Macroeconomics Dr/ Zeyad Albukhaiti

Lecture 5

The Components of Aggregate Expenditure Elements

1) The Consumption (C)
 The Simple Keynesian Theory on Consumption
Economists build models and theories to better understand the economic world. Of
the many such models, we have already discussed a few: the theory of supply and
demand and the classical theory of interest rates. In this section, we identify and discuss
a few of the key components and themes of another prominent macroeconomics model:
the simple Keynesian model.
 Assumptions
In the simple Keynesian model, certain simplifying assumptions hold:
 First, the price level is assumed to be constant until the economy reaches its
full employment, or Natural Real GDP, level.
 Second, there is no foreign sector: the model represents a closed economy, not
an open economy. So total spending in the economy is the sum of
consumption, investment, and government purchases.
 Third, the monetary side of the economy is excluded.
 The Consumption Function
Although Keynes was interested in the level of total spending in general, he was
particularly concerned about consumption, which was a major concern because it is
by far the largest slice of the total spending pie.
Keynes made three basic points about consumption:

1. Consumption depends on disposable income (income minus taxes).

2. Consumption and disposable income move in the same direction.
3. When disposable income changes, consumption changes by less.

These three points make a specific statement about the relationship between
consumption and disposable income: the consumption function, which can written
as:

C = α + bYd
 Macroeconomics Dr/ Zeyad Albukhaiti
Lecture 5
Where:

 C : is the aggregate consumption.

 Yd : disposable income.
 b : the slope of consumption function or MPC.
 α the minimum level of consumption ( the value of consumption at Y= 0).
 Let’s look, then, at MPC and α. Think of consumption (as specified by the
consumption function) as made up of two parts:
• Autonomous consumption (α ) is independent of disposable income.
• Induced consumption( bYd ) depends on disposable income.

MPC stands for marginal propensity to consume, which is the ratio of the
change in consumption to the change in disposable income:
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒄𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏
Marginal propensity to consume =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒅𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝒊𝒏𝒄𝒐𝒎𝒆
∆𝑪
MPC =
∆𝒀
The Greek symbol delta (Δ) stands for “change in.” Thus, the MPC is
equal to the change in consumption divided by the change in disposable
income. To illustrate, suppose consumption rises from $800 to $900 as
disposable income rises from $1,000 to $1,200. If we divide the change in
consumption ($100 by the change in disposable income ($200), we see that
the MPC equals 0.50. (Notice that the MPC is always a positive number
between 0 and 1 because of Keynes’s points 2 and 3.)
α is autonomous consumption, which changes not as disposable income
changes, but rather because of other factors.
The difference between autonomous and induced consumption can be
illustrated with an example. Suppose your taxes are lowered and your
disposable income consequently rises. With more disposable income, you buy
more goods and services (e.g., entertainment, books, DVDs).
The increase in disposable income has induced you to consume more—hence
the name induced consumption. Next, suppose that, even though your
 Macroeconomics Dr/ Zeyad Albukhaiti
Lecture 5
disposable income has not changed, for some reason you are consuming more.
You might be consuming more medication because you have recently become
ill, or you might be consuming more car maintenance services because your
car just broke down. Whatever the reason, you are consuming more of various
goods and services even though your disposable income has not changed at
all. This type of consumption is autonomous (i.e., independent) of disposable
income—hence the name autonomous consumption.
Look again at the consumption function:
Consumption = Autonomous consumption + (Marginal propensity to
consume × Disposable income)
C = α +( MPC × Yd)
Suppose α is $800, MPC is 0.80, and Yd is $1,500, and we insert these
numbers into the consumption function:
C = $800 + (0.80 × $1500) = $800 + $1200 = $ 2000
So what will cause an increase in consumption? Consumption, C, will
increase if any of the variables α, MPC, and Yd increases. Thus, C can be
increased in three ways:

1.Raise autonomous consumption. Suppose in our example that autonomous

consumption, α, goes from $800 to $1,000. This change will raise
consumption to $2,200: C = $1,000 + (0.80 × $1,500) = $2,200
2. Raise disposable income. Suppose disposable income, Yd, goes from $1,500
to $1,800. This change will raise consumption to $2,240:
C = $800 + (0.80 × $1,800) = $2,240. The increase in consumption from
$2,000 to $2,240 is due to an increase of $240 in induced consumption, a
dollar amount that the increase in disposable income induced.
3. Raise the MPC. Suppose the MPC rises to 0.90. This change will raise
consumption to $2,150: C 5$800 1 (0.90 3$1,500) 5$2,150.
 Macroeconomics Dr/ Zeyad Albukhaiti
Lecture 5
In Exhibit 6, α is assumed to be equal to $200 billion and the MPC to
0.80; thus, C = $200billion + (0.8)(Yd ). We then calculated different levels of
consumption (column 3) for different levels of disposable income (column 1).

(1) (2) (3) (4) (5) (6)

Disposable Change in Consumption Change in Saving Change
Income, Yd Yd Consumption S =Yd - c in
Saving
$ 800 $___ $ 840 $___ -$40 $___
1000 200 1000 160 0 40
1200 200 1160 160 40 40
1400 200 1320 160 80 40
1600 200 1480 160 120 40
1800 200 1640 160 160 40

Consumption Function

 Consumption and Saving

In Exhibit 6, we also calculated the saving levels (column 5) at the
different levels of disposable income. How did we calculate these levels?
Well, we know that C = α +( MPC )( Yd) and that households can only
consume or save. So it follows that saving, S, is the difference between
disposable income and consumption:

Saving = Disposable income - Consumption

= Disposable income - [Autonomous consumption
+ (Marginal propensity to consume Disposable income)]
 Macroeconomics Dr/ Zeyad Albukhaiti
Lecture 5
S = - α + bYd
S = Yd - [α - (MPC × Yd )]
The marginal propensity to save (MPS ) is the ratio of the change in saving to
the change in disposable income:
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒔𝒂𝒗𝒊𝒏𝒈
Marginal propensity to save =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒅𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝒊𝒏𝒄𝒐𝒎𝒆
∆𝒔
MPC =
∆𝒀
Disposable income can be used only for consumption or saving; that is,
C + S = Yd . So any change to disposable income can change only
consumption or saving. Therefore, the marginal MPC plus the MPS must
equal 1. MPC + MPS = 1. In Exhibit 6, the MPC is 0.80; so the MPS is 0.20.

Saving Function

Yd

 APC & APS

The average propensity to consume (APC )
𝒄𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏
Marginal propensity to consume =
𝑫𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝒊𝒏𝒄𝒐𝒎𝒆
𝑪
APC =
𝒀
 Macroeconomics Dr/ Zeyad Albukhaiti
Lecture 5
The average propensity to save (APS )
𝒔𝒂𝒗𝒊𝒏𝒈
Marginal propensity to save =
𝑫𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝒊𝒏𝒄𝒐𝒎𝒆
𝑺
APS =
𝒀
 The breakeven income
Is the income at with Y = C and S= 0
 Before the breakeven income : APC >1 & APS < 0.
 At the breakeven income : APC =1 & APS = 0.
 After the breakeven income : APC <1 & APS >0.
 Example :
If you are given the following consumption function:

C = 200 +0.9 Yd

1. Determine the minimum level of consumption.

2. Derive the saving function.
3. Determine the dissaving level at income = 0.
4. Calculate both C&S at Y=0, 1000, 2000, 3000, 4000.
5. Calculate the marginal propensity to consume (MPC) & marginal propensity to
save(MPS) at each level of income.
6. Calculate the average propensity to consume (APC) & average propensity to
save(APS) at each level of income.
7. Show graphically the consumption & the saving functions.