Suppose MPC is 0.8 initially. Households then change their behavior so that the MPC falls to 0.75. What happens to aggregate expenditures? Why? Macro Econ3, McEachern

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pohnpei397 eNotes educator| Certified Educator

Using only the information given in your question, all we can say is that the aggregate expenditures will drop.  Without other information, we cannot say exactly how much that drop will be.  To see why these two statements are true, let us look at the relationship between marginal propensity to consume (MPC) and aggregate expenditures.

There is a relationship between aggregate expenditures and MPC because MPC is a major determinant of consumption expenditures.  Aggregate expenditures are the sum of consumption, government spending, investment, and net exports.  Of these, consumption is by far the greatest part of aggregate expenditures.  Therefore, any change in consumption expenditures will bring about a change in aggregate expenditures.

Now let us look at the relationship between MPC and consumption expenditures.  This relationship can be expressed in terms of an equation.  That equation can be stated as

Consumption = Autonomous consumption + MPC*disposable income

If we call consumption “y,” autonomous consumption “b” and disposable income “x” you can see that we will have the equation for a line in slope intercept form.  This is because our new equation will be

Y = b+ MPC*x

The slope intercept form of a linear equation can be given as y = y-intercept + slope*x.  Given this, we can see that the MPC is the slope of the line that tells us how much consumption there will be for any given level of disposable income.

At any given level of disposable income, people will spend a certain amount of money on necessities.  This is the autonomous consumption.  In addition, however, people will spend some portion of the rest of their income and save the rest.  The proportion that they spend is the MPC.  If the MPC is .8, they are spending 80% of their disposable income and saving 20%.  If the MPC drops to .75, they are only spending 75% and are saving 25%.  This means that they will be spending less money for level of disposable income.

So, we know that a drop in MPC leads to a decrease in consumption.  We cannot know how much the drop is because we do not know the values for autonomous consumption or disposable income.  All we know is that there is a drop.  If consumption is dropping, aggregate expenditures are dropping as well.