INCOME

• You use your income in two ways – buying goods

& services OR saving for the future.

• The MPC (marginal propensity to consume) and

MPS (marginal propensity to save) tell us what
percentage of your income you are spending and
what percentage of your income you are saving .
Marginal Propensity to Consume (MPC)
• The fraction of any change in
disposable income (income left over
after taxes) that is consumed.

•MPC= Change in Consumption

Change in Disposable Income
• MPC = ΔC/ΔDI
 Marginal Propensity to Save
(MPS)

• The fraction of any change in disposable

income that is saved.

•MPS= Change in Savings

Change in Disposable Income
• MPS = ΔS/ΔDI
 Marginal Propensities
• Remember, people do two things
with their disposable income,
consume it or save it!
• MPC + MPS = 1
• Therefore MPC = 1 – MPS

• Therefore MPS = 1 – MPC

 Marginal Propensities
Calculate the following:

1. Mary just got a raise of $100 a week. She put

$25 in her savings account and spent $75.
What is her MPC and MPS?

2. Joe’s taxes dropped by $50 a week. He uses

the extra money to pay his sister $45 a week to
clean his apartment. The rest he saves. What
is his MPC and MPS?
 The Spending Multiplier Effect

• An increase in spending will result in an even

larger increase in GDP due to the fact that every
dollar spent is spent again multiple times.

• Any money spent is someone else’s income and

therefore subject to spending.

• Because we both spend and save our income the

MPC & MPS are important.
 The First Round of Government
Spending Causes The Biggest Splash

MPC of 75%
G spends $200 billion on the highways.

Highway workers save 25% of $200 billion [$50

billion] & spend 75% or $150 billion on boats.

Boat makers save 25% of $150 bil. [$37.50 bil.]

& spend 75% or $112.50 bil. on iPod Minis, etc.
 Spending Multipliers
• The limiting factor is savings. For every
additional dollar spent a portion of it will be
saved (the MPS). The spending multiplier
is the reciprocal of the MPS

Multiplier = 1/MPS or 1/(1-MPC).

• The larger the MPC (the smaller the MPS)

the larger the multiplier will be.
 ME = 1/MPS
MPC ME (spending multiplier)90%
.9 10
.8 5
.75 4 The larger the MPC, the smaller the MPS, and the
greater the multiplier. This is because we are
.60 2.5 spending more of our income and saving less.

.5 2
This is the “simple multiplier”
because it is based on a “simple model
of the economy”.
 Using the Multiplier
• The multiplier can be used to calculate how
any change in spending will affect total
income (GDP).

• The formula used is: Change in GDP =

Multiplier x Change in Autonomous
Aggregate Spending
1
∆Y (GDP) = ____ __ X ∆ AAS
(1 - MPC)
 Spending Multiplier

•Since any change in GDP is the result of the change in

spending x multiplier, you can find the multiplier by
dividing the change in GDP by the change in
autonomous aggregate spending.
Multiplier = ∆ GDP/ ∆ AAS

• Knowing that any change in spending will have a

multiplied effect government can calculate how much
to change autonomous aggregate spending by dividing
the needed change in GDP by the multiplier.
∆ AAS = ∆ GDP/ multiplier
 Current Disposable Income and Consumption
• The data clearly show a positive
relationship between current disposable
income and consumer spending.

• The Aggregate Consumption Function

describes this relationship for the
economy as a whole
C = A + MPC x Yd

C – Consumption (total amount spent)

A - Autonomous spending (amount spent
regardless of income)
MPC – Marginal Propensity to Consume (%
of any change in income that is spent
– the slope of the line)
Yd – Disposable income (income after
taxes)
• If disposable income
(Yd) increases then
Consumption (C)
increases (we move up
along the Consumption
Function)
• If disposable income
(Yd) decreases then
Consumption (C)
decreases (we move
down along the
Consumption Function)
Shifts of the Aggregate
Consumption Function
• Changes in Expected Future Disposable
Income
• If you expect a higher income in the future,
you will spend more now but if you expect a
lower income in the future you will save
more now.
• Changes in Aggregate Wealth
• Wealth is the accumulation of savings
• The greater your present wealth the less you
have to save and vice versa
• If Consumers expect their future incomes to be higher
they will buy more today, shifting the curve upward
• If Consumers’ wealth decreases today they will save
more and spend less today, shifting the curve
downward
Figure 16.4 Shifts of the Aggregate Consumption Function
Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition
Copyright © 2011 by Worth Publishers
Decide if the following will a) increase or decrease Consumption (C), and b)
indicate if the change was the result of movement along the curve or a shift in the
curve

1. A large segment of the population (baby boomers) nears retirement age.

2. Gradual shrinkage in the value of real assets owned by consumers.

3. Real GDP (output) increases, increasing disposable income.

4. The Federal government decreases income taxes.

5. The savings rate for households increases.

6. An increase in the unemployment rate.

7. A steady rise in the stock markets.

 Investment Spending
•Investment spending
fluctuates greatly over a
business cycle
•Economists distinguish
between planned and actual
investment

•Planned investment
(purchase of capital) depends
on three factors
1. The interest rate
2. The expected future level of
GDP
3. The current level of
production capacity
 The Interest Rate and Investment
Spending
A business’s
decision to
spend or borrow
money is
determined by
the current
interest rate r
versus their
projected rate of
return r’

I
I’
 eve

Expected Future Real GDP, Production

Capacity, and Investment Spending

An increase in
expected
future real
GDP or the
need for more
productive
capacity will r
result in more
investment at
the same
interest rate

I
I’
Planned vs Actual Investment

• Firms investment spending takes two forms:

spending on capital and changes in inventory
• When a firm’s inventories are higher than intended
due to an unforeseen decrease in sales, the result is
unplanned investment
• If sales are greater than expected the result is a
negative inventory investment
• In any given period actual investment is equal to
planned investment spending plus unplanned
inventory investment
Directions: Decide if the following is an a) increase or a decrease in Investment, b) if this was
the result of a movement along the curve or a shift of the curve and c) if it was planned
Investment or unplanned Investment

1. An unexpected increase in consumer spending

2. An increase in interest rates cause a rise in the cost of

business borrowing

3. Economic booms in Japan and Europe increase

demand for US exports

4. A steady rise in the growth rate of GDP

5. An unanticipated fall in sales