The MPC and MPS

  • Intro

    • When investment spending increases, there will be an increase in the income and the value of aggregate output by the same amount

    • An increase in aggregate output leads to an increase in disposable income and to more consumer spending, which leads to increased output

    • How large is the total effect on aggregate output if we sum up all the rounds of spending increases

    • It depends on what economists called the marginal propensity to consume (MPC) or the marginal propensity to save (MPS)

    • MPS=Change in savingsChange in income \text{MPS} = \dfrac{\text{Change in savings}}{\text{Change in income}}

    • MPC=Change in consumptionChange in income \text{MPC} = \dfrac{\text{Change in consumption}}{\text{Change in income}}

    • MPC + MPS = 1

  • The marginal Propensity to Consume

    • The MPC is a number between 0 and 1

    • If consumers save all their money, the number would be 0

    • If consumers spend all their money, the number would be 1

    • Usually, the number is between 0 and 1 with industrialized countries having a higher number and developing countries with lower numbers

    • If the MPC is 0.8, what's the impact on the total aggregate spending if there's an increase of 50 million in spending?

      • Total Increase = Spending Multiplier * Initial Increase = 1/(1-0.8) * 50 = 250

The Multiplier Effect


  • 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
  • Multiplier

    • ratio of the total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change

    Spending Multiplier 1 OR MPS 1 1 - MPC

  • The size of the multiplier depends on the MPC

    • The higher the MPC, the more disposable income get recycled back into consumer spending

    • The lower the MPC, the more disposable income "leak out" into savings

Consumption Function

  • Consumption function is an equation showing how an individual household's consumer spending changes with disposable income

  • Autonomous consumer spending would be the amount spent regardless of income


    Machine generated alternative text: c = a + MPC

  • Let's assume that a equals $20,000 and the MPC equals 0.6. What would the consumption be if the income is $100,000? $200,000?

    • c = a + MPC * yd = 20,000 + 0.6 * 100,000 = 80,000

    • c = a + MPC * yd = 20,000 + 0.6 * 200,000 = 140,000

  • Graph

    Household consumer spending, c Slope = MPC Ayd a Consumption
function, cf c=a+ MPC Ac = MPC x Ayd Household current disposable
income, Yd

Shift of the Aggregate Consumption Function

(a) An Upward Shift of the Aggregate Consumption Function Consumer
  spending, C Aggregate consumption function, CF2 Aggregate consumption
  function, CFI Disposable income, YD

(b) A Downward Shift of the Aggregate Consumption Function Consumer
  spending, C Aggregate consumption function, CFI Aggregate consumption
  function, CF2 Disposable income, YD

  • Changes in Expected Future Disposable Income

    • If you land a higher-paying job, you will tend to consume more money now even though your current income is the same

    • Conversely, if you are worried about a job layoff, you will probably decrease your current expense.

  • Changes in Aggregate Wealth

    • A booming stock market will tend to increase an individual's wealth, and therefore, his consumption

    • A fall in housing prices, conversely, will tend to decrease an individual's net worth, and therefore her consumption

Investment Spending

  • Planned investment spending is the investment spending that businesses intend to undertake during a given time period

  • If interest rates goes up, less investment spending occurs.

  • If interest rates go down, there is more investment spending

  • High expected future growth rate of GDP increases investment

  • Low expected future growth rate decreases investment

  • I = IUnplanned + IPlanned

  • Positive unplanned inventory investment occurs when sales are less than business expects. Excess sales leads to negative unplanned inventory investment

  • Rising inventory indicates slowing economy

Tax (or Government Transfer) Multiplier

  • Changes in taxes (or increase in transfer payment) shifts the aggregate demand curve by less than an equal-sized change in government purchases

  • The presence of taxed decrease the multiplier


Automatic Stabilizers

  • Government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands

  • As the economy expands, the multiplier reduces because the increase in income is siphoned off

  • As the economy contracts, the multiplier increase because the government is collecting less in taxes (a de facto expansionary policy in the face of a recession)

    4 2 -2 \_4 -8 -10 1965 With Automatic Stabilizers 1975 Without
Automatic Stabilizers 1985 1995 2005 Historical 2015 2025

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