I. Consumption Function (CF)

Chapter 10 I. Consumption Function (CF) A. With Y (GDP) on the horizontal axis, and C (Consumption Spending) on the vertical, the curve representing the relationship between the level of spending at various income levels is called the Consumption Function. For comparison, a line is also drawn at a 45 degree angle, starting at the origin. This line shows a 1:1 ratio of Consumption: Income, which only actually exists when the Consumption Function crosses the 45 degree line. B. At points to the left of this intersection, Consumption exceeds income (through borrowing). This region is called “dissavings” where the savings are a negative number. To the right of the intersection, income exceeds consumption spending. Graphically this is due to the slope of the CF being less than 45 degrees; the ratio of C/Y is less than 1:1. If it is 0.8/1 that means people spend 80 cents for every dollar of increased income. C. Change in output consumed, represented by movement along the CF, can only be caused by a change in Y (income). CF can shift (up or down) dependent on (note these are essentially demand –AD- shifters for the macroeconomy) : 1. Attitudes towards saving – influenced by religious and cultural customs, as well as concrete factors like the existence of pensions and insurance. 2. Assets – while income is measured on a yearly basis, assets are the accumulated, year after year, total worth of individuals. It often includes the inherited assets of previous generations as well. Assets take three forms: i. Liquid assets: money or close to money, such as bonds and savings accounts that can be quickly turned into cash. ii. Debt: accumulating debt enables C to increase (CF shifts up) while paying down debt causes CF to shift down. The interest rate and leniency or rigidity of the terms of lending also will influence the CF.

1 iii. Ownership of durable goods: if individuals purchase a variety of durable goods, their CF can shift down because they will not need to spend at that level again for some time. 3. Expectations, particularly about future income, the health of the economy, and the security of their employment 4.Taxes- directly influence C, therefore CF shifts if taxes fluctuate. 5.Distribution of income – if income is distributed away from the rich and towards the poor, overall spending will increase (CF shifts up) since the wealthier individuals are able to save more while the poor are more inclined to spend additional income. 6.Demographics – the makeup of society in terms of age, number of people in the population, and the percentage of the population in the workforce will all influence the CF.

Factors like taxes, assets, distribution of income or demographics are called “objective” or economic factors while attitudes towards savings and expectations are “psychological” factors.

II. Keynesian Multiplier and Propensities to Consume/Save For usefulness in equations/concepts, MPC is most important

A. APC: Average Propensity to Consume, the fraction of Disposable Income (DI) that is Consumed (C). APC= C/DI B. APS: Average Propensity to Save, the fraction of DI that is saved (S). APS=S/DI C. APC+APS=1 (after taxes, people can either spend or save) D. MPC: Marginal Propensity to Consume. Marginal: Additional unit of (Disposable income) Propensity: Tendency Consume: Spend

2 MPC is the amount of Consumption spending people will tend to make for an additional unit of income. If the MPC is .75, 75 cents of an additional dollar will be spent and 25 cents saved (MPS=.25). Of an additional 400M in Disposable Income, 300M would be spent. MPC+MPS=1

The book refers to MPC as MPE (marginal propensity to expend)

E. The Multiplier effect refers to the impact on Income of a given change in Consumption. The cumulative impact is greater than the initial change in consumption. Logically this is due to the fact that any new spending, whether it comes from taxes falling, an upswing in CC or stocks, or new, independent investment projects, that money gets spent. The proportion of new income that is spent is equal to the MPC. But that is just the first stage of spending really, since wherever that money was spent, it is now in the pockets of different consumers who will spend a proportion of their new income, also equal to the MPC. This process continues until the values in the rounds of spending become too small to count. If you were to add up these values (tedious, unnecessary) you would get the same number (total new level of spending) as simply multiplying the initial new spending amount by the multiplier. Mathematically, the multiplier = 1/(1- MPC) F. For convenience it is assumed in the shifting of the CF and the resulting increase in income that the multiplier (M) is instantaneous. Of course, in reality the rounds of spending take time and the multiplier effect takes up to a few years to completely work itself through the economy. The alternative to an “Instantaneous Multiplier”is a “Periodic Multiplier”that has a diminishing impact on income in each of several successive periods. We will depict these changes, graphically, as instantaneous.

3 G. To summarize, the multiplier equals: The total change in Income (after all “rounds of spending”are complete) / a given change in AE (the exogenous shock). On Page 249: In figures 10-10 a. and b., what government policy could close each gap. (hint: use the multiplier process)

III. Investment and Government Spending

A. The amount of autonomous Investment (II) has been drawn as a straight line (constant for all income levels), with a dollar value measured from the horizontal axis. To get the CF+II combined function, CF was simply shifted up by the value of II. G can be included in the same way, beginning with a function of II+G, which will shift II up by the amount of Government Spending (G). B. Government Spending can shift up or down for political or other non- economic reasons while II shifts in response to autonomous Investment shifters (like taxes, technology, expectations, productivity, interest rate).

IV. Savings

A. The argument that a society that saves more in a recession will lead to reduced output, and ultimately less savings, is called the “Paradox of Thrift.” The increase in savings must equal a decrease in spending, which signals to firms to decrease their usage of resources, causing unemployment and less overall saving.

V. Completing the Aggregate Demand–Income Model A. As covered previously, G can be added to II by shifting Intended Investment by the value of G. An economy in balance has not only S=I but G=T, so the element that needs to be added to the analysis is T (Taxes). The CF will shift down by MPC*(amount of taxes). This is because taxes decrease both Consumption and Saving. B. Equilibrium: Adjust the initial CF line up for II and G, and then down for taxes. The new intersection with the 45 degree line now determines equilibrium income, measured on the horizontal axis.

4 D. The Keynesian contention that an economy very often operated at temporary equilibrium points of unemployment or inflation (i.e. divergences from full- employment income levels) is evident on the AE-Income graph. In full-employment equilibrium, Potential Income= Potential Output (PO) and is the vertical line on p. 249. When potential output is to the right of equilibrium income, output is less than potential, which is called a “Recessionary gap.” The value of the difference between current income/output and potential output/income is the dollar value of the recessionary gap, or the amount AE would have to increase to attain capacity GDP. When potential output is to the left of equilibrium income, AE is more than income, which is called an “Inflationary gap.” Output exceeds potential, which will be inflationary unless AE can be decreased (through decreases G, for example, or Tax or Interest rate increases). The value of the difference between current income/output and potential output/income is the dollar value of the inflationary gap, or the amount AE would have to decrease to attain capacity GDP. VI. Balanced-Budget Multiplier A. Recall that the “rounds of spending” that follow an initial increase in AD cause the total change in Income to ultimately be greater than the initial increase in AD. If G increase by 100M (Million dollars), then the total change in Income (based on a MPC=.75) is 100*{1/(1-.75)}=400 million. B. If this government is to pursue a balanced budget policy, it will have to change taxes by an equal amount – in this case, positive 100M. Taxes also affect AD, but not as directly as G. When G increases, all that new money is spent. When taxes increase, Consumption does fall but only by an amount=MPC*T. This is because some of the new tax is paid for by a reduction in saving. In this example, the initial shock to AD will be 0.75*100=75. In the long term, this amount goes through the multiplier process 75*{1/(1-.75)}=300.

5 C. In summary, the increase in G of 100M caused Y to eventually increase 400M, while the taxes of 100M decreased Y by 300M. 400M- 300M=100M; the income level rises by a net of 100M when the change in G and T are both 100M. In this case, there was a positive increase in G and T, so the change in Income is positive. Another way to say this is the balanced-budget multiplier=1.

VII. In an open economy (one that trades with foreign nations) Y=C+G+I+Xn

A. Xn = X-M and can be assumed constant, shifting the CF+I+G (AD) function up, assuming of course that Xn is a positive number. If there is a trade deficit, the AD shifts down to adjust for foreign trade in an open economy. Exports increase AD and imports decrease it. Be able to use the change in imports or exports (e.g. $100 Billion) just as you would a change in consumption or government spending in the multiplier equation.