ECO100Y5 Chapter Notes - Chapter 11: Consumption Function, Keynesian Cross, Inventory Investment

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8 Feb 2016
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Chapter 11 – Income and Expenditure
 The Multiplier: An Informal Introduction
A change in investment spending arising from a change in
expectations starts a chain reaction in which the initial change in
real GDP leads to changes in consumer spending, leading to
further changes in real GDP, and so on. The total change in
aggregate output is a multiple of the initial change in investment
spending.
Any autonomous change in aggregate expenditure, a
change in spending that is not caused by a change in real GDP,
generates the same chain reaction. The total size of the change
in real GDP depends on the size of the multiplier. Assuming that
there are no taxes and no trade, the multiplier is equal to 1/(1-
MPC), where MPC is the marginal propensity to consume.
The total change in real GDP, ΔY, is equal to 1/(1-MPC) x ΔAE0.
oThe marginal propensity to consumer, or MPC, is the
increase in consumer spending when disposable income
rises by $1. MPC is a positive fraction less than 1, ie., 0 <
MPC < 1.
oMPC=(Δ consumer spending / Δ disposable income)
oExpenditure multiplier ratio: Total change in real GDP due
to an autonomous change in aggregate spending AND the
size of autonomous change in aggregate spending
 Consumer Spending
Slope of consumption function is equal to marginal propensity to
consume
The individual consumption function shows the relationship
between an individual household’ current disposable income and
its consumer spending
oc = ac + MPC x yd
oc – individual household consumer spending, yd
individual household disposable income, ac – autonomous
consumer spending
The aggregate consumption function shows the relationship
between disposable income and consumer spending across the
economy. It can shift due to changes in expected future
disposable income and changes in aggregate wealth.
oC = AC + MPC x YD
 Investment Spending
Planned investment spending is negatively related to the
interest rate and positively related to the expected future real
GDP. According to the accelerator principle, there is a positive
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