Chapter 12wpscms.pearsoncmg.com/wps/media/objects/15089/15451222/notes/...• Explain the key determinants of consumption and saving in the Keynesian ... – The interest rate is not
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Since the early 2000s, planned real investment spending has increased in most of the world’s nations.
As a percentage of global real GDP, however, planned real investment spending in the world’s developed countries has declined. Yet, it has been rising in emerging-economy nations. These are countries transitioning to a developed status.
How do changes in planned real investment spending affect a country’s real GDP?
Reading Chapter 12 will help you answer this question.
• The share of real GDP allocated to real consumption spending is:– 66 percent in Germany– 60 percent in the United Kingdom– 70 percent in the United States– Less than 41 percent in China?
• In this chapter, you will learn how an understanding of households’ real saving and real consumption spending can help you evaluate fluctuations in a national’s real GDP.
Determinants of Planned Consumption and Planned Saving (cont'd)
• Keynes argued that: – The interest rate is not the most important
factor in saving and consumption decisions– Rather, real saving and consumption decisions
depend primarily on a household’s real disposable income.
– Furthermore, a person’s anticipation about future flows of income influences how much of current income is allocated to consumption and how much is allocated to saving.
Determinants of Planned Consumption and Planned Saving (cont'd)
• The Life-Cycle Theory of Consumption– The most realistic and detailed theory of consumption,
often called the life-cycle theory of consumption, considers how a person varies saving and consumption as income ebbs and flows throughout an entire life span.
• This theory predicts that when an individual anticipates a higher income in the future, he or she will tend to consume more and save less in the current period than would have been the case otherwise.
Determinants of Planned Consumption and Planned Saving (cont'd)
• The Permanent Income Hypothesis– A related theory, called the permanent income hypothesis,
suggests that the income level that matters for a person’s decisions about current consumption and saving is permanent income, or expected average lifetime income.
• Thus, if a person’s flow of income temporarily rises without an increase in average lifetime income, the person responds by saving more and leaving consumption unchanged.
Example: Lower Household Wealth and Subdued Growth in Consumption
• Between 2007 and 2009, there was a substantial decline in two key components of real household wealth.– Inflation-adjusted wealth in housing fell by 25 percent
– Inflation-adjusted wealth in corporate stocks fell by 50 percent
• These wealth reductions shifted the U.S. consumption function downward.
• Real disposable income also fell, causing a leftward movement along the consumption function and a further drop in consumption.
Example: Adding a Third Dimension Requires New Investment Spending
• Of the approximately 40,000 movie screens in the United States, fewer than 8,000 are equipped with digital technology required for projection of three-dimensional (3D) movies.
• Conversion to the 3D technology costs about $70,000.
• Major movie-theater chains are currently undertaking this investment for more than 1,000 theaters.
• This adds up to an aggregate investment expenditure of about $700 million.
• By taking a few numerical examples, you can demonstrate to yourself an important property of the multiplier– The smaller the MPS, the larger the multiplier
What If . . . The government seeks a larger multiplier effect by funding private spending on certain items rather than buying them directly?
• Whether the government gives funds to households and firms for purchasing goods or whether the government makes the purchases directly, the resulting increase in total autonomous expenditure is the same.– Thus, the overall multiplier effect on equilibrium
real GDP would also be the same.– So, providing grants of public funds to be spent
by households and firms rather than having government purchase the same items will not enlarge the overall theoretical multiplier effect.
How a Change in Real Autonomous Spending Affects Real GDP When the Price Level Can Change
• So far our examination of how changes in real autonomous spending affects equilibrium real GDP has considered a situation in which the price level remains unchanged
• Our equilibrium analysis has only considered how AD shifts in response to investment, government spending, net exports
How a Change in Real Autonomous Spending Affects Real GDP When the Price Level Can Change (cont'd)
• When we take into account the aggregate supply curve, we must also consider responses of the equilibrium price level to a multiplier-induced change in AD
International Example: The Effect of Higher Autonomous Spending on China’s Real GDP
• Most estimates indicate that the marginal propensity to consume in China is about 0.50.
• So, assuming no change in the price level, the multiplier would be about 2.
• However, economists have estimated that the short-run effect of an initial increase in real autonomous spending on China’s real GDP is only about 1.1.
• Therefore, once the higher price level is taken into account, an additional one-unit increase in real autonomous expenditure causes a 1.1 unit increase in China’s annual real GDP.
You Are There: Evaluating the Effects of Declining Real Disposable Income
• Mark Vitner, an economist with Wells Fargo bank, examines the latest monthly economic data.
• Real disposable income fell by 0.3 percent during the month.
• Real consumption spending and real saving dipped as well, consistent with the theory.
• Vitner summarizes the situation by saying that household budgets are getting tighter and consumers are having difficulty maintaining their standard of living.
Issues & Applications: A Global Reversal in Planned Investment Spending (cont’d)
• Variations in planned real investment spending operate through the multiplier to bring about changes in equilibrium real GDP.
• Therefore, a country that experiences a larger upward shift in its planned investment function will observe a greater increase in its equilibrium real GDP.
• This explains why countries such as China, India, South Korea, and Singapore are emerging to take a place alongside developed nations.