Unit 3: 02/25/16

Consumption

Disposable Income (DI)

• Income after taxes on net income  (DI = Gross Income - Taxes)

There are 2 choices:

• with disposable income, households can either...

- consume (spend money on goods and services)

- save (not spend money on goods and services)

Consumption

• household spending 

• the ability to consume is constrained by...

- the amount of disposable income

- the propensity to save 

Do households consume if DI = D? 

Yes!

- Autonomous Consumption

- Dissaving 

Savings 

• households not spending 

- the ability to save is constrained by the amount of disposable income 

- the propensity to consume 

• Do households save if DI = D?

No! 

Averse Propensity and Average Propensity to Save 

• APC + APS = 1

• 1 - APC = APS

• 1 - APS = APC

• APC > 1 : Dissaving

• -APS : Dissaving 

MPC -Marginal Propensity to Consume 

- the fraction of any change in disposable income that is consumed.

MPC = change in consumption divided by change in disposable income

MPS -Marginal Propensity to Save 

- the fraction of any change in disposable income that is saved. 

MPS = change in savings divided by change in disposable income 

Marginal Propensities 

• MPC + MPS = 1

• MPC = 1 - MPS

• MPS = 1 - MPC

- people do two things with their disposable income, (CONSUME IT OR SAVE IT!)

The spending multiplier effect 

- an initial change in spending ( C, Ig, G, Xn) causes a larger change in aggregate spending or aggregate demand (AD)

- multiplier: change in AD divided by change in spending

Calculating the spending multiplier 

- the spending multiplier can be calculated from the MPC or the MPS. Multiplier= 1 divided by 1 - MPC or 1 divided by MPS

- multiplier are (+) when there is an increase in spending and (-) when there is a decrease

Calculating the tax multiplier

- when the government taxes, the multiplier works in reverse. Why??

• because now more is leaving the circular flow...

- tax multiplier (it's negative)

Formula = MPC divided by 1 - MPC or -MPC divided by MPS

• if there is a tax cut then the multiplier is (+), because there is now more money in the circular flow.