Chapter 8 - Consumption, Saving, Investment, and the Multiplier

Disposable income (DI)

The income a consumer has left over to spend or save once they have paid out net taxes

Net taxes

Taxes paid - Transfers received

Consumption and saving schedules

Tables that show the direct relationships between disposable income and consumption and saving

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

Dissaving

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

Saving function

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

Autonomous saving

The amount of saving that occurs no matter the level of disposable income

Marginal propensity to consume (MPC)

The change in consumption caused by a change in disposable income, or the slope of the consumption function

Marginal propensity to save (MPS)

The change in saving caused by a change in disposable income, or the slope of the saving function

what causes a change in disposable income

causes a movement along the consumption and savings functions.

Determinants of consumption and saving

Factors that shift the consumption and saving functions in the opposite direction

• wealth

• expectations

• household debt

Wealth

When the value of accumulated wealth increases, consumption functions shift upward, and the saving function shifts downward, because households can sell stock or other assets to consume more goods at their current level of disposable income

Expectations

Uncertainty or a low expectation about future income usually prompts a household to decrease consumption and increase saving. An expectation of a higher future price level spurs higher consumption right now and less saving.

Household debt

Households can increase consumption with borrowing, or debt. However, as households accumulate more and more debt, they need to use more and more disposable income to pay off the debt and thus **decrease consumption**.

Taxes and transfers

• If the government increases taxes, households see both consumption and saving decrease

• an increase in government transfer payments increases both consumption and saving functions.

upward shift in consumption

at all levels of disposable income, consumption is greater

* If consumption is greater at all levels of disposable income, saving must be lower and vice versa.

in tax and transfers, when the consumption function shifts upward, the saving function shifts downward.

the saving function shifts downward.

in tax and transfers, when the consumption function shifts downward

the saving function shifts upward.

when taxes increase or transfers decrease

both consumption and saving functions shift downward.

when taxes decrease or transfers increase

both consumption and saving functions shift upward.

Decision to invest

This decision is based on marginal benefits and marginal costs. A firm invests in projects as long as r ≥ i.

The marginal cost of the investment

The real rate of interest (i), or the cost of borrowing

Expected real rate of return (r)

The rate of real profit the firm anticipates receiving on investment expenditures

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.

Investment demand

The inverse relationship between the real interest rate and the cumulative dollars invested

Investment demand curve

Shows the inverse relationship between the interest rate and the cumulative dollars invested

Autonomous investment

The level of investment determined by investment demand. It is constant at all levels of GDP

Market for loanable funds

The market for dollars that are available to be borrowed for investment projects

Demand for loanable funds

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

Supply of loanable funds

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

Private saving

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

supply of loanable funds source

saving and lending

demand of loanable funds source

investment and borrowing

Multiplier effect

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

spending multiplier

Tax multiplier

The magnitude of the effect that a change in taxes has on real GDP

why is the mpc bigger than the tax multiplier

The spending multiplier begins to work as soon as there is a change in autonomous spendin, but the tax multiplier must first go through a person’s consumption function as disposable income.

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