Consumption, Real GDP, 12 and the Multiplier Learning Objectives After you have studied this chapter, you should be able to 1. define saving, savings, consumption, dissaving, autonomous consumption, average propensity to consume, average propensity to save, marginal propensity to consume, marginal propensity to save, 45-degree reference line, wealth, lump-sum tax, and multiplier; 2. distinguish between flow variables and stock variables; 3. relate consumption and saving to real GDP; 4. distinguish between the marginal propensity to consume (save) and the average propensity to consume (save); 5. calculate marginal and average propensities to consume (save), given the relevant information; 6. distinguish between the causes of a movement along and a shift in the consumption (saving) curve; 7. list the main determinants of planned business investment spending and recognize how each affects such spending; 8. predict what will happen to real GDP if total planned expenditures do not equal real GDP; 9. calculate the autonomous consumption or autonomous investment multiplier, given the relevant information; and 10. calculate the change in the equilibrium level of real GDP due to a change in autonomous expenditures, given the marginal propensity to consume. Outline 1. By definition, the sum of real consumption expenditures and real saving equals real disposable income. a. Saving, consumption, disposable income, and real GDP are flows that, therefore, are measured per unit of time. Savings and wealth are stocks whose values are measured at a given moment in time. b. Investment, which is a flow, includes expenditures by firms for capital goods. ©2014 Pearson Education, Inc. 154 Miller • Economics Today, Seventeenth Edition 2. John Maynard Keynes maintained that planned real saving and planned real consumption were determined by real disposable income. a. For the household, planned real consumption is typically plotted on the vertical axis and real disposable income on the horizontal axis. The planned saving curve can be derived by subtracting the planned consumption curve from the 45-degree line. b. Autonomous consumption is that consumption that is independent of real GDP, and it is the value of the vertical intercept on the consumption function. If consumption is positive at zero real disposable income, then dissaving must exist over the lower range of the consumption function. c. The average propensity to consume (APC) equals total real consumption divided by total real disposable income. The average propensity to save (APS) equals total real saving divided by total real disposable income. d. The marginal propensity to consume (MPC) equals the change in real consumption divided by the change in real disposable income. The marginal propensity to save (MPS) equals the change in real saving divided by the change in real disposable income. e. It must be true that APC + APS = 1. It is also true that MPC + MPS = 1. f. If wealth increases, the consumption function shifts upward. If wealth decreases, it shifts downward. 3. Investment includes business expenditures on plants and equipment, and on inventories. Such expenditures are more variable than household consumption expenditures because expectations play a more important role in investment expenditures. a. An inverse relationship exists between investment expenditures and the interest rate. b. Non-interest-rate determinants of investment spending include expectations, innovation and technology, and business taxes. i. If firms anticipate that investment will be more profitable, then more investment expenditures will be made at any interest rate. The investment curve will shift to the right. ii. Improvements in technology and innovation shift the planned investment curve to the right. iii. If business taxes rise, the planned investment curve shifts to the left. A reduction in such taxes shifts it to the right. 4. Real consumption depends on real disposable income, and it is also related to real GDP. The latter relationship is more convenient for our analysis. a. A portion of the consumption function is autonomous, or independent of real GDP. b. Net investment is dependent on the interest rate. For simplicity, we assume that it is autonomous, or independent of real GDP. c. The 45-degree reference line indicates where planned expenditures equal real GDP per year. 5. The equilibrium level of real GDP occurs at the point at which the planned expenditures curve intersects the 45-degree reference line. a. If total planned expenditures exceed real national income, then business inventories will fall involuntarily, and businesses will find it profitable to increase total production of goods and services, and real GDP will rise. ©2014 Pearson Education, Inc. Chapter 12 Consumption, Real GDP, and the Multiplier 155 b. If total planned expenditures are less than real national income, then business inventories will rise involuntarily, and businesses will find it profitable to decrease total production of goods and services, and real GDP will fall. 6. When autonomous expenditures change, the planned expenditures curve shifts, and there will be a multiplier effect. a. If autonomous consumption, autonomous investment, autonomous government expenditures, or net exports change, the planned expenditures curve shifts by an identical amount. b. Equilibrium real GDP per year will change by a multiple of the change in autonomous expenditure, in the same direction. 7. A multiplier effect exists because one person’s expenditure is another person’s income, and changes in autonomous spending lead to successive rounds of spending and income creation. a. The steeper the slope of the planned expenditures curve (the MPC), the greater is the multiplier. b. The simple multiplier equals the reciprocal of the MPS. c. Because of the multiplier effect, fluctuations in economic activity will be magnified. Key Terms 45-degree reference line Marginal propensity to consume Average propensity to consume (APC) (MPC) Average propensity to save (APS) Marginal propensity to save (MPS) Consumption Net wealth Dissaving Real disposable income Investment Saving Key Concepts Autonomous consumption Consumption function Lump-sum tax Capital goods Consumption goods Multiplier Completion Questions Fill in the blank, or circle the correct term. 1. Saving is a (stock, flow) concept, while savings is a __________________ concept. 2. The sum of planned consumption and planned saving equals _______________, by definition. When real disposable income rises, planned real consumption ___________________ and planned real saving ___________________. 3. The average propensity to save (APS) equals saving divided by __________________. The APC plus the APS equals __________________________. ©2014 Pearson Education, Inc. 156 Miller • Economics Today, Seventeenth Edition 4. The marginal propensity to consume (MPC) equals the change in consumption (divided by, plus, minus) the change in real disposable income. One minus the MPC equals the _________________. 5. The amount of consumption that is (dependent on, independent of) real disposable income is called autonomous consumption. When autonomous consumption exists, the vertical intercept of the consumption function is (negative, zero, positive), and the APC (falls, remains constant, rises) as real disposable income rises. 6. Dissaving exists when real consumption expenditures (equal, are less than, exceed) real disposable income. 7. The consumption function will shift if autonomous consumption changes due to changes in real household ______________. 8. Investment varies (directly, inversely) with changes in the interest rate. The planned investment curve shifts if there are changes in ___________________________, _______________________, or __________________________. 9. Along the 45-degree reference line, planned total expenditures equal ____________. Where the planned expenditures line intersects the 45-degree reference line (equilibrium, disequilibrium) exists. Where those curves do not intersect, _______________________ exists. 10. In the model in which government and foreign transactions are ignored, household planned consumption expenditures plus business investment expenditures equal aggregate _____________. 11. If total planned expenditures exceed real GDP, business inventories will ___________________ involuntarily and businesses will find it profitable to (increase, decrease) production of goods and services. If total planned expenditures are less than real GDP, business inventories will ___________________ involuntarily and businesses will find it profitable to ___________________ production of goods and services. 12. If autonomous government purchases of goods and services (G) are added to the aggregate expenditures curve, the aggregate expenditures curve will shift (upward, downward) and equilibrium real GDP per year will (rise, fall). 13. If net exports are added to the aggregate expenditure curve and imports exceed exports, then net exports are a (positive, negative) number, and equilibrium real GDP will (rise, fall) by an amount (greater than, equal to, less than) net exports. True-False Questions Circle the T if the statement is true, the F if it is false. Explain to yourself why a statement is false. T F 1. The APC plus the MPC equals 1, by definition. T F 2. In the Keynesian model, if wealth rises, the consumption function shifts upward. ©2014 Pearson Education, Inc. Chapter 12 Consumption, Real GDP, and the Multiplier 157 T F 3. In the Keynesian model, the APC falls, and the