INCOME AND EXPENDITURE

MPC, MPS & Investment Spending

THE MULTIPLIER: AN INTRODUCTION We use the multiplier to explain the effects of

changes in spending on the economy Ceteris paribus, an increase in spending increases

income & GDP by that same amount As a result, disposable income rises, which leads to

more spending and increased production

MARGINAL PROPENSITY TO CONSUME MPC is a measure of the total effect

MPC = ∆ consumer spending∆ disposable income

Because we are looking at the part of each additional dollar that consumers will spend, the MPC is a number between 0 and 1

The remainder (1 - MPC) is the Marginal Propensity to Save

THE CHAIN REACTION OF SPENDING Each $1 of spending adds to GDP, and this

translates into a round of consumer spending (MPC X $1), then another round, etc.

Ultimately, the impact of that change in spending is a multiple of the original change

The total increase in Real GDP from x dollars of spending = 1/(1-MPC) X x

At each stage, some of the rise in income “leaks out” because it is saved. The formula shows the cumulative effect of several “rounds” of spending

THE MULTIPLIER (FOR SPENDING AND INVESTMENT) The multiplier is the ratio of total change in Real

GDP to the size of autonomous change in spending (the cause of the chain reaction)

∆Y -OR- 1

∆AAS (1-MPC) Size of the multiplier depends on MPC – Higher MPC,

higher multiplier Taxes, foreign trade, etc. complicate the model

Tax Multiplier = - MPC/(1-MPC) The tax multiplier is ALWAYS negative

CONSUMER SPENDING – FROM MICRO TO MACRO Largest determinant of consumer spending is

disposable income Consumption function is c = a + MPC yd

The a represents autonomous consumer spending, the amount a household would spend even if it had no income

For households, MPC = ∆c/∆ yd

AGGREGATE CONSUMPTION FUNCTION

C = A + MPC YD

YD is the aggregate disposable income of a society

Aggregate CF is the relationship between YD and consumption for the economy as a whole

This equation graphs as a linear function, with A as the vertical axis intercept

SHIFTS OF CF Two factors will shift CF

1. Expectations about future disposable income – Expecting good times will shift CF up, expecting hard times will shift it down – “permanent income hypothesis”

2. Changes in aggregate wealth – Those with the most savings (wealth) can afford to spend more & a rise in aggregate wealth will shift CF up, while a fall in aggregate wealth will shift it down – “life cycle hypothesis”

INVESTMENT SPENDING Because of the multiplier, booms & busts in

investment spending tend to drive the business cycle

I= IPlanned + I Unplanned

PLANNED INVESTMENT Planned investment spending is dependent on 3

factors:1. Interest rates

Drive residential construction. Impact other investment spending. Businesses

only invest when the rate of return is higher than the cost (or opportunity cost) of the funds.

High interest rate makes any investment project less attractive.

PLANNED INVESTMENT Planned investment spending is dependent on 3

factors:2. Expected Real GDP

Firms who don’t expect sales growth plan for minimal investment spending.

Expected sales growth results in need to expand production capacity.

3. Production Capacity If current capacity is higher than needed for

current sales, growing capacity is a lesser concern.

INVESTMENT DEMAND CURVE Investment demand curve shows the inverse

relationship between interest rates and investment demand.

SHIFTS TO INVESTMENT DEMAND CURVEFactors that increase Expected Rate of Return (shift curve right)

Factors that decreaseExpected Rate of Return(shift curve left)

Operating costs Operating costs

Taxes Taxes

Stock on hand Stock on hand

Expected sales (good conditions)

Expected sales (bad conditions)

Technology/innovation

INVENTORIES & UNPLANNED INVESTMENT SPENDING Businesses maintain inventories to satisfy buyers Inventory investment – Value of total inventories in

an economy over a period of time. This can be a negative number when inventories are reduced.

If sales fall, businesses might end up with larger inventories than expected (unplanned inventory investment)

Rising inventories signal economic slowdown