consumption, investment and the multiplier: chapter 9

Consumption, Investment Consumption, Investment and the Multiplier: Chapter 9and the Multiplier: Chapter 9

What is GDP?What is GDP?

• Gross Domestic Product (GDP)-Gross Domestic Product (GDP)- is the nation’s expenditure on all the final goods and services produced during the year at market price.

How is GDP calculated?How is GDP calculated?

• You learned one way to calculate GDP is by adding all of Nation’s expenditures.

• Another method used is the income approach (not discussed here).

Nation’s ExpendituresNation’s Expenditures

Consumption

InvestmentGovernment Spending

Net Exports

CC == GDPGDPII+ GG+ XXnn+

This lecture will concentrate on Consumption

ConsumptionConsumption

• Consumption is the nation’s expenditures on all final goods and services produced during the year at market prices– Consumption was almost $2 trillion dollars

in 2002

ConsumptionConsumption

• Americans spend over 95% of their income after taxes

• The total of everyone’s expenditures is called consumption

• Consumption is designated by the letter C

• C is the largest sector of GDP

• CC is just over two-thirds of GDP

Consumption Consumption (Continued)(Continued)

• The consumption functions states–As income rises, consumption (C)

rises, but not as quicklyIncome = Consuption + Saving + taxes

Y = C + S + t and, Disposible Income = Consuption + Saving

Yd = C + S or,

Yd = Y - tTherefore, consumption varies with disposable

income (DI)

Consumption and Disposable Income

As Income rises so does Consumption

NOT AS QUICKLY!NOT AS QUICKLY!BUT

DIDI increases . . . C C increases but by a smaller amount

DIDI decreases . . . CC decreases but by a smaller amount

Two Ways To View Consumption-Income Relationship

1. As the ratio of total consumption to total disposable income. (APC)

2. As the relationship of changes in consumption to changes in disposable income. (MPC)

The Marginal Propensity to Consume

• The marginal propensity to consume (MPC) is the fraction of each additional (marginal) dollar of disposable income spent on consumption.

Marginal Propensityto Consume (MPC)

MPC = in Consumption

in Income

CHANGECHANGE

CHANGECHANGE

Marginal Propensityto Consume (MPC)

Table 4

Year DI C S

1998 $30000 $23000 $7000

1999 $40000 $31000 $9000

Marginal Propensityto Consume (MPC)

Table 4 (continued)

Year DI C S

1998 $30000 $23000 $7000

1999 $40000 $31000 $9000

10000 8000 2000Change

Table 4 (Continued)Year DI C S

1998 $30000 $23000 $7000

1999 $40000 $31000 $9000

10000 8000 2000Change

MPC =---------------- = ---------- = ------- = .8Change in C 8000 8

Change in DI 10000 10

Table 4 (Continued) Year DI C S

1998 $30000 $23000 $7000

1999 $40000 $31000 $9000

10000 8000 2000Change

MPC =---------------- = ---------- = ------- = .8Change in C 8000 8

Change in DI 10000 10

MPS = -------------- = ---------- = -------- = .2Change in S 2000 2

Change in DI 10000 10

+

1.0

The MPC and MPS

MPS = 0.20 MPC = 0.80

45

$1000

$1000

$6000

?$6000

Graphing the Consumption Function

If Consumption rose at the same rate as Disposable Income . . . A graph of this function would be a 45 line

Disposable income ($)

45û

1,000

1,000

2,000

3,000

2,000 3,000

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Exp

end

itu

re (

$)

Disposable Income ($)

C

$6000

5700

$6000

Saving = $300

$2700

$3000

Dissaving = $300

$2700

Saving = - $300

C

Dissaving

Saving

Graphing the Consumption Function

Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.

DI C S

3000 1750

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

Exp

end

itu

re (

$)

Disposable Income ($)

Graphing the Consumption Function

DI C S

3000 1750 1250

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

Saving is the vertical distance between the “C” line and the 45 degree line

Exp

end

itu

re (

$)

Disposable Income ($)

Graphing the Consumption Function

DI C S

3000 1750 1250 2000 1440

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.

Graphing the Consumption Function

DI C S

3000 1750 1250 2000 1440 560

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

Saving is the vertical distance between the “C” line and the 45 degree line

Exp

end

itu

re (

$)

Graphing the Consumption Function

DI C S

3000 1750 1250 2000 1440 560 1000 1000

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.

Graphing the Consumption Function

DI C S

3000 1750 1250 2000 1440 560 1000 1000 0

5-37

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

Saving is “0” at 1000 DI because there is NO distance between the C line and the 45 degree line.

Graphing the Consumption Function

DI C S

3000 1750 1250 2000 1440 560 1000 1000 0 0 625

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.

Graphing the Consumption Function

DI C S

3000 1750 1250 2000 1440 560 1000 1000 0 0 625

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

When DI is “0” the level of Consumption is called Autonomous Consumption (AC)

Graphing the Consumption Function

DI C S

3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

Saving is the vertical distance between the “C” line and the 45 degree line. Saving is negative to the left of where the C line crosses the 45 degree line

Autonomous vs. Induced

• Autonomous means Self Governing

Autonomous Consumption versus Induced Consumption

• Autonomous consumption (AC) is the level of consumption when disposable income is “0”–It is called autonomous

because it is independent of change in disposable income

Induced Consumption• Induce consumption (IC) is that

part of consumption which varies with the level of disposable income

–As disposable income rises, induced income rises

–As disposable income fall, induced income falls

C = Autonomous C + Induced C

So

Induced C = C – Autonomous C

C

$0

This is your This is your Autonomous Autonomous ConsumptionConsumption

Graphing the Consumption Function

DI C S

3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

DI = 0

What is IC?

IC = C - AC

IC = 625 - 625

IC = 0

Graphing the Consumption Function

DI C S

3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

DI = 1000

What is IC?

IC = C - AC

IC = 1000 - 625

IC = 375

Graphing the Consumption Function

DI C S

3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

DI = 2000

What is IC?

IC = C - AC

IC = 1440 - 625

IC = 815

Graphing the Consumption Function

DI C S

3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

DI = 3000

What is IC?

IC = C - AC

IC = 1750 - 625

IC = 1125

Determinants of ConsumptionDeterminants of Consumption1. Disposable Income

The most important determinant of consumption

2. Credit Availability

3. Stock of Liquid Assets in the hands of consumers

4. Stock of Durable Goods in the hands of consumers

5. Keeping up with the Jones's

6. Consumer Expectations

Permanent Income Hypothesis

(Milton Friedman)• People gear their consumption to

their expected lifetime average earnings more than to their current income– Apparently there are quite a few deviations

from the behavior predicted by the permanent income hypothesis

The Determinants of Saving

• There is no single reason why people save

• Some spend virtually all of their disposable income

• Some spend more than they earn• Americans now save less than 5% of

disposable income• Americans used to save 7-10% of

disposable income

Investment

InvestmentInvestment

• “Investment” is the thing that really makes our economy go and grow!

• Investment is any NEW– Plant and equipment

• Investment is any NEW– Additional inventory

• Investment is any NEW– Residential housing

Inventory Investment

Includes only net change

Date Level of Inventory

Jan. 1, 2003 $120 million

July 1, 2003 145 million

Dec. 31, 2003 130 million

Inventory Investment

Includes only net changeDate Level of Inventory

Jan. 1, 2003 $120 million

July 1, 2003 145 million

Dec. 31, 2003 130 million

Started the year with $120 million

Ended the year with 130 million

The net change is a (+) 10 million

Inventory Investment (Continued)

Includes only net changeDate Level of Inventory

Jan. 1, 2003 $130 million

July 1, 2003 145 million

Dec. 31, 2003 120 million

Started the year with $130 million

Ended the year with 120 million

The net change is a (-) 10 million

Investment in Plant and Investment in Plant and EquipmentEquipment

• Investment in plant and equipment is more stable than inventory– Even in bad years companies will still

invest a substantial amount in new plant and equipment• This is mainly because old and obsolete

factories, office buildings, and machinery must be replaced

– This is the depreciation part of investment

Residential Construction

• Involves replacing old housing as well as adding to it

• Fluctuates considerably from year to year

• Has mortgage interest rates play a dominant role

Investment• Investment is the most volatile sector in

our economy

GDP = C + + G + Xn

• Fluctuations in GDP are largely fluctuations in investment

II

Investment (Continued)

• Recessions are touched off by declines in investment

• Recoveries are brought about by rising investment

How Do Savings Get Invested?

• Money saved is put into stocks and bonds

• Banks loan money based on their demand deposits and reserve requirements

• Businesses take this money and buy new plant and equipment, and add to their inventory

• Corporations also use “retained earnings” and “depreciation allowances”

Gross Investment vs Net Investment

• In the equation:

GDP = C + GDP = C + II + G + Xn + G + Xn• The “I”“I” represent gross investment

Gross investment - depreciation = net investmentGross investment - depreciation = net investment– Depreciation is taking into account for the fact

that plant & equipment wear out and houses deteriorate

Gross Investment - Depreciation = Net Investment– Depreciation is taking into account for the fact

that plant & equipment wear out and houses deteriorate.

– start the year with 10 machines

– bought 6 machines (gross investment)

– worn out/obsolete - 4 machines (depreciation)

– end the year with 12 machines– actual gain of 2 machines (net investment)

Calculate Gross Investment and Net Investment

Date Date level of level of inventoryinventory

Jan 1 $60 billionJan 1 $60 billion

July 1 55 billionJuly 1 55 billion

Dec 31 70 billionDec 31 70 billion

Expenditures on new plant & equipmentExpenditures on new plant & equipment

$120 billion$120 billion

Expenditures on new residential housingExpenditures on new residential housing

$ 90 billion$ 90 billion

Depreciation on plant & equipment andDepreciation on plant & equipment and

residential housing $30 billionresidential housing $30 billion6-27

Solution

Date level of inventory

Jan1 $60 billion

July 1 55 billion

Dec 31 70 billion inventory investment $ 10

Expenditures on new plant & equipment new P & E 120

$120 billion new RH 90

Expenditures on new residential housing gross investment 220

$ 90 billion - depreciation - 30

Depreciation on plant & equipment and net investment $ 190

Residential housing $30 billion

Building Capital• Investment involves sacrifice (on

someone’s part)

• To invest– We must work more– We must consume less (save)

Determinants of the Level of Investment

• Sales outlook

• Capacity utilization rate

• Interest rate

• Expected rate of profit (ERP)

The Sales OutlookThe Sales Outlook• You won’t invest if the sales outlook is

bad

– If sales are expected to be strong the next few months the business is probably willing to add inventory

– If sales outlook is good for the next few years, firms will probably purchase new plant and equipment

Capacity Utilization Rate

• This is the percent of plant and equipment that is actually being used at any given time

• You won’t invest if you have a lot of unused capacity– During recessions, why build more when

you are not using all of what you have

• Other factors– Manufacturing is a shrinking part of U.S.

economy due to imports and increasing investment overseas by U.S. Companies

The Interest Rate

• You won’t invest if interest rates are too high

Interest rate = The interest paid / The amount borrowedInterest rate = The interest paid / The amount borrowed

Assume you borrow $1000 for one year @ 12 %, how much interest do you pay?

.12 = X

$1000

X = $120

The Interest Rate• You won’t invest if interest rates are too

high

Interest rate = The interest paid / The amount borrowed

X = $120

$1000

X = .12 = 12 %

Assume you borrowed $1000 for one year and paid $120 interest. What was the interest rate?

You Won’t Invest If Interest Rates Are Too High

• In general, the lower the interest rate, the more business firms will borrow

• To know how much they will borrow and whether they will borrow, you need to compare the interest rate with the expected rate of profit

• Even if they are investing their own money they need to make this comparison

Why Do Firms Invest?

• Firm’s will only invest if the expected profit rate is “high enough”

• Firms invest when– Their sales outlook is good– Their capacity utilization rate is high– Their expected profit rate is high

• Even if firm’s invest their own money, the interest rate is still a consideration

45

$1000

$1000

$6000

?$6000

C

C+I

This Distance EqualsGrossGross

InvestmentInvestment

Disposable income ($)

45û

C

1,000

1,000

2,000

3,000

2,000 3,000Disposable income ($)

45û

C

C + I

1,000

1,000

2,000

3,000

2,000 3,000

Graphing the C + I Line

To keep things simple so we can read the graph we’re going to assume the level of investment stays the same for all levels of income

Simplifying Assumption

C

C+I

C line and the C+I line are parallel

Disposable income ($)

45û

C

1,000

1,000

2,000

3,000

2,000 3,000Disposable income ($)

45û

C

C + I

1,000

1,000

2,000

3,000

2,000 3,000

Graphing the C + I Line

How much is I when disposable income is 1000, 2000, and 3,000?

The C line and the C+I line are parallel. Therefore I is about 480 at every level of disposable income.

480

Government Spending

Government Purchases versus Transfer Payments

• The government spends trillions of dollars a year– GDP = C + I + GDP = C + I + G G + Xn+ Xn

• The GG in our formula refers to Government purchases

• It does NOT refer to transfer payments.

What is a transfer payment?

Transfer payments is the government taking money from one group and giving it to another group in the economy.

Transfer Payments Include

• Social Security– Transferring between the generations

• Veteran Benefits– Transferring money to veterans

• Unemployment Benefits– Transferring from the employed to the

Unemployed.

Government Purchases vs. Transfers

– Approximately half is “transfer payments”• The largest transfer payment is social security• These payments eventually end up in the “C”

part GDP (after they are spent)

– Approximately half is “government purchases”

• The largest government purchase is defense• These end up in the “G” part of GDP

Graphing in “G”

C

C+I

C+I+G

G

Graphing the C + I + G + Xn Line

Disposable income ($)

45û

2,000 3,0001,000

1,000

2,000

C

3,000

C +I+G

C +I

How much is G?

Answer: 400

The Export-Import Sector

The Basis for International Trade• The basis for international trade is that

a nation can import a particular good or service at a lower cost than if it were produced domestically– In other words, if you can buy it cheaper

than you can make it you should buy it– This maxim is true for individuals and

nations

A Summing Up: C + I + G + Xn

Net exports = Xn

Xn = Exports - Imports

C

C+I

C+I+G

C+I+G+(X-M)C+I+G+(X-M)

Due to Imports being greater than Exports

45û

8,000

10,000

8,000 10,000

6,000

6,000

4,000

4,0002,000

2,000

C +I +G

Disposable income ($)

45û

8,000

10,000

8,000 10,000

6,000

6,000

4,000

4,0002,000

2,000

C +I +G

Disposable income ($)

C +I +G +Xn

C + I + G + Xn

Why is the C + I + G + Xn line lower than the C + I + G line?

Answer: It is lower because net exports (Xn) are negative

100 200 300 400 500 600 700

United States

Germany 520

Japan 388

China 214

South Korea 133

Mexico 118

Canada 358

Taiwan 110

Singapore 110

Switzerland 79

(billions of dollars)

683

The World’s Top Ten Exporting Nations, 1999

The GAPS & The Multiplier

The Multiplier and Its Applications

• Any change in spending (C, I, or G) will set off a chain reaction, leading to a multiplied change in GDP

GDP = C + I + G + Xn

How much the multiplied change is depends on the MPC and MPS

Calculating the Multiplier

• RememberMPC + MPS = 1, therefore, MPS = 1 - MPC

Multiplier = -----------------------1

1 - MPC

Multiplier = ----------------------1

MPS

Because the multiplier (like C) deals with spending, 1/(1-MPC) is a more appropriate formula)

Calculating the Multiplier

• The MPC is .5. Find the multiplier

Calculating the Multiplier(Continued)

• The MPC is .5. Find the multiplier

Multiplier = ---------------- = -------- = ----- = 21

1 - MPC

1

1 – .5

1

.5

Calculating the MultiplierStep-by-Step Working of the Multiplier When MPC is .5

$1,000.00 $ 500.00 $ 250.00 $ 125.00 $ 62.50 $ 31.25 $ 15.625 $ 7.813 $ 3.906 $ etc. $ etc. $2,000.00

It is surely much easier to use the multiplier of 2 (2 X $1,000 = $2000) than to go through this process and add up all the figures

Calculating the Multiplier(Continued)

• The MPC is .75. Find the multiplier

Calculating the Multiplier(Continued)

• The MPC is .75. Find the multiplier

Multiplier = ---------------- = -------- = ----- = 411 1

1 - MPC 1 – .75 .25

Applications of the Multiplier

• The Multiplier is used to calculate the effect of changes in C, I, or G on GDP

GDP = 2,500; Multiplier = 3; C rises by 10

What is the new level of GDP?GDPNew = GDPInitial + (Change in spending X Multiplier)

GDPNew = 2500 + ( 10 x 3)GDPNew = 2500 + ( 30)GDPNew = 2530

Applications of the Multiplier

• The Multiplier is used to calculate the effect of changes in C, I, or G on GDP

GDP = X; Multiplier = 3; C rises by 10

What happens to GDP?GDPNew = GDPInitial + (Change in spending X Multiplier)

GDPNew = X + ( 10 x 3)GDPNew = X + ( 30)GDP increases by 30

Applications of the Multiplier

• The Multiplier is used to calculate the effect of changes in C, I, or G on GDP

GDP = X; Multiplier = 7; G falls by 5

What happens to GDP?GDPNew = GDPInitial + (Change in spending X Multiplier)

GDPNew = X + ( -5 x 7)GDPNew = X + ( -35)GDP decreases by 35

Applications of the Multiplier• How big is the multiplier (M)?

1 2 3 4 5 6 7 8 9

9

8

7

6

5

4

3

2

1

Deflationary gapC +I +G +Xn

2

GDP (in trillions of dollars)

Full-employment GDP

M = distance between the equilibrium GDP and the full-employment GDP / by the gap

M = 2 / 2 = 1

Applications of the Multiplier• How big is the multiplier (M)?

2,000

1,500

1,000

500

0

Inflationary gap

500 1,000 1,500 2,000

C +I +G +Xn

500

Full-employment GDP

GDP (in trillions of dollars)

M = distance between the equilibrium GDP and the full-employment GDP / by the gap

M = 500 / 200 = 2.5

Graphing the C + I + G + Xn Line

Disposable income ($)

45û

2,000 3,0001,000

1,000

2,000

C

3,000

C +I+G

C +I

To keep the graph as simple as possible, we are assuming the government spends a constant amount of money regardless of the level of disposable income

The Relationship Between Total Planned Expenditures and the Aggregate Demand

Pric

e Le

vel

Real GDP

Tot

al P

lann

ed

Con

sum

ptio

n

C,

G,

I, N

, X

Real GDP

200

100

TPE100p

TPE200p

600 800