The Multiplier: An Informational IntroductionMarginal propensity to consume (MPC) – the increase in consumer spending when disposable income rises by $1When consumer spending alters due to an increase or decline in disposable income, MPS is the change in the consumer spending divided by the change in disposable income ? MPC = ? Consumer spending / ? Disposable income Consumers usually spend only a part but not the entire amount of an additional dollar of disposable income; therefore, MPC is between 0 and 1 all the timeThe additional disposable income that consumer don’t spend is savedMarginal propensity to save (MPS) – the fraction of an additional dollar of disposable income that is savedMPS = 1 – MPCAssuming no international trade or taxes are in effect, each $1 increase in spending raises disposable income AND GDP by $1.Total increase in RGDP from $100 billion rise in I (investment spending) = 1/(1 – MPC) X $100 billionAutonomous change in aggregate spending – an initial increase or decrease in aggregate spending that is the cause of a series of income and spending changes (not result)Multiplier – the ratio of the total change in real GDPThis is caused by an autonomous change in aggregate spending to the size of that autonomous change?AAS = autonomous change in aggregate spending?Y = the total change in real GDPMultiplier is equal to ?Y/?AASTotal change in real GDP/ Autonomous change in aggregate spendingTotal change in real GDP is due to an autonomous change in aggregate spending: ?Y = 1/(1 – MPC) × ?AASIII. Multiplier = ?Y/?AAS = 1/(1-MPC)Size of the multiplier depends on Marginal Propensity to Consume (MPC) If the MPC is high, then the multiplier is as wellTrue because size of the MPC determines how large each round of expansion is compared with the previous roundHigher MPC = less disposable income leaking out into saving at each expansion roundConsumer spendingCurrent Disposable Income and Consumer SpendingIV. Consumption Function – an equation displaying how an individual household’s consumer spending habits/routines with their current disposable incomeC = a + MPC X ydYd is individual household current disposable income.MPC is the marginal propensity to consume, the amount by which consumer spending rises if current disposable income rises by $1.A is a constant term – individual household autonomous consumer spending, the amount a household would spend if it had no disposable income.MPC is expressed as the ratio of change in consumer spending to the change in current disposable income. Rewritten as:MPC = ?c/?ydMultiplying both sides of the equation by ?yd: MPC X ?yd = ?cWhen yd goes up by $1, c goes up by MPC X $1Slope of consumption function = rise over run = ?c/yd = MPCii. The aggregate consumption function is the relationship for the economy as a whole between aggregate current disposable income and aggregate consumer spending.C = A + MPC X ydC is aggregate consumer spending (consumer spending)Yd is aggregate current disposable income (disposable income)A is aggregate autonomous consumer spending, the amount of consumer spending when yd equals zero.Shifts of the Aggregate Consumption Functioni. Two principal causes of shifts of the aggregate consumption function: changes in expected future disposable income and changes in aggregate wealth.Changes in Expected Future Disposable IncomeConsumer spending ultimately depends mainly on the income people expect to have over the long term rather than on their current income: permanent income hypothesis.Changes in Aggregate WealthAccording to the life-cycle hypothesis, consumers plan their spending over their lifetime, not just in response to their current disposable income.Investment SpendingPlanned investment spending is the investment spending that businesses intend to undertake during a given period.i. The level of investment spending businesses actually carry out is sometimes not the same level as was planned.ii. Planned investment spending depends on three principal factors: the interest rate, the expected future level of real GDP, and the current level of production capacity.The Interest Rate and Investment Spendingi. Past profits used to finance investment spending are called retained earnings.ii. Weather a firm borrows money or uses retained earnings to fund an investment spending project is the same because it must take into account the opportunity cost of its funds.iii. Planned investment spending – spending on investment projects that firms voluntarily decide whether or not to undertake – is negatively related to the interest rate.Higher interest rates lead to lower level of planned investment spending.Expected Future Real GDP, Production Capacity, and Investment Spendingi. Firms will undertake more investment spending when they expect their sales to grow.ii. The higher the current capacity, the lower the investment spending.iii. Combine 1) growth in expected future sales and 2) the size of current production capacity, we can see one situation in which firms will most likely undertake high levels of investment spending: when they expect sales to grow rapidlyiv. A high expected future growth rate of real GDP is an indicator of high expected growth in future sales.Inventories and Unplanned Investment Spendingi. Inventories are stocks of goods held to satisfy future sales.ii. Inventory investment is the value of the change in total inventories held in the economy during a given period.Unlike other forms of investment spending, inventory investment can actually be negative.iii. Because firms cannot always accurately predict sales, they often find themselves holding larger or smaller inventories than they had intended.Positive unplanned inventory investment occurs when actual sales are less than businesses expected, leading to unplanned increases in inventories. Sales in excess of expectations result in negative unplanned inventory investment.Actual investment spending is the sum of planned investment spending and unplanned inventory investment.