Macro 3: Consumption, Saving, Investment, and the Multiplier

Disposable income (DI)

The income a consumer has left over to spend or save once he or she has paid out net taxes. DI = Y - T.

Consumption and saving schedules

Tables that show the direct relationships between disposable income and consumption and saving. As DI increases for a typical household, C and S both increase.

Consumption function

A linear relationship showing how increases in disposable income cause increases in consumption.

Autonomous consumption

The amount of consumption that occurs no matter the level of disposable income. In a linear consumption function, this shows up as a constant and graphically it appears as the y intercept.

Saving function

A linear relationship showing how increases in disposable income cause increases in saving.

Dissaving

Another way of saying that saving is less than zero. This can occur at low levels of disposable income when the consumer must liquidate assets or borrow to maintain consumption.

Autonomous saving

The amount of saving that occurs no matter the level of disposable income. In a linear saving function, this shows up as a constant and graphically it appears as the y intercept.

Marginal Propensity to Consume (MPC)

The change in consumption caused by a change in disposable income, or the slope of the consumption function: MPC = ΔC/ΔDI.

Marginal propensity to save (MPS)

The change in saving caused by a change in disposable income, or the slope of the saving function: MPS = ΔS/ΔDI.

Determinants of consumption and saving

Factors that shift the consumption and saving functions in the opposite direction are wealth, expectations, and household debt. The factors that change consumption and saving functions in the same direction are taxes and transfers.

Expected real rate of return (r)

The rate of real profit the firm anticipates receiving on investment expenditures. This is the marginal benefit of an investment project.

Real rate of interest (i)

The cost of borrowing to fund an investment. This can be thought of as the marginal cost of an investment project.

Decision to invest

A firm invests in projects as long as r ≥ i.

Investment demand

The inverse relationship between the real interest rate and the cumulative dollars invested. Like any demand curve, this is drawn with a negative slope.

Autonomous investment

The level of investment determined by investment demand. It is autonomous because it is assumed to be constant at all levels of GDP.

Market for loanable funds

The market for dollars that are available to be borrowed for investment projects. Equilibrium in this market is determined at the real interest rate where the dollars saved (supply) is equal to the dollars borrowed (demand).

Demand for loanable funds

The negative relationship between the real interest rate and the dollars invested and borrowed by firms and by the government.

Private saving

Saving conducted by households and equal to the difference between disposable income and consumption.

Supply of loanable funds

The positive relationship between the dollars saved and the real interest rate.

Multiplier effect

Describes how a change in any component of aggregate expenditures creates a larger change in GDP.

Spending multiplier

The magnitude of the spending multiplier effect is calculated as = (ΔGDP)/(Δ spending) = 1/MPS = 1/(1 - MPC).

Tax multiplier

The magnitude of the effect that a change in taxes has on real GDP. Tm = (ΔGDP)/(Δ taxes) = MPC × Multiplier = MPC/MPS

Balanced-budget multiplier

When a change in government spending is offset by a change in lump-sum taxes, real GDP changes by the amount of the change in G; the balanced-budget multiplier is thus equal to 1.