ECON.102.

Chapter 11
Income and Expenditure

Chowdhury Mahmoud

March 14, 2022

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Learning outcomes I

I Multiplier effect
I Aggregate consumption function
I Factors shifting aggregate consumption function: expected future income and
aggregate wealth effect
I Determinant of investment
I Planned vs. unplanned investment spending
I Income-Expenditure model

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Model assumptions

I producers are willing to supply additional output at a fixed price

I interest rate is fixed
I no government spending and no taxes
I Closed economy (X = M = 0 ∆ NX = 0)

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The multiplier

I Consider Amazon decides to invest $100 million building storage facility in

Richmond. What will be the ultimate change in BC’s GDP as a consequence?
I Multiplier refers to the fact of multiple rounds of increases in aggregate
output following the initial change
I How to measure the total effect of any such initial change in aggregate
expenditure in the economy?

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MPC (marginal propensity to consume) I
I There is a limit leading to a fixed amount increase in aggregate income; this
is determined by the value of MPC
I definition MPC is the increase in consumer spending when disposable income
rises by $1

consumer spending
MPC =
disposable income

I if for a $5 increase in disposable income the consumer spending increases by

$4
$4, then the MPC = = 0.8
$5
I Disposable income = consumption expenditure + saving

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MPC (marginal propensity to consume) II

I MPS marginal propensity to save: the proportion of each additional dollar

saved or not spent on consumption purposes

MPS = 1 ≠ MPC

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A numerical example I
I Let Amazon invests $100 million in investment in BC this initially will raises
the real GDP by $100 million
I income = Real GDP
I Therefore, income = $100 million
I This will lead to a second-round increase in real GDP = MPC ◊ $100 million
I The third round increase in real GDP:

MPC ◊ MPC ◊ $100 million

I Every thing else remaining the same, this will repeat infinite number of times
leading to total effect on real GDP:

(1 + MPC + MPC 2 + MPC 3 + . . . ) ◊ $100 million

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A numerical example II

I Mathematical formula:
1
1 + x + x2 + x3 + · · · =
1≠x

, for 0 < |x | < 1

I Total effect in real GDP from an initial increase of $100 million is an increase
1
of, ◊ $100 million
1 ≠ MPC

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Autonomous expenditure and multiplier I
I We separate two components:
I initial change: triggered by a change up and above the initial real GDP
I the subsequent change which we will call the multiplier effect

I the initial change is called autonomous change

I the subsequent change is the multiplier effect
I therefore, for an autonomous change given by, AE0 and the total change
denoted by, Y we can write,
1
Y = ◊ AE0
1 ≠ MPC

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Autonomous expenditure and multiplier II

Y 1
I therefore, the multiplier is, = =
AE0 1 ≠ MPC

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Consumer spending

I according to the expenditure approach: Real GDP = C + I + G + (X ≠ M)

I given our assumptions in this chapter: Real GDP = C + I as
G = T = TR = 0 and X = M = 0
I among all components for all economies by far the most important one is,
consumption spending
I individual consumption spending is driven by household’s disposable income
I by aggregating individual consumption spending decisions we can derive
aggregate consumption function

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$32,000

Consumption spending
$27,000

$21,000

$20,000 $27,000 $38,000

Disposable income

Figure 1: Nature of consumption spending

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$32,000

Consumption spending
$27,000

$21,000

$20,000 $27,000 $38,000

Disposable income

Figure 2: Nature of consumption spending

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The consumption function I
-consumption function: an equation showing how an individual household’s
consumer spending varies with the household’s disposable income.

c = – + MPC ◊ yd

I c, a household’s consumer spending

I yd , household’s disposable income
I MPC, marginal propensity to consume
I – autonomous consumer spending, a constant used to represent a situation
where the household has no income
I here, the role of MPC is as discussed before; that is,

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The consumption function II

c
MPC =
yd

I MPC captures the amount by which the expenditure increase in response to a

$1 increase in income
I an example, c = 15, 000 + 0.75 ◊ yd

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THE CONSUMPTION FUNCTION (3 of 3)
ac is an individual household’s autonomous consumer spending, the
value of c when yd is zero—the vertical intercept.
MPC is the slope: rise over run.
Figure 11-3

Krugman, Macroeconomics:
Krugman,
Canadian
Economics,
Edition, 4e,
6e, © 2020 16 / 31
2021 Worth Publishers
Deriving aggregate production function I

I Suppose the economy consists of three people: Angelina, Felicia, and Marina.
The table 19 shows how their consumer spending varies with disposable
income;
Consumer spending
Current disposable income
Angelina Felicia Marina
$0 $8000 $6500 $7250
$10000 12000 14500 14250

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Deriving aggregate consumption function

I for Angelina: c = 8000 + 0.4 ◊ yD

I for Felicia: c = 6500 + 0.8 ◊ yD
I for Marina: c = 7250 + 0.7 ◊ yD

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Aggregate consumption spending

Consumer spending
Current disposable income
Angelina Felicia Marina Aggregate
spending
$0 $8000 $6500 $7250 $21750
$10000($30000) 12000 14500 14250 $40750
40750 ≠ 21750
I Therefore, aggregate MPC = = 0.633
30000

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Aggregate consumption function

I the relationship for the economy as a whole between the aggregate

consumption spending and aggregate disposable income that is Real GDP.
I C = — + MPC ◊ YD
I here, — is the intercept that is the consumption spending at the $0 level of
disposable income
I MPC: marginal propensity to consume at the macroeconomy level
I YD is Real GDP

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Shifts of the aggregate consumption function

I Changes in expected future disposable income

I permanent income hypothesis
I puzzle solved by the permanent income hypothesis

I Changes in aggregate wealth

I life cycle hypothesis

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INVESTMENT SPENDING (1 of 2)
• Small yet powerful: although much smaller than consumer
spending, investment spending tends to drive the
booms and busts in the business cycle (shown here:
three recent recessions).
Figure 11-7

Krugman, Macroeconomics:
Krugman,
Canadian
Economics,
Edition, 4e,
6e, © 2020 22 / 31
2021 Worth Publishers
Investment spending, I

I Planned investment spending: the investment spending that businesses plan

or intend to undertake during a given period depends on:
I interest rate, i
I expected future real GDP
I current level of production capacity

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Accelerator principle

I a higher rate of growth in real GDP leads to a higher planned investment

spending
I a lower growth rate of real GDP leads to a lower planned investment spending

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Unplanned investment spending

I inventories: goods held to satisfy future sales needs

I inventory investment: the value of the change in total inventories
I unplanned inventory investment: the value of the change in total
inventories due to unexpected swings in sales
I positive: when there is an unexpected increase in the value of inventory
I negative: when unexpectedly the inventory value falls

I Actual investment spending = Iplanned + Iunplanned

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The income-expenditure model

I under usual assumptions (mentioned before in this chapter)

GDP = C +I
YD = GDP
C = C̄ + MPC ◊ YD
I = Iplanned + Iunplanned

I AEplanned , planned aggregate expenditure depends on the level of real GDP

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AEplanned and real GDP

Example: if C = 300 + 0.6 ◊ YD

Real GDP YD C Iplanned AEplanned
($ billion) ($ billion) ($ billion) ($ billion) ($ billion)
0 0 300 500 800
500 500 600 500 1100
1000 1000 900 500
1500 1500 1200 500
2000 2000 1500 500
2500 2500 1800 500 2300
3000 3000 2100 500 2600

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THE AGGREGATE CONSUMPTION
FUNCTION AND PLANNED AGGREGATE
EXPENDITURE

Figure 11-9
The lower line, CF, is the
aggregate consumption
function constructed from
Table 11-2.

The upper line, AEPlanned,

is the planned aggregate
expenditure line, also
constructed from Table
11-2.

Krugman, Macroeconomics:
Krugman,
Canadian
Economics,
Edition, 4e,
6e, © 2020 28 / 31
2021 Worth Publishers
Income expenditure equilibrium

GDP = C + I
= C + Iplanned + Iunplanned
= AEplanned + Iunplanned

I Therefore, AEplanned is different from real GDP only when Iunplanned is non-zero

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FIGURE 11-10: INCOME–EXPENDITURE
EQUILIBRIUM

Income–expenditure
equilibrium occurs at
E where AEPlanned
crosses the 45-
degree line.
This type of diagram
is known as the
Keynesian cross.

Krugman, Macroeconomics:
Krugman,
Canadian
Economics,
Edition, 4e,
6e, © 2020 30 / 31
2021 Worth Publishers
FIGURE 11-11 THE MULTIPLIER
The economy is initially at equilibrium point E1.
An autonomous increase shifts AEPlanned upward by 400. The economy is
now at point X. IUnplanned = −400. Firms increase production, and the economy
reaches a new income–expenditure equilibrium at E2.

Krugman, Macroeconomics:
Krugman,
Canadian
Economics,
Edition, 4e,
6e, © 2020 31 / 31
2021 Worth Publishers
Priciples of MACROECONOMICS
Chapter 11: Income and Expenditure

Chowdhury Mahmoud

March 10, 2022

Name: . . . . . . . . . . . . . . . . . . . . . . . . ID: . . . . . . . . . . . . . . . . . . . . . . . .

1
Econ 102 sec 015 Questions Chapter 11 Term II, 2022
Multiple choice questions;
Numerical questions
Question 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 pt
Economists observed the only five residents of a very small economy and estimated
each one’s consumer spending at various levels of current disposable income. The
accompanying table shows each resident’s consumer spending at three income
levels.

Individual consumer Individual current disposable income

spending by $0 $20,000 $40,000
Andre $1,000 $15,000 $29,000
Barbara 2,500 12,500 22,500
Casey 2,000 20,000 38,000
Declan 5,000 17,000 29,000
Elena 4,000 19,000 34,000

a. What is each resident’s consumption function? What is MPC for each

resident?
b. What is the economy’s aggregate consumption function? What is MPC for
the economy?

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Econ 102 sec 015 Questions Chapter 11 Term II, 2022
Question 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 pt
From 2014 to 2019, Eastlandia experienced large fluctuations in both aggregate
consumer spending and disposable income, but wealth, the interest rate, and
expected future disposable income did not change. The accompanying table shows
the level of aggregate consumer spending and disposable income in millions of
dollars for each of these years. Use this information to answer the following
questions.

Disposable income Consumer spending

Year
(millions of dollars) (millions of dollars)
2014 $100 $180
2015 350 380
2016 300 340
2017 400 420
2018 375 400
2019 500 500

a. Plot the aggregate consumption function for Eastlandia.

b. What is MPC? What is MPS?
c. What is the aggregate consumption function?

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Econ 102 sec 015 Questions Chapter 11 Term II, 2022
Question 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 pt
In an economy with no government and no foreign sectors, autonomous consumer
spending is $250 billion, planned investment spending is $350 billion, and the
marginal propensity to consume is 2/3.
a. Plot the aggregate consumption function and planned aggregate expenditure.
b. What is unplanned inventory investment when real GDP equals $600 billion?
c. What is Y → , income–expenditure equilibrium GDP?
d. What is the value of the multiplier?
e. If planned investment spending rises to $450 billion, what will be the new
Y →?

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Econ 102 sec 015 Questions Chapter 11 Term II, 2022
Question 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 pt
An economy has a marginal propensity to consume of 0.5, and Y → , in-
come–expenditure equilibrium GDP, equals $500 billion. Given an autonomous
increase in planned investment of $10 billion, show the rounds of increased
spending that take place by completing the accompanying table. The first
and second rows are filled in for you. In the first row, the increase of planned
investment spending of $10 billion raises real GDP and YD by $10 billion, leading
to an increase in consumer spending of $5 billion (MPC → change in disposable
income) in row 2, raising real GDP and YD by a further $5 billion.

Rounds Change in Iplanned or C Change in real GDP Change in YD

(billions of dollars)
1 !Iplanned = $10 $10 $10
2 !C = $5 ? ?
3 !C =? ? ?
4 !C =? ? ?
5 !C =? ? ?
6 !C =? ? ?
7 !C =? ? ?
8 !C =? ? ?
9 !C =? ? ?
10 !C =? ? ?

a. What is the total change in real GDP after the 10 rounds? What is the
value of the multiplier? What would you expect the total change in Y → to be
based on the multiplier formula? How do your answers to the first and third
questions compare?
b. Redo the table starting from round 2, assuming MPC is 0.75. What is the
total change in real GDP after 10 rounds? What is the value of the multiplier?
As the marginal propensity to consume increases, what happens to the value
of the multiplier?

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Econ 102 sec 015 Questions Chapter 11 Term II, 2022
Question 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 pt
Answert the following questions:
a. The accompanying table shows gross domestic product (GDP), disposable
income (YD), consumer spending (C), and planned investment spending
(Iplanned ) in an economy. Assume there is no government or foreign sec-
tor in this economy. Complete the table by calculating planned aggregate
expenditure (AEplanned ) and unplanned inventory investment (Iunplanned )
b. What is the aggregate consumption function?
c. What is Y → , income–expenditure equilibrium GDP?
d. What is the value of the multiplier?
e. If planned investment spending falls to $200 billion, what will be the new Y → ?
f. If autonomous consumer spending rises to $200 billion, what will be the new
Y →?

GDP YD C Iplanned AEplanned Iunplanned

$0 $0 $100 $300 ? ?
400 400 400 300 ? ?
800 800 700 300 ? ?
1200 1200 1000 300 ? ?
1600 1600 1300 300 ? ?
2000 2000 1600 300 ? ?
2400 2400 1900 300 ? ?
2800 2800 2200 300 ? ?
3200 3200 2500 300 ? ?

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