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27

>> Income and Expenditure
Krugman/Wells

©2009 Worth Publishers

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WHAT YOU WILL LEARN IN THIS CHAPTER

The nature of the multiplier, which shows how initial changes in spending lead to further changes. The meaning of the aggregate consumption function, which shows how disposable income affects consumer spending How expected future income and aggregate wealthaffect consumer spending The determinants of investment spending, and the distinction between planned investment and unplanned inventory investment

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WHAT YOU WILL LEARN IN THIS CHAPTER

How the inventory adjustment process moves the economy to a new equilibrium after a change in demand Why investment spending is considered a leading indicator of the future state of the economy

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The Multiplier: An Informal Introduction

The marginal propensity to consume, or MPC, is the increase in consumer spending when disposable income rises by $1. The marginal propensity to save, or MPS, is the increase in household savings when disposable income rises by $1.

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The Multiplier: An Informal Introduction

Increase in investment spending = $100 billion +Second-round increase in consumer spending = MPC × $100 billion + Third-round increase in consumer spending = MPC2 × $100 billion + Fourth-round increase in consumer spending = MPC3 × $100 billion ••••••••••••

Total increase in real GDP = (1 + MPC + MPC2 + MPC3 + . . .) × $100 billion
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The Multiplier: An Informal Introduction

So the $100 billion increase in investment spending setsoff a chain reaction in the economy. The net result of this chain reaction is that a $100 billion increase in investment spending leads to a change in real GDP that is a multiple of the size of that initial change in spending. How large is this multiple?

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The Multiplier: Numerical Example

Rounds of Increases of Real GDP When MPC = 0.6

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The Multiplier: NumericalExample

In the end, real GDP rises by $250 billion as a consequence of the initial $100 billion rise in investment spending: 1/(1 − 0.6) × $100 billion = 2.5 × $100 billion = $250 billion

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The Multiplier: An Informal Introduction

An autonomous change in aggregate spending is an initial change in the desired level of spending by firms, households, or government at a given level ofreal GDP.

The multiplier is the ratio of the total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change.

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►ECONOMICS IN ACTION

The Multiplier and the Great Depression

The concept of the multiplier was originally devised by economists trying to understand the Great Depression. Most economists believe that the slump from1929 to 1933 was driven by a collapse in investment spending. But as the economy shrank, consumer spending also fell sharply, multiplying the effect on real GDP. In 1929, government in the United States was very small by modern standards: taxes were low and major government programs like Social Security and Medicare had not yet come into being. In the modern U.S. economy, taxes are much higher,and so is government spending. Why does this matter? Because taxes and some government programs act as automatic stabilizers, reducing the size of the multiplier.
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Consumer Spending

The consumption function is an equation showing how an individual household’s consumer spending varies with the household’s current disposable income.

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Disposable Income and ConsumerSpending

Consumer spending

$100,000

80,000

60,000

40,000

20,000

0

$50,000

100,000

150,000

Current disposable income
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The Consumption Function

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The Consumption Function

Deriving the Slope of the Consumption Function

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The Consumption Function

For American households in 2006, the best estimate of the average household’s...
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