Difficulty: Introductory-Intermediate | Prerequisites: Basic understanding of GDP components (Ch. 10-11)
This is the first half of Chapter 13, covering the four components of aggregate expenditure: consumption, investment, government purchases, and net exports. You need to understand each component's function and its shifters before you can build the aggregate expenditure model in Part 2. If you skipped the GDP chapters, go back: you need to know what C, I, G, and NX stand for.
Aggregate expenditure is built from four components: consumer spending (C), private investment (I), government purchases (G), and net exports (NX). Consumer spending is the only one that rises with disposable income; the others are treated as fixed (autonomous). The marginal propensity to consume (MPC) and the marginal propensity to save (MPS) always add up to 1, and they determine how much of each extra dollar of income gets spent versus saved.
Marginal propensity to consume (MPC)
The fraction of each additional dollar of disposable income that goes to consumption spending. Formally: change in consumption / change in disposable income. Think of it as: "out of every extra dollar I earn, how many cents do I spend?"
Marginal propensity to save (MPS)
The fraction of each additional dollar of disposable income that goes to saving. Formally: change in saving / change in disposable income. In simple terms, this is the flip side of MPC. Whatever you do not spend, you save. MPC + MPS = 1, always.
Autonomous consumption
The portion of consumer spending that happens regardless of income. People still spend even when income is zero, drawing on savings or credit. On a graph of the consumption function, this is the vertical intercept.
Induced spending
The portion of consumer spending that is directly driven by having income above zero. This is the part that rises as disposable income rises, and it is governed by the MPC.
Consumption function
The relationship between disposable income and consumer spending, graphed as an upward-sloping line. The slope equals the MPC (always between 0 and 1), and the vertical intercept equals autonomous consumption.
Investment function
The relationship between disposable income and private investment spending. It is graphed as a flat horizontal line because investment does not depend on current disposable income. Think of it as: businesses invest based on expected profits and interest rates, not on how much consumers currently earn.
Net exports function (NX)
Exports minus imports. Exports are flat (they depend on foreign income, not domestic), but imports rise with domestic income, so the net exports function slopes downward.
Consumption function shifters
Factors that shift the entire consumption function up or down (a parallel shift), as opposed to moving along it. The four main ones are: price level, real interest rate, household wealth, and expected future disposable income.
As disposable income rises, people both spend more and save more. The question is how much of each extra dollar goes where.
MPC + MPS = 1. If MPC is 0.8, then MPS is 0.2: for every extra dollar, 80 cents are spent and 20 cents are saved.
MPC tends to fall as income rises. Wealthier households spend a smaller fraction of each additional dollar than poorer households do.
Investments count as saving in this framework. They are a way of storing value rather than consuming it.
Graphed with disposable income on the x-axis and consumer spending on the y-axis.
The vertical intercept is autonomous consumption: spending that happens even at zero income (funded by savings, credit, or transfers).
The slope of the line is the MPC, and it is always between 0 and 1.
Induced spending is everything above autonomous consumption. It is the part of spending that exists only because income is positive.
These shift the whole function up or down without changing its slope:
Price level (negative relationship): higher prices reduce real purchasing power, so spending falls.
Real interest rate (negative relationship): higher rates make borrowing more expensive, so spending falls.
Value of household wealth (positive relationship): if a household's house or portfolio rises in value, the asset is "doing the saving" for them, so they spend more out of current income.
Expected future disposable income (positive relationship): if people expect a pay rise or promotion, they spend more today.
Refers to spending on newly produced physical capital by private firms, plus the value of new homes.
The investment function is a flat horizontal line when plotted against disposable income. Investment does not respond to current disposable income.
Expected profitability (positive): if firms expect higher returns, they invest more in capital.
Real interest rate (negative): higher rates make borrowing to invest more costly, so investment falls.
Also graphed as a flat horizontal line against disposable income. Government spending decisions are made through the political process, not driven by current household income.
Exports are determined by foreign income, not domestic income, so the export function is flat.
Imports rise with domestic income (more income means more spending on foreign goods), so the net exports function slopes downward.
As income increases, imports increase, pulling NX into negative territory.
Currency exchange rate (negative for NX): a stronger home currency makes domestic goods more expensive abroad (exports fall) and foreign goods cheaper at home (imports rise). Both effects reduce net exports.
Real interest rate (negative for imports): higher domestic rates attract foreign capital, strengthening the currency, which reduces imports. (Note: the effect on NX via exchange rates is the main channel.)
Real GDP growth in trading partner countries (positive): if trading partners are growing, they buy more of the home country's exports, shifting the function up.
MPC = \frac{\Delta C}{\Delta Y_d}where C is consumption and Yd is disposable income.
MPS = \frac{\Delta S}{\Delta Y_d}where S is saving.
MPC + MPS = 1Always. Whatever is not consumed is saved.
Consumption function (linear form):
C = a + (MPC x Yd)
where a is autonomous consumption (the vertical intercept) and MPC x Yd is induced spending.
Diagram notes:
The consumption function is an upward-sloping line starting at a on the y-axis, with slope = MPC.
The investment function and government purchases function are both flat horizontal lines (they do not vary with disposable income).
The net exports function slopes downward because imports rise with income while exports remain flat.
The consumption function explains why tax rebates aimed at lower-income households tend to stimulate more spending than those aimed at higher-income households: the poor have a higher MPC, so more of the rebate gets spent rather than saved.
Net export shifters matter in practice whenever a country's currency strengthens or weakens. A strong dollar, for example, makes American exports more expensive abroad and foreign imports cheaper at home, which is why trade deficits tend to widen when the dollar is strong.
Students often think MPC + MPS can be something other than 1. It cannot. Every extra dollar is either spent or saved; there is no third option.
Students confuse a movement along the consumption function (income changes, spending changes) with a shift of the consumption function (something other than income changes, like wealth or expectations). A change in disposable income moves you along the line. A change in wealth or interest rates shifts the entire line.
Students sometimes assume investment spending rises with disposable income. It does not in this model. Investment depends on expected profitability and interest rates, not on household income.
Students forget that exports depend on foreign income, not domestic income. A boom at home increases imports, not exports.
You will almost certainly be asked to calculate MPC given MPS (or vice versa). Remember: MPC + MPS = 1.
Expect questions that ask you to identify which factor shifts the consumption function versus which moves you along it.
Know the direction of each shifter (positive or negative relationship) for all four components of AE.
The investment and government functions being flat is a common multiple-choice trap. Do not confuse "unaffected by disposable income" with "never changes." These functions can shift; they just do not respond to income.
True or false: MPC + MPS = 1. (True)
Fill in the blank: The vertical intercept of the consumption function represents __________ consumption. (autonomous)
True or false: Private investment spending increases as disposable income increases. (False, the investment function is flat with respect to disposable income.)
Fill in the blank: If the MPC is 0.75, the MPS is __________. (0.25)
True or false: A stronger domestic currency increases net exports. (False, it decreases net exports because exports fall and imports rise.)
Q: If the MPC is 0.6, what is the MPS? If disposable income rises by $1,000, how much additional consumption occurs?
A: MPS = 1 - 0.6 = 0.4. Additional consumption = 0.6 x $1,000 = $600.
Q: A household's disposable income is $0, but it still spends $5,000. What is this spending called, and where does it appear on the consumption function graph?
A: This is autonomous consumption. It appears as the vertical intercept (y-intercept) of the consumption function.
Q: Which of the following shifts the consumption function (as opposed to causing movement along it): (a) an increase in disposable income, (b) a rise in household wealth, (c) a rise in the real interest rate?
A: (b) and (c) shift the function. (a) causes movement along the function. A rise in household wealth shifts it up; a rise in the real interest rate shifts it down.
Q: Explain why the net exports function has a negative slope.
A: Exports depend on foreign income and are constant with respect to domestic income (flat). Imports rise as domestic income rises. Since NX = exports - imports, NX falls as domestic income rises, producing a downward slope.
Q: The dollar strengthens against the euro. What happens to U.S. net exports and why?
A: U.S. net exports fall. A stronger dollar makes American goods more expensive for European buyers (exports decrease) and European goods cheaper for American buyers (imports increase). Both effects push NX downward.
This material feeds directly into the aggregate expenditure (AE) model covered in Part 2 of these notes. You need the individual component functions (C, I, G, NX) to construct the AE line. The MPC is especially important because it determines the slope of the AE line, which in turn determines the size of the spending multiplier.
The consumption function also connects to fiscal policy (Ch. 14-15): tax cuts increase disposable income, moving households along the consumption function, while transfer payments work the same way. Understanding which variables shift C versus move along it is essential for analysing policy effects.
Marginal propensity to consume, MPC, marginal propensity to save, MPS, autonomous consumption, induced spending, consumption function, consumption function shifters, investment function, investment shifters, government purchases function, net exports function, net export shifters, aggregate expenditure components, disposable income, AE model components, ECO 2013, Principles of Macroeconomics, Chapter 13, expenditure multipliers, University of Florida macroeconomics