Income and Expenditure

Income and Expenditure Lisbeth Mosquera Romina Angelelli

Emver Davila Juilian Builes

The Multiplier: Introduction

• Four assumptions based on the article:

1. Producers are willing to supply additional output at a fixed price. As a result, changes in overall spending would translate into changes in aggregate output

2. The interest rate would be as given.3. No government spending and no taxes.4. Exports and imports are zero.

Marginal Propensity to ConsumeMPC

• The increase in consumer spending when disposable income spending rises by $1. When consumer spending changes, because of a rise or fall in disposable income, MPC =

Consumer Spending/ Disposable Spending

EX: If consumer spending goes up by $6 billion when disposable income goes up by $10 billion.

MPC= $6 billion/$10 billion= 0.6

Marginal Propensity to Save

*Because consumers normally spend part but not all of an additional dollar of disposable income, MPC is a number between 0 and 1.*

• The additional disposable income that consumers don’t spend is saved; The Marginal Propensity to Save (MPS) is the fraction of an additional dollar of disposable income that is saved.

MPS= 1-MPC

Autonomous Change in Aggregate Spending

• An initial rise or fall in aggregate spending that is the cause, not the result, of a series of income and spending changes.

Autonomous: “self-governing” which means it is the cause, not the result, of the chain reaction.

Multiplier• The ratio of the total change in real GDP caused by an autonomous

change in aggregate spending to the size of that autonomous change.

Multiplier= Change in equilibrium expenditure/ Change in autonomous expenditure

The change in equilibrium expenditure also equals the change in real GDP= ΔY and the change in autonomous expenditure is a change in investment= ΔI

EX: ΔY= $2 trillion/ ΔI= $0.5 trillion Multiplier is = 4

The Multiplier and The Great Depression

1929 1933 Change

Investment Spending

$101.7 $18.9 -$82.8

Consumer Spending

$736. 6 $601.1 -$135.5

Real GDP $977.0 $716.4 -$260.6

Investment Spending, Consumer Spending and Real GDP in the Great Depression (Billions of 2005 dollars)

Consumer Spending Accounts for two-thirds of total

spending on final goods and services

Current disposable income is a determinant of consumer

spending

Current Disposable Income

• Is the income after taxes are paid and government transfers are received.

• Those with higher disposable incomes are more likely to have higher standards of living (ex. Expensive cars, expensive houses, spend more on food and clothing)

• Disposable income and spending has a clear relationship

Consumption Function• Is an equation showing how an individual

household’s consumer spending varies with the household’s current disposable income.

• c is individual household consumer spending• yd is individual household current disposable income • MPC= marginal propensity to consume • a is a constant term – individual household autonomous consumer

spending, the amount a household would spend if it had no disposable income ( a is greater than zero because a household with no disposable income would be able to fund some consumption either by borrowing or using savings)

c = a + MPC X yd

MPC for individual household

MPC= Δc/Δyd

If the change in disposable income is multiplied to both sides it is evident that when the disposable income goes up by $1, consumer spending goes up by MPC X $1

Consumption Function

In reality no data would fit the consumption function but it is a pretty good estimation.

Aggregate Consumption Function

• For the economy is a whole rather than by individual households

C = A + MPC X YD

Shifts of Aggregate Consumption Function

• It shows the relationship between disposable income and consumer spending for the economy as a whole.

• When things other than disposable income change, the aggregate consumption function shifts.

• Two causes of shifts of aggregate consumption function.

1. Changes in expected future disposable income2. Changes in aggregate wealth.

Changes in Expected Future Disposable Income

• Expectations about future disposable income can affect consumer spending.

• For example, after graduation you get hired to a well paid job but won’t start until months later so disposable income has not changed yet. You may still be likely to spend more on final goods and services because you know a higher income is coming and vice versa.

Changes in Expected Future Disposable Income Cont. (Theory of Consumption Function).

• People with high current income save a larger fraction of their income than those with low current income.

• There are systematic differences between current and expected future income that create a positive relationship between current income and savings rate.

• When the economy grows, current and expected future incomes rise together.

• Higher current incomes tend to lead to higher savings today, but higher expected future income tends to lead to lower savings today.

• Permanent income hypothesis-The economic theory that individuals and families base consumption expenditures on their normal, or permanent, income rather than current income. for example, a bonus, will have little impact on consumer spending.

Interest Rate

Level of planned investment spending.

- A higher interest rate leads to a lower level of planned investment spending.

Interest Rate

Level of planned investment spending

- If Interest rates fall then Investment spending will go up

Interest Rate vs. Investment Spending

Interest Rate and Investment Spending

• Planned Investment Spending- is the investment spending that firms undertake during a given period.

• The effects of Interest rates can be seen clearly on one specific for of investment spending which is the spending on homes.

• Firms will usually only go ahead with some spending projects only if they expect a rate of return higher then what the cost of the founds they need to borrow to finance the project. If interest rates go up then less projects will be started by firms.

Expected Future Real GDP, Production Capacity, and Investment Spending

• Some firms have enough capacity to produce the amount it is capable of selling but doesn’t expect their sales to increase in the future. These firms will engage in investment spending just to replace their equipment that may be to old or damaged to last any longer.

• If a firm expects their sales to increase then they will undertake investment spending to increase its current production capacity.

• Firms will undertake more investment spending when they expect their sales to grow.

What is an indicator of high expected growth in future sales?

• A high expected future growth rate of real GDP can indicate a high expected growth in future sales.

• A higher expected growth rate of real GDP results in a higher level of investment spending

• A lower expected growth rate of real GDP leads to lower investment spending.

Inventories and Unplanned Investment Spending

• Inventories- Stocks of good held to satisfy future spending. Firms hold inventories so they can quickly satisfy buyers.

• At the end of 2009, the overall value of inventories in the U.S. economy was estimated at $1.9 trillion, more than 13% of GDP.

Inventories and Unplanned Investment Spending (cont.)

• Inventory Investment is the value of the change in total inventories held in the economy during a given period. Unlike other forms of investment spending, inventory investment can actually be negative. If an industry reduces its inventory then it has engaged in negative inventory investment.

• When a firms inventories are higher than intended due to an unforeseen decrease in sales which results in unplanned inventory investment.

Cont.

• An unexpected increase in sales depletes inventories and causes the value of unplanned inventory investment to be negative.

The End