Disposable Income and Comsumption

1/25/16

Disposable Income (DI)

Income after taxes or net income

DI= Gross Income - Taxes

Savings and Consumption

2 choices

Households can either

1. Consume (spend money on goods and services)

OR

2. Save (not spend money on goods and services)

Consumption

Household spending

Ability to consume is constrained by the amount of disposable income and the propensity to save

Do households consume if DI=0?

Possibly Autonomous Consumption(monthly bills auto pulled from bank) or Dissaving

Saving

Household is Not Spending

Ability to save is constrained by the amount of disposable income and the propensity to consume

Do households save if DI=0? No

APC

Average Propensity to Consume

APS

Average Pro

APC+APS=1

1-APC=APS

1-APS=APC

If APC>1 you have entered a period of Dissaving

-APS= Period of Dissaving

Marginal Propensity to Consume (MPC) - The fraction of any change in disposable income that is consumed.

Marginal Propensity to Consume=Changing in Consumption/Change in Disposable Income

MPC= Delta C/Delta DI

Marginal Propensity to Save (MPS) - The fraction of any changes in disposable income that is saved.

MPS=Change in Savings/Change in Disposable Income

MPS=Delta S/Delta DI

MPC+MPS=1

MPC=1-MPS

MPS=1-MPC

*Consume or save is the only things optional with disposable income

Spending Multiplier -  the initial change in spending (comes from C, Ig, G, or Xn) causes a larger change in aggregate Demand (AD)

Multiplier =  Change in AD/ Change in Spending(C, Ig, G, or Xn)

Multiplier= Delta AD/ Delta C, Ig, G, or Xn

The Spending Multiplier can be calculated from the MPC or the MPS.

Multiplier = 1/1-MPC or 1/MPS

Multipliers are + when there is an increase in spending and - when there is a decrease

Tax Multiplier - when the government taxes, the multiplier works in reverse ( money leaves the circular flow model)

Always Negative

-MPC=1-MPC

or

-MPC/MPS

If there is a tax-CUT, then the multiplier is +, because there is now more money in the circular flow

Ex. Assume U.S. citizens spend 90¢ for every extra $1 they earn. Further assume that the real interest rate (r%) decreases, causing a $50 billion increase in gross private investment. Calculate the effect of a $50 billion increase in IG on U.S. Aggregate Demand (AD) or AE.

–Step 1: Calculate the MPC and MPS

•MPC = ΔC/ΔDI =  .9/1 = .9

•MPS = 1 – MPC = .10

–Step 2: Determine which multiplier to use, and whether it’s + or -

•The problem mentions an increase in Δ IG .: use a (+) spending multiplier

–Step 3: Calculate the Spending and/or Tax Multiplier

•1/MPS = 1/.10 = 10

–Step 4: Calculate the Change in AD/AE

•(Δ C, IG, G, or XN) * Spending Multiplier

•($50 billion Δ IG) * (10) = $500 billion ΔAD/AE