End of

ECON 151 PRINCIPLES OF MACROECONOMICS

Chapter 10
Chapter 12: Consumption, Real
GDP, and the Multiplier
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
1
1

Some Simplifying Assumptions

in a Keynesian Model

To simplify the income determination model

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

12-2

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.
12-3

Some Simplifying Assumptions

in a Keynesian Model (cont'd)

Saving

The act of not consuming all of ones current income

Whatever is not consumed 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.

Dissaving

Negative saving; a situation in which spending exceeds

income

12-4

Some Simplifying Assumptions

in a Keynesian Model (cont'd)

Consumption plus saving equals

disposable income.

Saving equals disposable income minus

consumption.

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

Capital Goods
Producer

durables; nonconsumable goods

that firms use to make other goods
12-6

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.
12-7

Spending on Human Capital:

Investment or Consumption?

Economists define human capital as the accumulation

of investments and training
in education.

From this perspective, educational

expenses should be regarded as a form
of investment spending.

Nevertheless, in official U.S. government statistics,

household spending on education is classified as
consumption.
12-8

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,

the less they wanted
to consume.

Keynes argued that real saving and consumption

decisions depend primarily on a households real
disposable income.
12-9

Determinants of Planned Consumption and

Planned Saving (cont'd)
Keynes was concerned with changes
in AD as reflected in planned expenditures.
His initial focus was on Consumption.

AD = C + I + G + X

12-10

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.

12-11

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.

12-12

Table 12-1 Real Consumption and Saving

Schedules: A Hypothetical Case

12-13

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

On

the following graph, DPI is labeled as YD.

However, under the Keynesian simplifying
assumptions, when all components of AD are
reflected, the label becomes Y for real GDP.
12-14

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.

12-15

Figure 12-1
The Consumption
and Saving
Functions

12-16

Figure 12-1 The Consumption

and Saving Functions (cont'd)

12-17

Figure 12-1 The Consumption

and Saving Functions (cont'd)

12-18

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
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
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
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

12-22

Determinants of Planned Consumption and

Planned Saving (cont'd)

Some relationships
Average

propensity to consume and average

propensity to save must sum to 100% of total
income. (APC + APS = 1)

Marginal

propensity to consume and marginal

propensity to save must sum to 100% of the
change in income. (MPC + MPS = 1)
12-23

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

Population

Wealth

determinants of consumption

12-24

Determinants of Planned Consumption and

Planned Saving (cont'd)

Wealth
The

stock of assets owned by a person,

household, firm or nation

For

a household, wealth can consist of a

house, cars, personal belongings, stocks,
bonds, bank accounts, and cash.

12-25

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.
12-26

Figure 12-2
Planned Real Investment, Panel (a)

12-27

Figure 12-2
Planned Real Investment, Panel (b)

12-28

Determining Equilibrium
Real GDP (cont'd)

Adding the investment function

AD = C + I + G + X

12-29

Figure 12-4 Combining

Consumption and Investment

12-30

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.
12-31

Figure 12-5 Planned and Actual Rates of

Saving and Investment

12-32

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

Unplanned decreases in business inventories

Business

will increase production of goods and

services and increase employment

12-33

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.
12-34

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
12-35

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

12-36

Table 12-2 The Determination

of Equilibrium Real GDP with Government and
Net Exports Added

12-37

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.
12-38

Figure 12-6
The Equilibrium Level of Real GDP
Recall that planned AD
=C+I+G+X
Although not identified
as such by Keynes, the
45-degree reference
line can be thought of
as actual expenditures
or AS.
Equilibrium will occur
where AD = AS.
12-39

The Equilibrium Level of Real

GDP

Observations
If

C+I+G+X=Y

If

C+I+G+X>Y

If

Equilibrium GDP
Unplanned drop in inventories
Businesses increase output
Y returns to equilibrium

C+I+G+X<Y

Unplanned rise in inventories

Businesses cut output
Y returns to equilibrium

12-40

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
12-41

Table 12-3 The Multiplier

Process

12-42

The Multiplier (cont'd)

The multiplier formula

1
1
Multiplier =
=
1 - MPC
MPS

12-43

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.
12-44

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

12-45

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.

12-46

How a Change in Real Autonomous Spending

Affects Real GDP When
the Price Level Can Change

So far our examination of how changes

in real autonomous spending affects equilibrium
real GDP has considered a situation in which the
price level remains unchanged.

Our equilibrium analysis has only considered

how AD shifts in response to autonomous
consumption, investment, government spending,
net exports.
12-47

How a Change in Real Autonomous Spending

Affects Real GDP When
the Price Level Can Change (cont'd)

When we take into account the aggregate supply

curve, we must also consider responses of the
equilibrium price level to a multiplier-induced
change in AD.

12-48

Figure 12-7 Effect of a Rise

in Autonomous Spending on
Equilibrium Real GDP

12-49

The Relationship Between Aggregate

Demand and the C + I + G + X Curve

There is clearly a relationship; aggregate

demand consists of consumption,
investment, government, and the foreign
sector.

12-50

The Relationship Between

Aggregate Demand and the
C + I + G + X Curve (cont'd)

There is a major difference

C

+ I + G + X curve drawn with price

level constant

AD

curve drawn with the price

level changing

12-51

The Relationship Between Aggregate Demand

and the C + I + G + X Curve (cont'd)

To derive the aggregate demand curve from the

C + I + G + X curve, we must now allow the price
level to change.
Since we know that at higher prices, real
spending is diminished, we can show two
C + I + G + X curves at different price levels.
We can then plot the equilibrium outcomes of
each as AD at the two price levels as reflected
on the AS-AD model graph.
12-52

Figure 12-8
The
Relationship
Between AD
and the C + I +
G + X Curve

12-53

End of
ECON 151 PRINCIPLES OF MACROECONOMICS
Chapter 10
Chapter 12: Consumption, Real
GDP, and the Multiplier
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
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