CHAPTER 12 CONSUMPTION, INCOME, AND THE MULTIPLIERCHAPTER 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 consumption. so ross private domestic investment equals net investment. INCOME. This rate is a flow. It is expressed per unit of time. 'iven all these simplifyin assumptions. $n( Con'0/*t&on: %onsumption & savin 6 disposable income. In-!'t/!nt: ! flow concept that includes expenditures on new machines. 1.CHAPTER 12: CONSUMPTION. R!)$t&n. It has to hold true at every moment in time. SOME SIMPLIFYING ASSUMPTIONS IN A KEYNESIAN MODEL: 3)4 5usinesses pay no indirect taxes. This is called an accountin identity. 3-4 The economy is closed.': S$-&n. is a stock measured at a certain point or instant in time. Anot !" Loo# $t D!%&n&t&on' $n( R!)$t&on' &*': %onsumption is the act of usin income for the purchase of consumption oods. "avin s. AND THE MULTIPLIER 116 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. buildin s and . A.4 There is no depreciation. 2. $rom it the definition of savin is7 "avin 6 disposable income . by contrast.': It is important to distin uish between savin and savin s. 3. 5y definition. %onsumption oods are oods purchased by households for immediate satisfaction. Sto+#' $n( F)o. 1. whatever is not consumed is saved. or capital consumption allowances. In+o/! to S$-&n. such as sales taxes. 3*4 5usinesses distribute all of their profits to shareholders. $n( S$-&n. "avin is an action that occurs at a particular rate. real disposable income will be equal to real national income minus taxes. M$". C. !1% & !1" 6 ) 3)99 percent of total income4. A-!"$. The savin function shows that planned savin also increases with disposable income. oods. A-!"$. 3)99 percent of the chan e in in- 2. which does not depend at all on disposable income.&n$) P"o*!n'&t6 to S$-! 2MPS5: The chan e in savin divided by the chan e in disposable income. INCOME. 2. A-!"$. B.&n$) P"o*!n'&t6 to Con'0/! $n( to S$-! 1. i. #issavin is ne ative savin 7 it is a situation where spendin exceeds income. 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.e. E. AND THE MULTIPLIER 117 equipment. So/! R!)$t&on' &*' 1. #issavin can occur when a household is able to borrow or use up existin owned assets.&n$) P"o*!n'&t6 to Con'0/! 2MPC5: The chan e in consumption divided by the chan e in disposable income. $n( A0tono/o0' Con'0/*t&on: The amount of planned consumption. t ! N0/3!"': 2S!! F&.! P"o*!n'&t6 to Con'0/! 2APC5: %onsumption divided by disposable income8 the proportion of total disposable income that is consumed. II. is called autonomous consumption. G"$* &n. M$". M$". planned consumption rises also.CHAPTER 12: CONSUMPTION. 2S!! T$3)! 12415 A.! P"o*!n'&t6 to S$-! 2APS5: "avin divided by disposable income8 the proportion of total disposable income that is saved. but by less than does income.! P"o*!n'&t6 to Con'0/! $n( to S$-!: 1. !s real disposable income oes up. capital business inventories.0"! 12415 D&''$-&n. D. 21% & 21" 6 ) come4 . 2. AND THE MULTIPLIER 118 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. real national income can be substituted for real disposable income in the consumption function. .0"! 12485 B."!! R!%!"!n+! L&n!: The line alon which planned expenditures are equal to real national income per year.0"! 12415 A. $or this reason. planned investment spendin increases. and vice versa. 2S!! LOTM 12475 III.0"! 12425 W $t C$0'!' t ! In-!'t/!nt F0n+t&on to S &%t: If noninterest rate determinants of investment chan e. subjective expectations of the economic future. a chan e in expectations. chan es in productive technolo y.CHAPTER 12: CONSUMPTION. ! chan e in population up or down. because investment decisions of business people are based on hi hly variable. T ! P)$nn!( In-!'t/!nt F0n+t&on: !t all times businesses perceive an array of investment opportunities. capital equipment.eal ross private domestic investment in the 0nited "tates has been volatile compared to real consumption. CONSUMPTION AS A FUNCTION OF REAL NATIONAL INCOME: <et taxes avera e about ). percent of national income. and chan es in business taxes cause a shift in the investment function. "ince each project is profitable only if its rate of return exceeds the rate of interest8 it follows that as the interest rate falls. the investment schedule will shift. T ! 894D!. INCOME. +xpectations of business people. or a chan e in real household wealth will cause the consumption function to shift. . 2S!! F&. 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&. B. DETERMINANTS OF INVESTMENT: Investment is defined as expenditures on new plant. the consumption curve shifts upward or downward. and chan es in business inventories. The investment function is represented as an inverse relationship between the rate of interest and the quantity of planned investment. A((&n. 2S!! F&. A. IV. 2S!! F&. and local overnment purchases are politically determined and can thus be considered autonomous. T ! Fo"!&. products. Imports depend on economic conditions in the 0nited "tates The difference between imports and exports is net exports.esource-usin federal. 2S!! F&. T ! M0)t&*)&!" Fo"/0)$: The autonomous spendin multiplier is equal to the reciprocal of the mar inal propensity to save.CHAPTER 12: CONSUMPTION. VII. there will be an increase or decrease in real national income in the form of unplanned inventory chan es. t ! E. :hen the savin rate planned by households differs from the investment rate planned by businesses. state. 2S!! T$3)! 12415 A.0"! 12495 KEYNESIAN E:UILIBRIUM WITH GOVERNMENT AND THE FOREIGN SEC4 TOR ADDED: 2S!! T$3)! 12425 A. The multiplier is directly related to the 21% and inversely related to the 21". The chan e in the equilibrium level of real national income due . i. D!t!"/&n&n. B.n S!+to": The level of exports depends on international economic conditions in the countries that buy 0.". Go-!"n/!nt: .0&)&3"&0/ L!-!) o% R!$) N$t&on$) In+o/! *!" Y!$": The equilibrium level of real national income exists whenever total planned expenditures equal total production. the /0)t&*)&!" = 1 > 21 4 MPC5 = 1 > MPS. AND THE MULTIPLIER 119 V. THE MULTIPLIER: The multiplier is the number by which a permanent chan e in autonomous spendin such as autonomous investment or autonomous consumption is multiplied to et the chan e in the equilibrium level of real national income. iven a constant price level. There is no tendency for businesses to alter the rate of production or the level of employment because they are neither increasin nor decreasin their inventories in an unplanned way. C. SAVINGS AND INVESTMENT: PLANNED VERSUS ACTUAL: +quilibrium occurs at the intersection of the planned savin and planned investment schedules.0"! 124<5 VI. .eal national income and employment will chan e until unplanned inventory chan es are a ain =ero.e.. INCOME. !ny permanent increase in autonomous spendin will cause a more than proportional increase in real national income. . and a decline in net exports will cause the %&I&'&( curve to shift downward.!" normally is positively sloped. THE MULTIPLIER WHEN THE PRICE LEVEL CAN CHANGE: The multiplier effect on equilibrium overall level of real nation income will be smaller if part of the increase in nominal national income occurs because the price level increases. the real balance effect. VIII. The price level does not stay fixed because ". increased borrowin with a resultin increase in the interest rate. 2S!! F&.CHAPTER 12: CONSUMPTION.n&%&+$n+! o% t ! M0)t&*)&!": The multiplier ma nifies chan es in equilibrium real national income caused by chan es in autonomous spendin . B.0"! 124 ?5 I@. . 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. INCOME. 2S!! F&. T ! S&. THE RELATIONSHIP BETWEEN AGGREGATE DEMAND AND THE CAIAGA@ CURVE: The %&I&'&( curve is drawn assumin a iven price level.eal national income will fall.0"! 124B5 . AND THE MULTIPLIER 120 to a chan e in autonomous spendin is the /0)t&*)&!" t&/!' t ! + $n.! &n $0tono/o0' '*!n(&n. If the price level oes up. obert F.--9. -. -.o er D..eply to !ndo and 2odi liani and to #e1rano and 2ayer. and %ompany. . %harles 1. <ew >ork7 2acmillan.B American Economic Review. 'ordon. and #.. :alters. Keynes. BThe "tability of Keynesian and 2onetary 2ultipliers in the 0nited "tates. B. @A/-@?9.. -th ed. <ovember )?//. )?@A. 5arret. @.B Review of Economics and Statistics. 'ardner. !.. /?.ow. INCOME. AND THE MULTIPLIER 121 SELECTED REFERENCES !ckley. pp. 2. $riedman.. Macroeconomics: Theory and Policy. . Interest. !nthony.-@A. 2odi liani. Fohn 2. "eptember I?/. The General Theory of Employment. <ew >ork7 "t. 5oston7 Dittle.. Col. and $. . )?A@. %ampa na.B American Economic Review. and Money.obert :. 2iller. !ndo. <o.. and !.. <o. )?/). . The Keynesian Revol tion. DC.. "eptember )?/. 1ulsinelli. Macroeconomics. Interest and 2oney. Dawrence..-@*A.?. . <ew >ork7 Garper and .. Klein. )?/. and .!. <ew >ork7 Garcourt. Col. pp. 2artinEs 1ress. Macroeconomics.CHAPTER 12: CONSUMPTION. pp. )?A). 5rown. )?A/. Macroeconomics. 2eiselman. BCelocity and the Investment 2ultiplier. <ew >ork7 2acmillan.