UNIT 3: Consumption and Savings

                                                             Consumption and savings

Disposable income (DI)

•     Income after taxes or net income
•        DI = Gross Income - Taxes

                                  2 choices

With disposable income, households can either

-          Consume (spend money on goods and services)

-          Save (not spend money on goods and services)

                                Consumption

-          House hold spending

-          The ability to consumme 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 househols save if DI =0?

-          No

                                   APC and APS

·         APC + APS = 1

·         1 – APC = APS

·         1 – APS = APC

·         APC > 1 : Dissaving

·         - APS : Dissaving

                            Marginal Propensity to consume (MPC)

·         The fraction of any change in disposable income that is consumed.

·         MPC = change in consumption divided by change in disposable income

                             Marginal propensity to save (MPS)

·         The fraction of any change in disposable income that is saved.

·         MPS = change in savings divided by change in disposable income.

                                Marginal Propensities

MPC + MPS = 1

MPC = 1 – MPS

MPS = 1 – MPC

·         Remember, people do two things with their disposable income. They consume it or save it.

                                           The spending multiplier effects

·         An initial change in spending  (C, IG, G, Xn) Causes a larger change in Aggregate Spending (AS), or Aggregate Demand (AD).

·         Multiplier = change in AD divided by change in spending.

                                        Calculating the spending multiplier

·         The spending multiplier can be calculated the MPC or the MPS

·         Multiplier = 1 divided by 1-MPC or 1 divided by MPS

·         Multipliers are (+) when there is an increase in spending and (-) when there is 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: its negative)

·         -MPC divided by 1-MPC or –MPC divided by MPS

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