Unit 3 - Disposable Income

February 20, 2015

With disposable income (DI) theres 2 choices households have, either consume (spend money on goods & services) or save (not spending money)

DI is income after taxes or net income. DI = Gross income - Taxes

Consumption (household spending) The ability to consume is constrained by

• The amount of DI
• The propensity to save

Do households consume if DI=0

• Autonomous consumption
•  Dissaving

        APC= C/DI = %DI that is spent

Savings (household not spending) The ability to save is constrained by

• The amount of DI
• The propensity to consume

Do households save if DI = 0

• No

       APS= S/DI = %DI that is not spent

APC & APS 

• APC + APS = 1
• 1- APC = APS
• 1- APS = APC
• APC > 1 therefore Dissaving
• APS therefore Dissaving

MPC & MPS

• Marginal propensity to consume (MPC)
• ∆ C / ∆ DI
• % of every extra dollar earned that is spent
• Marginal propensity to save (MPS)
• ∆ S / ∆ DI
• % of every dollar earned that is saved
• MPC + MPS = 1
• 1 - MPC = MPS
• 1 - MPS = MPC

The spending multiplier effect 

• An initial change in spending (C, Ig, G, Xn) causes a large change in aggregate spending or aggregate demand
• Multiplier = ∆ in AD / ∆ in spending
• Why does this happen? Expenditures and income flow continuously which sets of a spending increase in the economy.

The spending multiplier

• Can be calculated from the MPC or MPS
• Multiplier = 1 / 1 - MPC or 1 / MPS
• Positive when there is increase in spending Negative when there is a decrease

The tax multiplier

• When government taxes, the multiplier works in reverse
• Why? Because now money is leaving the circular flow 
• Tax multiplier (Its negative) = - MPC / 1 - MPC  or - MPC / MPS
• If there is a tax cut, then the multiplier is positive, because there is now more money in the circular flow.