Unit 3 - Consumption & Saving, Spending & Tax Multiplier (2-25-16)

Disposable Income (DI): income after taxes or net income. (DI = Gross Income - Taxes)

2 Choices:
With disposable income, households can either:

1. Consume (spend $ on goods & services)
2. Save (not spend $ on goods & services)

Consumption

• Household spending

Ability to consume is constrained by: 

• The amount of disposable income
• The propensity to save

Do households consume if DI = 0?

• Autonomous consumption
• Dissaving

Saving

• Household NOT spending

The ability to save is constrained by:

• The amount of disposable income
• The propensity to consume

Do households save if DI = 0?

• NO

APC & APS

Average Propensity to Consume

Average Propensity to Save

• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 = DISSAVING
• -APS = DISSAVING

Marginal Propensity to Consume (MPC)

• Fraction of any change in disposable income that is consumed
• MPC = (Δ in Consumption / Δ in Disposable Income)

Marginal Propensity to Save (MPS)

• Fraction of any change in disposable income saved
• MPS = (Δ in Savings / Δ in Disposable Income)

MPC + MPS = 1

MPC = 1 - MPS

MPS = 1 - MPC

Spending Muliplier Effect

An initial change in spending (C, Ig, G, Xn) causes a larger change in aggregate spending or aggregate demand.

• Multiplier = (Δ in AD / Δ in spending (C, Ig, G, or Xn)

Calculating the Spending Multiplier

• Multiplier = (1 / 1 - MPC) or (1 / MPS)
• Multipliers are postive(+) when there is an increase in spending and negative(-) when there's a decrease

Calculating the Tax Multiplier

When the government taxes, the multiplier works in reverse.

WHY?

• Because now money is leaving the circular flow

Tax Multiplier (note: It's NEGATIVE)

• (-MPC / 1 - MPC) or (-MPC /  MPS)
• If there's a tax cut, then multiplier is positive(+), because there's more money in the circular flow