Mr. RedelsheimerAP Economics

CONSUMPTION AND SAVING

APC Consumption / Income

APS Saving / Income

MPS Change in Saving Change in Income

MPC Change in Consumption Change in Income

Co

nsu

mp

tio

n

o45

o

C

Consumptionschedule

C

Disposable Income

SAVING

DISSAVING

MPC = Slope of C

MPC + MPS = 1

CONSUMPTION AND SAVING

.80 .85 .90 .95 1.0

United States

Canada

United Kingdom

Netherlands

Germany

Italy

Japan

France

GLOBAL PERSPECTIVEAverage Propensities to Consume,Selected Nations, 2000

Statistical Abstract of the United States, 2002

Changein GDP =Multiplier x initial change

in spending

THE MULTIPLIER EFFECT

Multiplier =Change in Real GDP

Initial Change in Spending

For Example…

THE MULTIPLIER EFFECT

Increase in Investment of $5

Second Round

Third Round

Fourth Round

Fifth Round

All Other Rounds

Total

(1)Change in

Income

(2)Change in

Consumption(MPC = .75)

(3)Change in

Saving(MPS = .25)

$ 5.00

3.75

2.81

2.11

1.58

4.75

$ 3.75

2.81

2.11

1.58

1.19

3.56

$ 1.25

.94

.70

.53

.39

1.19

$20.00 $15.00 $ 5.00

LLet’s et’s GGo o TTo o Padre Island Padre Island and and Party Party With TheWith The Multiplier Multiplier

• During spring break, college students like to head to Padre IslandPadre Island. The “multiplier”“multiplier” is getting ready to work.

• With dollars in their pockets, the students spend money on food and drink, motel rooms, dance clubs, etc. These dollars raise total income there by some multiple of itselfmultiple of itself.

• College students buy pizzas, beer, and sodas. The people who sell these items find their incomes rising. They spend some fraction of their increased income, which generates additional incomegenerates additional income for for othersothers.

• If the students spend $8 million$8 million at Padre and the MPC is .60, then college students will increase income in Padre by $20 $20 millionmillion.

• When the networks show scenes on the beach, the average person simply sees college students having a good time.

• But – economists see the multiplier at workmultiplier at work, generating higher levels of income for many of the residents of Padre Island.

Change inGDP = Multiplier x initial change

in spending

Multiplier = or 1

MPS

1

1 - MPC

THE MULTIPLIER EFFECT

Inverse relationship between: Multiplier & MPS

Multiplier Effect and the Marginal Propensities

$1,000.00$1,000.00 500.00500.00 250.00250.00 125.00125.00 62.5062.50 31.2531.25 15.62515.625 7.81257.8125 3.906253.90625 1.9531251.953125 .9765625.9765625 .48828125.48828125 .244140625.244140625 .1220703125.1220703125 .06103515625.06103515625 .030517578125.030517578125 .015258789062.015258789062

$2,000,000,000$2,000,000,000

Step by Step Working of “Multiplier” [MPC is .5]Step by Step Working of “Multiplier” [MPC is .5]

[[Increased by aIncreased by a multiple multiple of of 2]2]

““What A Girl What A Girl Wants.”Wants.”

GovernmentGovernment increases spending increases spending byby $1 billion$1 billion with a with a multipliermultiplier of of 22

On new highwaysOn new highwaysHighway workers buy new boatsHighway workers buy new boatsBoat builders buy plasma TVsBoat builders buy plasma TVsTV factory workers buy new carsTV factory workers buy new carsAuto workers buy clothesAuto workers buy clothesApparel workers spend $ on moviesApparel workers spend $ on moviesMovie Movie moguls spend money onmoguls spend money on Christina Christina Agulera songs.Agulera songs.

The First Round of GovernmentThe First Round of Government

Spending Causes The Biggest Splash Spending Causes The Biggest Splash MPC of 75%MPC of 75%G spends $G spends $200200 billion on the billion on the highwayshighways..

Highway workers save 25% of $200 Highway workers save 25% of $200 billion billion [$50 [$50 billion] & spend 75% or $150 billion on boats. billion] & spend 75% or $150 billion on boats.

Boat makers save 25% of $150 Boat makers save 25% of $150 bil.bil. [$37.50 bil.] [$37.50 bil.] & & spend 75% or $112.50 bil. on iPod Minis, etc.spend 75% or $112.50 bil. on iPod Minis, etc.

MPC MPC 1/MPS 1/MPS = = M M.90.90 1/.101/.10 = = 1010.80.80 1/.201/.20 = 5= 5.75.75 1/.251/.25 = 4= 4.60.60 1/.401/.40 = 2.5= 2.5.50.50 1/.501/.50 = 2= 2

MME [ChangeE [Change in in G, Ig,G, Ig, or or Xn] = Xn] = 1/MPS1/MPS

MMTT

44

33

1.51.5

11

99

The The 2000 Olympics2000 Olympics resulted in resulted in $3 1/2 billion$3 1/2 billion to Australia’s economy over a year’s time.to Australia’s economy over a year’s time.Super BowlSuper Bowl brought brought $166 million$166 million to Houston. to Houston.Fiesta BowlFiesta Bowl for national title brought in for national title brought in $85 million$85 million..

OUOU

MMTT = MPC/MPS= MPC/MPSMMEE = 1/MPS = 1/MPS

MPCMPC MMEE

.9.9 1010

.8.8 55

.75.75 44

.60.60 2.52.5

.5.5 22

The larger the MPClarger the MPC, the smaller the MPSsmaller the MPS, and the greater the multipliergreater the multiplier. This is the “simple multiplier”“simple multiplier”because it is based on a “simple model “simple model of theof the economy” economy”.

NNotice the otice the 22ndnd round round

with with .9.9 versusversus .5.5

THE MULTIPLIER EFFECT

.9

.8

.75

.67

.5

10

5

4

3

2

MPC Multiplier

MPC and the Multiplier

Investment (billions of dollars)

inte

res

t ra

te, i

(pe

rce

nt)

16

14

12

10

8

6

4

2

0

INVESTMENTDEMAND

CURVE

5 10 15 20 25 30 35 40

I D

Interest Rate – InvestmentRelationship

Should A NewShould A New Drill PressDrill Press Be Purchased?Be Purchased?

Positive profit expectationsPositive profit expectations and the real interest ratereal interest rate are the most important determinants of investment.

Drill Press - $1,000Drill Press - $1,000A. Expected gross profits Expected gross profits = $1,100$1,100 or a 10% return10% return. [$100/$1,000 x 100 = 10%] [At 88%%, investinvest; at 1212%%, don’t investdon’t invest]

B. Real interest rateReal interest rate [nominal interest rate-inflation]

Single FirmSingle Firm

Investment (billions)

Exp

ecte

d r

ate

of

retu

rn,

r,

an

d in

tere

st

rate

, i

(perc

en

ts)

16

14

12

10

88%%

6

44%%

2

05 10 15 2020 25 3030 35 40 QIDQID QIDQID

CChange in hange in Quantity Quantity of of Investment Demanded [QID]Investment Demanded [QID](Interest rate change, point to point movement)(Interest rate change, point to point movement)

DI Firms will undertake all investments[additions to plant, [additions to plant, equipment, inventory,equipment, inventory,and residential construction]and residential construction] which have an expected rate of net profit greater than [or equal to] the real rate of interest.

Monetary PolicyMonetary Policy – by loweringinterest rates, the Fed can increase Ig & employment.

[[IInnvveerrssee r relationship elationship bbetweenetween real interest r real interest rateate and and QID]QID]

GLOBAL PERSPECTIVEGross Investment Expenditures as a Percentage of GDP, Selected Nations

30%

20%

10%

0%GermanyFranceUnited

StatesCanadaMexico United

KingdomSwedenJapanSouth

Korea

Source: World Bank

NominalNominalInterestInterest

RateRate

RealRealInterestInterest

RateRate

AnticipatedAnticipatedInflationInflation

--

1212%%

55%%77%%

Real Interest RateReal Interest Rate[[Nominal I.R.Nominal I.R. –– inflation rateinflation rate == Real I.R.Real I.R.]]

==

GDP will increase by a “multiple” of GDP will increase by a “multiple” of 44 & & that is why it is called the “multiplier”.that is why it is called the “multiplier”.

The Magical MultiplierThe Magical Multiplier

INVESTMENT DEMAND & SCHEDULEINVESTMENT DEMAND & SCHEDULE

Exp

ecte

d r

ate

of

retu

rn,

r, a

nd

real in

tere

st

rate

, i (p

erc

en

ts)

Investment(billions of dollars)

2020

88

DDII

InvestmentInvestmentDemand CurveDemand Curve

2020

Balanced Budget Multiplier [$20 billion]Balanced Budget Multiplier [$20 billion][[“T” affects AD indirectly thru “C“T” affects AD indirectly thru “C”; ”; “G” affects AD directly“G” affects AD directly]]

GDP = $80

Net Change in GDP = Net Change in GDP = The increase in “T” means we The increase in “T” means we would have consumed $15 and would have consumed $15 and kept $5 in our pockets. kept $5 in our pockets.

The increase in “G” The increase in “G” flows directly into flows directly into the economy.the economy.

MME = 1/MPSE = 1/MPS

MME = 1/.25 = 4E = 1/.25 = 4

So, 4 x $20 = So, 4 x $20 = $80$80

G $20

MT = MPC/MPS=.75/.25=MT = MPC/MPS=.75/.25=33So, 3 x -$20So, 3 x -$20 = = -$60-$60

GDP = -$60

Ca= -$15

Sa= -$5

T $20

$470 billion$470 billion

ASAS

AD1AD1

$490 $490 billionbillion

PLPL

ADAD22

+$20+$20

Balanced Budget Multiplier

Is ALWAYS 1.

MPCMPC andand MPSMPS

VolVolatility of Investmenttility of Investment

R R R R R R R R R R R R R R