Consumption, Real GDP, and the Multiplier (Chapter 11) PDF

Chapter 11 Economics Today Consumption, A Canadian Perspective: Real GDP and Macroeconomics the Multiplier  Learning Objectives 11.1 Distinguish between saving and savings and explain how saving and consumption are related. 11.2 Explain the key determina...

Chapter 11 Economics Today Consumption, A Canadian Perspective: Real GDP and Macroeconomics the Multiplier  Learning Objectives 11.1 Distinguish between saving and savings and explain how saving and consumption are related. 11.2 Explain the key determinants of consumption and saving in the Keynesian model. 11.3 Identify the primary determinants of planned investment. 9-2  Learning Objectives 11.4 Describe how equilibrium national income is established in the Keynesian model. 11.5 Evaluate why autonomous changes in total planned expenditures have a multiplier effect on equilibrium national income. 11.6 Understand the relationship between total planned expenditures and the aggregate demand curve. 9-3  A Brief History: Keynesian Economics John Maynard Keynes was one of the most influential economists of the 20th century. Keynes was a British economist, whose ideas fundamentally changed macroeconomic theory and the economic policies of governments. He built on and greatly refined earlier work on the causes of business cycles, and is widely considered the founder of modern macroeconomics, his ideas are the basis of Keynesian economics. During the Great Depression of the 1930s, Keynes spearheaded a revolution in economic thinking, challenging the ideas of neoclassical economics that held that free markets would, in the short to medium term, automatically provide full employment, if workers were flexible in their wage demands. He argued that aggregate demand (total spending in the economy) determined the overall level of economic activity, and that inadequate aggregate demand could lead to prolonged periods of high unemployment. 9-4  A Brief History: Keynesian Economics Keynes advocated the use of fiscal and monetary policies to mitigate the adverse effects of economic recessions and depressions. He detailed these ideas in his magnum opus, The General Theory of Employment, Interest and Money, published in 1936. By the late 1930s, leading Western economies had begun adopting Keynes's policy recommendations. Almost all capitalist governments had done so by the end of the two decades following Keynes's death in 1946. Keynes's influence started to wane in the 1970s, partly as a result of the stagflation that plagued the Anglo-American economies during that decade, and partly because of criticism of Keynesian policies by Milton Friedman and other monetarists, who disputed the ability of government to favourably regulate the business cycle with fiscal policy. 9-5 Determinants of Planned Consumption and Planned Saving Assuming we have an economy close to potential GDP where unemployment is low; theoretically requiring minimal government intervention; Under these conditions; the Keynesian theory of economics argued that saving and consumption decisions depend primarily on an individual’s real current income. Consumption Function  The relationship between planned consumption expenditures and their current level of real income. 9-6  Determinants of Planned Consumption and Planned Saving Autonomous Consumption  The part of consumption that is independent of the level of disposable income. Induced (Spending) consumption  The part of consumption that depends on the level of income Dissaving  Negative saving; spending exceeds income. 9-7  Saving and Consumption Definitions & Relationships National Income (Y) = Disposable Income (Yd) + Taxes (T) Yd Y  Τ Disposable Income (Yd) = Consumption (C) + Savings(S) Yd C  S S  Yd - C 9-8  Determinants of Planned Consumption and Planned Saving Marginal Propensity to Consume (MPC)  The ratio of the change in consumption to the change in disposable income. change∈consumption MPC= change∈real disposable income 9-9  Determinants of Planned Consumption and Planned Saving Marginal Propensity to Save (MPS)  The ratio of the change in saving to the change in disposable income. change∈saving MPS= change∈real disposableincome 9-10  Determinants of Planned Consumption and Planned Saving MPC  MPS 1 9-11  Determinants of Planned Consumption and Planned Saving (1) (2) (3) (4) (5) Planned Real Planned Real Saving Marginal Marginal Disposal Real Con- Per Year Propensity Propensity Income per sumption (S  Yd-C ) to Consume to Save Combination Year (Yd ) per year (C) (1) - (2) (MPC  C/Yd ) (MPSS/Yd ) A $0 $2,000 $-2,000 ---- ---- B 2,000 3,600 -1,600.8.2 C 4,000 5,200 -1,200.8.2 D 6,000 6,800 -800.8.2 E 8,000 8,400 -400.8.2 F 10,000 10,000 0.8.2 G 12,000 11,600 400.8.2 H 14,000 13,200 800.8.2 I 16,000 14,800 1,200.8.2 J 18,000 16,400 1,600.8.2 K 20,000 18,000 2,000.8.2 9-12 Determinants of Planned Consumption and Planned Saving 20,000 C = Yd Saving K Planned Real Consumption 16,000 J (C, dollars per year) I 12,000 Break-even H income F Consumption G function E 8,000 D C B (equal 4,000 A vertical 2,000 Dissaving distance) 45 Autonomous consumption 0 4,000 8,000 12,000 16,000 20,000 Real Disposable Income (Yd dollars per year) 9-13 Determinants of Planned Consumption and Planned Saving (equal vertical distance) Saving Planned Real Saving (S, dollars per year) K 2,000 I J 4,000 8,000 G H 0 E F 12,000 16,000 20,000 C D -2,000 B A Dissaving Real Disposable Income (Yd dollars per year) 9-14  Determinants of Planned Consumption and Planned Saving Causes of Shifts in the Consumption Function  Non-income determinants of consumption Population Expectations Wealth 9-15  Determinants of Planned Consumption and Planned Saving 45o C2 C2 C1 Planned Real Consumption (C, dollars per year) Assume positive economic expectations C1 Y1 Y2 Real Disposable Income (Yd dollars per year) 9-16  Determinants of Planned Consumption and Planned Saving 45o C1 Planned Real Consumption (C, dollars per year) C2 C1 C2 Assume wealth decreases Y2 Y1 Real Disposable Income (Yd dollars per year) 9-17 Determinants of Investment Historically  Investment has been more volatile than consumption. 9-18 Determinants of Investment Planned investment Rate of Interest per Year (percent per year) ($ billions) 7.5 20 7.0 30 6.5 40 6.0 50 5.5 60 5.0 70 4.5 80 4.0 90 3.5 100 3.0 110 9-19 Determinants of Investment 7.5 Rate of Interest (percent per year) 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 I 0 10 20 30 40 50 60 70 80 90 100 110 Planned Investment per Year ($ billions) 9-20  Determinants of Investment What Causes the Investment Function to Shift? 1) Expectations 2) Productive technology 3) Business taxes 9-21 Determinants of Investment Rate of Interest (percent per year) Positive profit outlook r1 I1 I1 Planned Investment per Year ($ billions) 9-22 Determinants of Investment Rate of Interest (percent per year) Positive profit outlook r1 I1 I2 I1 I2 Planned Investment per Year ($ billions) 9-23 Determinants of Investment Rate of Interest (percent per year) Taxes Increase r1 I2 I1 I2 I1 Planned Investment per Year ($ billions) 9-24 Equilibrium in the Keynesian Model Real Investment per Year There is no relation between I and Y -- $70 billion at all Y levels ($ billions) 70 I I is autonomous 0 200 400 600 Real National Income per Year ($ billions) 9-25 Equilibrium in the Keynesian Model C=Y 250 C e lin Planned Consumption per Year c e en 100 fer C is a function of re o real national income. ($ billions) 45 Assume MPC =.8 150 100 Autonomous consumption 50 30 45o 0 50 100 150 200 250 Real National Income per Year ($ billions) 9-26 Equilibrium in the Keynesian Model 600 C+I Planned Consumption and Planned C Investment per Year ($ billions) 500 400 C+I=Y 300 1) C + I = total planned 200 expenditures 2) Equilibrium: C + I = Y 3) Equilibrium Y = $500 billion 100 45o 30 0 100 200 300 400 500 600 Real National Income per Year ($ billions) 9-27  Equilibrium in the Keynesian Model Total Planned Expenditures  When all expenditures in the economy are added together (C+I+G+(X-M)) it is called the Total Planned Expenditure function.  The slope of this function is called the Marginal Propensity to Spend (MPE). 9-28  Equilibrium in the Keynesian Model Marginal Propensity to Spend (MPE)  Represents the portion of money that is spent in the domestic economy out of every extra dollar of national income received.  The remaining portion is called leakages (savings, taxes and imports). 9-29  Equilibrium in the Keynesian Model (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) Direction Net of Change Real Real Exports Total Planned Unplanned in Real National Disposable Planned Planned Planned Government (exports- Expenditures Inventory National Income Taxes Income Consumption Saving Investment Spending imports) (4)+(6)+(7)+(8) Changes Income 200 100 100 110 -10 70 100 10 290 -90 Increase 250 100 150 150 0 70 100 10 330 -80 Increase 300 100 200 190 10 70 100 10 370 -70 Increase 400 100 300 270 30 70 100 10 450 -50 Increase 500 100 400 350 50 70 100 10 530 -30 Increase 600 100 500 430 70 70 100 10 610 -10 Increase 650 100 550 470 80 70 100 10 650 0 Neither (equilibrium) 700 100 600 510 90 70 100 10 690 +10 Decrease 800 100 700 590 110 70 100 10 770 +30 Decrease 9-30 Equilibrium in the Keynesian Model 700 E2 TPE = C + I + G + (X-M) 600 C Purchases, and Net Exports Consumption, Investment, 500 Government ($ billions) 400 300 200 E1 100 45 0 100 150 200 300 400 500 600 650 700 800 Real National Income per Year ($ billions) 9-31  The Multiplier Multiplier  The ratio of the change in autonomous expenditures (TPE) to the change in the equilibrium level of real national income (GDP)  It happens because income received by one group is (mostly) being spent on goods and services produced elsewhere in the economy. 9-32  The Multiplier The Multiplier Formula 1 Multiplier = Proportion of leakages Multiplier = 1 / 0.20 = 5.0 9-33  The Multiplier Assumption: MPE =.8 or 4/5 (1) (2) (3) (4) Annual Increase Annual Increase Annual Increase in Real in Planned in National Income Expenditures Leakages Round ($ billions per year) ($ billions per year) ($ billions per year) 1 ($10 billion per year increase in I ) 10.00 8.000 2.000 2 8.00 6.400 1.600 3 6.40 5.120 1.280 4 5.12 4.096 1.024 5 4.09 3.277 0.819............ All later rounds 16.38 13.107 3.277 Totals (C + I + G + (X-M)) 50.00 40.00 10.000 9-34  The Multiplier The multiplier is larger when:  The marginal propensity to save is smaller  The marginal propensity to import is smaller  The marginal tax rate is lower. In summary the multiplier is larger when the proportion of leakages is smaller: 9-35 Autonomous and induced spending; mpc, mpm and other formulae Total Planned Expenditure ( TPE ) = C + I + G + X – M Other formulae The consumption function: C = autonomous C + mpc (Y) Investment function + I = autonomous I Government function + G = autonomous G Export function + X = autonomous X Import function - M = autonomous M + mpm(Y) Total Planned expenditure function TPE = autonomous TPE + mpe (Y) Assume mpc =.90 Multiplier = 1/ (1-.80) = 1/ 0.20 = 5 9-36 mpm =.10  The Multiplier The Multiplier Formula for a closed economy; no trade, or taxes where TPE = C + I + G; can be calculated as: 1 1 Multiplier = = 1- mpc mps 1 Multiplier = 1 – Marginal Propensity to Spend 9-37  The Multiplier The Multiplier Formula for an open economy (trade) and induced taxes where TPE = C + I + G + (X – M) can also be calculated as: 1 Multiplier = 1- mpe mpe = mpc (1- t) – mpm t = marginal tax rate mpm = marginal propensity to import 9-38  The Multiplier Understanding Formulas mpe = mpc (1- t) – mpm t = marginal tax rate (induced tax e.g. Income Tax) mpm = marginal propensity to import mpc = change in C / change in Y mpm = change in M / change in Y Assume mpe = mpc (1-t) - mpm mpc =.90 mpe = 0.90 (1-.20) -.10 mpm =.10 mpe = 0.62 t = 0.20 Multiplier = 1/ (1-.62) = 1/ 0.38 = 2.63 9-39 The Multiplier: Lets do some calculations. Assume mpc = 0.90; t = 0.20; mpm = 0.40 mpe = mpc (1- t) – mpm 1. If no tax and no trade; mpe = mpc = 0.90 2. If no tax; but trade exists; mpe = mpc – mpm = 0.90 – 0.40 = 0.50 3. With trade and taxes; mpe = mpc (1-t) – mpm = 0.90 (1-.20) – 0.40 = 0.32 9-40 The Multiplier: Lets do some calculations. Assume mpc = 0.90; t = 0.20; mpm = 0.40 Since we know the multiplier = 1 / (1 – mpe) 1. No trade and no taxes: When mpe = 0.90; Multiplier = 1 / (1-.90) = 10 2. No taxes but introduce trade: When mpe = 0.50; Multiplier = 1 / (1-.50) = 2 3. With trade and taxes: When mpe = 0.32; Multiplier = 1 / (1-.32) = 1.47 As trade and taxes are introduced the mpe becomes smaller and thus the multiplier value declines, lessening the impact on equilibrium GDP. 9-41 Sample Problem Total Planned Spending at various Autonomous vs Induced Spending; income levels. MPE and the multiplier Y C I G X M TPE The first line in red represents Autonomous spending (spending independent of income) or when 0 20 60 50 60 40 150 income = 0 50 65 60 50 60 60 175 100 110 60 50 60 80 200 TPE = C + I + G + X - M Induced spending occurs when 150 155 60 50 60 100 225 spending changes when income 200 200 60 50 60 120 250 changes which is the C, and M 250 245 60 50 60 140 275 Column. Columns I, G, and X are 300 290 60 50 60 160 300 Constant. - Let’s calculate mpe, the 350 335 60 50 60 180 325 Multiplier and equilibrium income. Copyright © 2005 Pearson Education Canada Inc. 9-42 Sample Problem ; mpc, mpm and other formulae Total Planned Expenditure ( TPE ) = C + I + G + X – M mpc = (C2 - C1) / (Y2 - Y1) = (65 - 20) / (50 - 0) = 45 /50 = 0.90 mpm = (M2 – M1) / (Y2 – Y1) = (60 – 40) / (50 – 0) = 20 /50 = 0.40 Other formulae The consumption function: C = autonomous C + mpc (Y) Investment function + I = autonomous I Government function + G = autonomous G Export function + X = autonomous X Import function - M = autonomous M + mpm(Y) Total Planned expenditure function TPE = autonomous TPE + mpe (Y) 9-43 Sample Problem ; mpc, mpm and other formulae Total Planned Expenditure ( TPE ) = C + I + G + X – M mpc = (C2 - C1) / (Y2 - Y1) = (65 - 20) / (50 - 0) = 45 /50 = 0.90 mpm = (M2 – M1) / (Y2 – Y1) = (60 – 40) / (50 – 0) = 20 /50 = 0.40 Other formulae C = autonomous C + mpc (Y) C = 20 + 0.90(Y) + I = autonomous I I = 60 + G = autonomous G G = 50 + X = autonomous X X = 60 - M = autonomous M + mpm(Y) M = 40 + 0.40 (Y) TPE = autonomous TPE + mpe (Y) TPE = 150 + 0.50 (Y) 9-44 Sample Problem ; mpc, mpm and other formulae TPE = autonomous TPE + mpe (Y) TPE = 150 + 0.50 (Y) Multiplier = 1 / (1 – mpe) = 1 / (1 -.50) = 1 / 0.50 = 2 Equilibrium income = Autonomus spending x Multiplier = Autonomus TPE x Multiplier = 150 x 2 = 300 9-45 Sample Problem; assume we have an open economy (with trade) and no taxes. Using the data on the table above; TPE = C + I + G + X – M C = Ca + mpc (Y) = 20 + 0.90(Y) I= Ia = 60 G = Ga = 50 X = Xa = 60 M = Ma + mpm(Y) = 40 + 0.50 (Y) TPE = TPEa + mpe(Y) = 150 + 0.40(Y) Mpe = mpc (1-t) – mpm = 0.90 (1 – 0) – 0.40 = 0.50 Multiplier = 1 / (1 – mpe) = 1 / (1 -.50) = 2 Equilibrium income = Ye = TPEa x Multiplier = 150 x 2 = 300 9-46 Sample Problem continued: Total Planned Expenditure and the Multiplier Effect with Trade If TPE autonomous spending = 150, When Income = 0; but now the multiplier = 2 45 due to spending on Government Purchases, and Net imports from other Consumption, Investment, countries. than equilibrium Real GDP Exports = 150 x 2 = 300 For each additional $1 increase in TPE TPE = 150+0.5Y There will be a $2 increase in Real GDP E1 now. 150 E.g. Spending on imports does not support domestic production. 300 650 700 Real Income ($ billions) 9-47 Sample Problem 2 Total Planned Spending at various Autonomous vs Induced Spending; income levels. MPE and the multiplier Y C I G X M TPE The first line in red represents Autonomous spending (spending independent of income) or when 0 20 60 50 130 income = 0 50 65 60 50 175 100 110 60 50 220 TPE = C + I + G Induced spending occurs when 150 155 60 50 265 spending changes when income 200 200 60 50 310 changes which is the C, and M 250 245 60 50 355 Column. Columns I, G, and X are 300 290 60 50 400 Constant. - Let’s calculate mpe, the 350 335 60 50 445 Multiplier and equilibrium income. 9-48 Sample Problem; assume we have a closed economy (no trade) and no taxes. Using the data on the table above; TPE = C + I + G C = Ca + mpc (Y) = 20 + 0.90(Y) I= Ia = 60 G = Ga = 50 TPE = TPEa + mpe(Y) = 130 + 0.90(Y) Mpe = mpc ( 1-t) – mpm = 0.90 ( 1 – 0) – 0 = 0.90 Multiplier = 1 / (1 – mpe) = 1 / (1 -.90) = 10 Equilibrium income = Ye = TPEa x Multiplier = 130 x 10 = 1300 9-49 Sample Problem continued: TPE Total Planned Expenditure and the Multiplier autonomous spending = 130 Effect with no Trade When Income = 0; but now the multiplier = 10 Therefore 45 equilibrium Real Government Purchases, and Net GDP = 130 x 10 Consumption, Investment, E2 = 1300 TPE = 130+0.9Y For each additional $1 Exports increase in TPE There will be a $10 increase in Real GDP now. E1 150 TPE = 150+0.5Y E.g. Spending on imports does 130 not support 140 domestic production. 300 1300 Real Less Imports Income higher National ($ billions) Income (GDP) 9-50  Sample Problem: Summary Total spending made up of consumer spending, investment spending and government spending with no trade or taxes result in a larger multiplier effect on GDP than with trade and taxes. If imports are introduced, domestic income is leaving the country supporting the other nations workers. Greater the imports, the smaller the multiplier thus lessening the impact of autonomous spending on equilibrium GDP. 9-51  Sample Problem: Summary Returning to the previous problem where TPE = C + I + G, and no trade or taxes; we established that TPE = 130 + 0.90(Y). If for example Autonomous Government spending, increased by $10 than TPE would equal: TPE = 140 + 0.90(Y). Equilibrium Income would rise by $10 x Multiplier (10) = $100 or Equilibrium GDP = TPE(autonomous) x Multiplier = 140 x 10 = $1400 If autonomous spending rises than the TPE curve would shift up parallel to the old TPE line since the mpe did not change; as evidenced on the next slide. 9-52  Sample Problem: Total Planned Expenditure assuming no trade 45 TPE = 140+0.9Y Government Purchases, and Net Consumption, Investment, TPE = 130+0.9Y E2 If TPE autonomous spending = Exports 130, When Income = 0, with a multiplier = 5 than E1 equilibrium Real GDP = 130 x 10 = 1300 140 130 For each additional $1 increase in TPE There will be a $10 increase in Real GDP. E.g. If autonomous spending 1300 1400 Real rises by $10; than Equilibrium Income Ye = $1400 billion ($ billions) 9-53 The Relationship Between Total Planned Expenditures and the Aggregate Demand Curve B - At P = 100, Y = 800 (A) - At P = 200, Y = 600 (B) 200 Price Level A 100 AD 600 800 Real Income ($ billions) 9-54 The Relationship Between the Total Planned Expenditure and the Aggregate Demand Curve (C + I + G + X)100 Government Purchases, and Net Consumption, Investment, (C + I + G + X)200 E1 Exports -Assume prices increase to 200 E2 -C + I + G + X decreases -Equilibrium Y falls to $600 billion 45 600 800 Real Income ($ billions) 9-55  The Relationship Between Total Planned Expenditures and the Aggregate Demand Curve Increases Aggregate Demand and TPE Consumption rise in level of personal wealth fall in personal taxes fall in personal debt more optimistic expectations about the economy Investment fall in real interest rates decrease in business taxes more optimistic expectations of profitability Government more spending in the economy Net decrease in value of the Canadian dollar increase in value of our trading partners’ currency Exports increase in our trading partners’ GDP decrease in Canadian import taxes 9-56  The Relationship Between Total Planned Expenditures and the Aggregate Demand Curve Decreases Aggregate Demand and TPE Consumption fall in level of personal wealth rise in personal taxes rise in personal debt less optimistic expectations about the economy Investment rise in real interest rates increase in business taxes less optimistic expectations of profitability Government less spending in the economy Net increase in value of the Canadian dollar decrease in value of our trading partners’ currency Exports decrease in our trading partners’ GDP increase in Canadian import taxes 9-57