Consumption and Saving Unit 3

 February 25, 2016

Disposable Income (DI):

Income after taxes or net income

with DI, households can...

• Consume (spend money)
• Save (not spend money)

Consumption:

• Household Spending 
• the ability to consume is constrained by amount of disposable income and the prosperity to save
• Do households consume if DI=0?   Autonomous consumption

Saving:

• Household is NOT spending
• Ability to save is constrained by amount of DI and propensity to save
• Do households 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)

Fraction of any change in DI that is consumed.

MPC= Change in consumption/ change in DI

Marginal Propensity to Save (MPS)

Fraction of any change in disposable income that is saved

MPS= change in savings/change in DI

MPC+MPS=1

MPC= 1-MPS

MPS= 1-MPC

Spending Multiplier Effect

Initial change in spending (C, G, Xn, Ic) causes a larger change in aggregate spending, or aggregate demand (AD).

Multiplier = Change in AD/ change in spending

Calculating spending multiplier 

Multiplier = 1/ (1-MPC )      or    1/MPS

[+]there is an increase in spending

[-]  when there is a decrease

• When the government taxes, the multiplier works in reverse...

Because money is now leaving the circular flow

Tax Multiplier = -MPC/1-MPC    or   -MPC/MPS

when there is a tax cut the multiplier is [+] because there is now more money in the circular flow

Steps: 

1. Calculate the MPC and MPS
2. Determine which multiplier to use and whether it is [+] or [-]
3.  Calculate the spending and or tax multiplier
4.  Calculate the change in AD