L3 Consumption

Income and Spending
AD and Equilibrium
• Total demand (expenditure):
AD C  I  G  NX
• In equilibrium: quantity produced = demand
Y  AD C  I  G  NX
• If not, unplanned inventory (dis)investment
IU Y  AD
• If IU > 0, firms cut back on production until output and
AD are again in equilibrium
• Keynesian Cross!
Consumption Function
• largest component of AD
• Consumption rises with income
C C  cY C 0 0  c 1
• C: consumption, Y: income
• Intercept: consumption when income is zero

• greater than zero; subsistence level of consumption
• Slope: the marginal propensity to consume (MPC)
• the increase in consumption per unit increase in income
Consumption Function (2)
[Insert Figure 9-1 here]

Consumption and Savings
• Income is either spent or saved
S Y  C
• Thus, the savings function:
S Y  C Y  C  cY  C  (1  c)Y
• Saving is an increasing function of income
•marginal propensity to save (MPS), s = 1-c
• Note: by definition, MPC + MPS = 1

Autonomous Spending
• Consumption depends on disposable income,
YD Y  TA  TR
C C  cYD C  c(Y  TR  TA )
AD C  I  G  NX
C  c(Y  TA  TR )  I  G  NX
C  c(TA  TR )  I  G  NX   cY
 A  cY
where A is independent of income, or autonomous!

AD and Autonomous Spending

Equilibrium Income and Output
• Equilibrium occurs where Y=AD
• illustrated by the 45° line  point E
• how the economy reaches equilibrium

• Below Y0
• firms’ inventories decline
• they increase production
• Above Y0
• firms’ inventories increase
• they decrease production
Process continues until reach Y0
Equilibrium Output
• solve for the equilibrium output, Y0, algebraically:
• The equilibrium condition is Y = AD
Y  A  cY
• Thus,
Y  cY  A
Y (1  c )  A
1
Y0  A
(1  c )
Equilibrium Output (2)
• Equilibrium output, a function of the MPC and A
• A change in autonomous spending to a change in output?
• Algebraically,
1
Y  A
(1  c)
• Ex. If the MPC = 0.9, then 1/(1-c) = 10
• an increase in government spending by $1 billion results in an
increase in output by $10 billion
• Recipients of increased government spending increase their

own spending, recipients of those spendings increase their
spending and so on
Saving and Investment
• If no government or trade, planned investment equals saving!
• The vertical distance between the AD and consumption = I
• The vertical distance between consumption and the 45° line = S
 at Y0 , S = I, which implies IU = 0
Saving and Investment (2)
• With government and foreign trade in the model,
• Income is either spent, saved, or paid in taxes:
Y C  S  TA  TR
• Complete aggregate demand is
AD C  I  G  NX
• Putting the two together:
C  I  G  NX C  S  TA  TR
I S  (TA  TR  G )  NX
The Multiplier
• a $1 increase in autonomous spending  raises the equilibrium
income more than $1
• Out of an additional dollar in income, $c is consumed
• Output increases by (1+c) to meet this increased expenditure
• process continues
The steps in the process are

shown in Table 9-1.
The Multiplier (2)
• successive rounds of increased spending:
2 3
AD A  cA  c A  c A  ...
2 3
A (1  c  c  c  ...)
• A geometric series that simplifies to (c < 1):
1
AD  A Y0
(1  c )
• Multiplier: amount of change in equilibrium output
when autonomous demand increases by 1 unit
Y 1
 
A (1  c )
Graphical Interpretation
Government Sector
• Government:
1. Government expenditures (component of AD)
2. Taxes and transfers
• Fiscal policy addresses G, TR, and TA

• Assume: G and TR constant
• Assume: a proportional income tax (t)
C C  c(Y  TR  tY )
C  cTR  c(1  t )Y
Government Sector (2)
AD C  I  G  NX
C  cTR  c(1  t )Y   I  G  NX
 A  c(1  t )Y
Y  A  c(1  t )Y
• eq. condition, Y=AD: Y  c(1  t )Y  A
Y 1  c(1  t )  A
A
Y0 
1  c(1  t )
• AD curve flattens and the multiplier reduces to
1
(1  c(1  t ))
Income Taxes as an Automatic Stabilizer
• Automatic stabilizer: mechanisms that automatically
(without case-by-case government intervention)
reduces the amount by which output changes in
response to a change in autonomous demand
• With automatic stabilizers, swings in demand have a
smaller effect on output when are in place
• Example: progressive income tax
• Example: unemployment benefits
• Continue to consume even without a job
Changes in G(1)
• Suppose G increases
• AD shifts upward by that amount
• At the initial level of output, Y0, the demand > output,
• firms increase production until reach new equilibrium (E’)
• Change in equilibrium income

1
Y0  G G G
1  c(1  t )
Changes in G(2)
Changes in G(3)
• Change in income/production
1
Y0  G G G
1  c(1  t )
• If c = 0.80 and t = 0.25, the multiplier is 2.5
• A $1 increase in G ----> increase in income: $2.50

Changes in TR
• Suppose government increases TR
• Autonomous spending rises by only cTR
• Output would increase by G cTR
• The multiplier for transfer payments < that of G
• by a factor of c
• Part of any increase in TR is saved (since considered income)
• Suppose government increases marginal tax rates
• direct effect: AD reduces
• disposable income decreases, and thus consumption falls
• indirect effect: multiplier is smaller
• shock will have a smaller effect on AD
Budget Surplus
• Excess of government’s revenues over its expenditures
BS TA  G  TR
• A negative budget surplus is a budget deficit
• What happens with a budget deficit?

• Budget deficit  Government borrowing
• Government borrowing  difficult for private firms to borrow
• Investment falls  slows economic growth
Budget Surplus in India
Source: RBI
Budget Surplus (3)
• If TA = tY:
BS tY  G  TR
• Deficit at low levels of income
• Surplus at high levels of income
Budget Surplus (4)
• Budget surplus:
BS tY  G  TR
• Budget deficit depends on
• government’s policy choices (G, t, and TR)
• anything that shifts the level of income!
• e.g., If investment rises
 the level of output rises
 budget deficit falls as tax revenues increase
Budget Surplus (5)
• Changes in fiscal policy and budget surplus
• An increase in G reduces the surplus
• Also, increases income, and thus tax revenues
 (Possibly) increased tax collections > increase in G
• Increasing G implies: Y0 G G
• a fraction of which is collected in taxes: tG G

• change in BS: BS TA  G
tG G  G
(1  c )(1  t )
 G
1  c(1  t )

L3 Consumption

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L3 Consumption

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Income and Spending

• Intercept: consumption when income is zero

[Insert Figure 9-1 here]

• Note: by definition, MPC + MPS = 1

where A is independent of income, or autonomous!

[Insert Figure 9-2 here]

• how the economy reaches equilibrium

• Recipients of increased government spending increase their

The steps in the process are

• Fiscal policy addresses G, TR, and TA

• Change in equilibrium income

• If c = 0.80 and t = 0.25, the multiplier is 2.5

• A $1 increase in G ----> increase in income: $2.50

• What happens with a budget deficit?

• Increasing G implies: Y0 G G

• a fraction of which is collected in taxes: tG G

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