Unit 3 Notes - February 25th, 2016

Consumption & Saving

Disposable Income (DI)

·         Income after taxes // Net Income

·         DI = Gross Income – Taxes (DI = GI – T)

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:

o   The amount of disposable income

o   The propensity to save

·         Do households consume if DI = 0? Yes.

o   Autonomous Consumption

o   Dissaving

Saving:

·         Households not spending

·         The ability to save is constrained by:

o   The amount of disposable income

o   The propensity to consume

·         Do households save if DI = 0?  No. It’s not an option.

Average Propensity to Consume (APC) and Average Propensity to Save (APS)

·         APC + APS = 1

·         1 – APC = APS

·         1 – APS = APC

·         APC > 1 = Dissaving

·         -APS = Dissaving

Marginal Propensities

Marginal Propensity to Consume (MPC): Fraction of any change in disposable income that is consumed.

MPC = Change in Consumption / Change in Disposable Income

MPC = ▲C / ▲DI

Marginal Propensity to Save (MPS): Fraction of any change in disposable income that is saved.

MPS = Change in Savings / Change in Disposable Income

MPS = ▲S / ▲DI

MPC + MPS = 1

MPC = 1 – MPS

MPS = 1 – MPC

People who do things with DI consume it or save it.

Multipliers

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 / Change in Spending

Multiplier = ▲AD / ▲C, IG, G, or Xn

Calculating the Spending Multiplier:

Spending Multiplier = 1 / 1 – MPC or 1 / MPS

Multipliers are positive when there is an increase in spending and negative when there is a decrease in spending.

Calculating the Taxing Multiplier:

Tax Multiplier (Negative) = -MPC / 1 – MPC or –MPC / MPS

When the government taxes, the multiplier works in reverse because the money is now leaving the circular flow.

If there is a tax cut, then the multiplier is positive because there is now more money in the circular flow.