Consumption and Savings

February 23, 2017

Disposable Income

income after taxes or net income

DI = gross income - taxes

with disposable income, households can either:

         consume (spend money on goods and services)

         save (not spend money on goods and services)

Consumption

• household spending

• the ability to consume is constrained by:

•          the amount of DI

•          the propensity to save

Average Propensity to Consume (APC) = % DI that is spent

Saving

• household not spending

• the ability to save is constrained by:

•            the amount of DI

•           the propensity to consume

Average Propensity to Consume (APS) = % DI not spen

APS + APC = 1

APC > 1 = dissaving

APC = dissaving

Marginal Propensity to Consume (MPC)

• % of every extra dollar earned that is spent

• △C / △DI

Marginal Propensity to Save (MPS)

• % of every extra dollar that is saved

• △S / △DI

MPC + MPS = 1

Determinants of C and S

• wealth

• expectations

• household debt

• taxes

The Spending Multiplier Effect

• an initial change in spending (C, Ig, G, Xn) causes a larger change in aggregate spending, or aggregate demand

Multiplier = △AD / △Spending

Multiplier = AD / △(C, Ig, G, Xn)

Why does this happen?

expenditures and income flow continuously which sets off a spending increase in the economy

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

Calculating the Tax Multiplier

• when the government taxes, the multiplier works in reverse because now money is leaving the circular flow
• Tax multiplier = -MPC / 1-MPC  or  -MPC / MPS   (It's a negative number)

If there is a tax cut, then the multiplier is (+) because there is now more money in the circular flow