Chapter 21: Spending

Components of GDP, Forecast GDP, Equilibrium of Spending/Output, Spending Multiplier

Gross Domestic Product

What is Gross Domestic Product (GDP)?

Gross Domestic Product is the value of all the final goods and services produced in a country within a specific time period. The total amount produced (total output or real GDP) equals the total amount of spending individuals & institutions want to do in a year plus the accumulation of inventories.

Total output is equal to total income; wages, profits, rents, interest & taxes.

This image is simplified. Consumers don’t spend entire incomes; they save. Businesses don’t use all of their income to pay wages; they investment. Also, some of the production is sent abroad & people buy some products from abroad. Governments tax income to provide defense & other services, or provide income through welfare. There are no guarantees that spending equals output.

Components of GDP

GDP = Consumption + Investment + Government Spending (– Welfare) + Exports (– Imports)

What are Factors Affecting Consumption Spending?

What is Consumption?

Consumption is the total spending by individuals on products in a year. It’s ~70% of the GDP.


Consumption spending depends primarily upon income. As income rises, consumption spending rises.

What are the 2 Parts of Consumption Spending? Consumption = a + b (disposable income)

  • Disposable Income: Income after taxes are paid.
  • Autonomous Portion: A portion that’s independent of disposable income (level of consumption if you had no income). You would still need to eat, regardless of how much income you have.

‘b’ is a variable that is multiplied by disposable income. ‘b’ is a fraction that is positive but less than 1. This variable is known as the Marginal Propensity to Consume (MPC), which is the percentage of income that is consumed. The opposite, Marginal Propensity to Save (MPS), is the percentage of income saved.

How to Calculate Marginal Propensity to Consume?

Marginal propensity to consume is the change in consumption divided by the change in income.

Future Income

Peoples’ expectations of their future incomes influence their consumption spending now.

Expectations of related economic conditions play an important role. If people expect economic conditions to worsen, they tend to spend less and save more. If expectations are that conditions will improve, people tend to spend more. If you expect to lose your job next month, you will probably be a little more conservative this month. If you expect to get a raise next month, you may spend a little more this month.


If wealth increases, we would expect consumption to increase but the effect is rather small. For each increase in wealth of $1,000, consumption spending increases about $50.

Interest Rates

If interest rates increase, we would expect those individuals who borrow to reduce their borrowing. Changes in interest rates, however, appear to have only a small effect on consumption.

Transfer Payments

Government transfer payments, such as social security and Medicare, will affect total income, which in turn affects disposable income, thereby changing consumption spending.

The y-intercept of this graph is ‘a’, the autonomous portion of spending. The consumption function’s slope is equal to the marginal propensity to consume (MPC).

Extra Information

  • An increase in income has no change in the level of exports. It does increase imports.


What is Investment?

Investment spending represents an increase in capacity to produce future output. It accounts for 15-20% percent of the GDP. Spending by consumers is considered consumption, while spending by businesses is considered investment even if the same item is purchased.

Investment also includes changes in inventories and new residential construction. ~70% of investment spending consists of business investment in structures & equipment.

Buying stocks and bonds is not counted as investment in calculating GDP, because when you buy a stock, most of the time you are buying it from an individual.

What Determines Investment Spending?

Businesses invest because they expect to earn profits. Thus, the determinants are estimated revenues/costs & expectations of economic conditions. Interest rates & investment spending are inversely related, while GDP growth & investment amounts are directly related.


When real GDP is increasing, investment spending will also increase.


To make an investment, businesses must either borrow funds or use their own. In either case, the cost is either the interest they pay or the interest they give up.

Increases in taxes on corporate profits will reduce after-tax profit. A tax credit, reduce taxes owed.


Business expectations about revenues/costs will affect the decision-making process. Because investment spending is undertaken to expand future output, expected future conditions are more important than current conditions.

Net Exports

Factors affecting Exports

An increase in income of other countries, an increase in international preferences for our goods, an increase in prices of substitute goods in foreign countries, or a decline in import tariffs in other countries will increase demand for our exports & cause the equilibrium quantity to increase. Exports depend on our prices relative to prices in other countries.

Factors Affecting Imports

If our incomes, taste for goods from other countries, or our prices of substitute goods decrease, then our demand for imports will decrease. If foreign prices of substitute goods decrease, then our demand for imports will increase. If our tariffs on imports increase, then demand for imports will decrease. Imports are subtracted from GDP, because when we import a good, we consume it, which is counted as consumption.

Government Spending

What is Government Spending?

Government spending included in GDP is the total spending on products by all levels of government in a specific time period. ~18% of the GDP. Governments spend money on a variety of programs, such as defense, education, public works projects, government worker salaries, etc. Government spending does not include expenditures normally described as transfer payments (welfare).

Government spending tends to be influenced mostly by political concerns & only indirectly by the economic system. As such, we are initially going to treat it as independent of income even though in the long run, government spending surely rises as income rises.

Income-Expenditure Model

Assumptions in the Income-Expenditure Model

  • We will assume that there will be no price changes.
  • Producers can produce whatever is demanded; that is, there is no constraint on supply.
  • Government, investment, exports, and imports are all autonomous, that is, independent of anything else in the model. We know that as income increases, investment is likely to increase and imports are likely to increase. But here we are going to assume that neither happens.

What is on the y & x Axis of this Model?

Real levels of spending (how much individuals, businesses, foreigners, and governments want to spend at each level of income) will be on the vertical axis. On the horizontal axis; real levels of income & output (real output is the same as real GDP & income).

What is the Total Spending Line?

The total spending line is the cyan line in the following:

How do we know where we’ll end up on the line?

Why do we draw a 45° line?

To show where spending equals output! It’s simply a useful tool. For example; only at $8 trillion is the economy in equilibrium.

The Spending Multiplier

What is the Spending Multiplier?

The spending multiplier is the multiple by which an increase in autonomous spending (due to a change in government spending or investment) ripples through the economy.

A mathematical model would show the following:

where “a” is autonomous consumption and “b” is the marginal propensity to consume (MPC).

If we substitute our consumption function into the definition of GDP, we get the following:

What is the Tax Multiplier?

The spending multiplier works because an increase in income caused a subsequent change in spending. The change in spending is smaller than the change in income because part of the change in income is saved. The greater the saving, the less the increase in consumption & the less the spending multiplier will ultimately be. Taxes function much like saving in this instance. The greater the tax rate, the less the subsequent change in spending will be. Thus, an increase in income taxes will reduce the size of the spending multiplier.

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