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Ch 8. Basic Macroeconomic Relationships

Explore the basic macroeconomic relationships between consumption and disposable income from 1980 to 2002, including average propensities to consume and save, as well as marginal propensities to consume and save. Understand the fundamental dynamics of consumption, saving, investment risks, and the factors influencing investment demand in this period.

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Ch 8. Basic Macroeconomic Relationships

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  1. Ch 8. Basic Macroeconomic Relationships

  2. Consumption and disposable income, 1980 – 2002. Each dot shows consumption and DI in a given year. Line C generalizes the relationship between consumption & DI, indicates a direct relationship and shows that households consume most of their incomes. A. Income & consumption schedules. -- Savings (S) equals disposable income (DI) minus consumption (C). -- 45 degree line shows all points where DI and C are equal. -- The Consumption Schedule and the Savings Schedule.

  3. Basic Relationships • Income-Consumption • Income-Saving • 45° Line • C = DI on the Line • S = DI - C

  4. If a family’s C > DI, The APC is > 1. B. APC (average propensity to consume) APC = consumption income C. APS (average propensity to save) APS = saving income -- From the schedule before, the APC is 450 = 45 or about 96%. 470 47 -- The APS is 20 = 2 or about 4%. 470 47 -- ‘Average’ is for one year. APC + APS = 1

  5. GLOBAL PERSPECTIVE Consumption and Saving Average Propensities to Consume Select Nations GDPs Average Propensities to Consume .80 .85 .90 .95 1.00 United States Canada United Kingdom Japan Germany Netherlands Italy France .963 .958 .953 .942 .896 .893 .840 .833 Source: Statistical Abstract of the United States, 2006

  6. D. MPC (marginal propensity to consume) MPC = change in consumption change in income E. MPS (marginal propensity to save) MPS = change in saving change in income MPC + MPS = 1 MPC + MPS = APC + APS -- ‘Marginal’ is over time

  7. -- The graph is on the next slide.

  8. (a) consumption and (b) saving schedule. • The saving schedule in (b) is found by subtracting the consumption schedule in (a) vertically from the 45 degree line. • Consumption equals disposable income (and savings equals zero) at $390 billion in this example.

  9. (1) Level of Output And Income (GDP=DI) (4) Average Propensity to Consume (APC) (2)/(1) (5) Average Propensity to Save (APS) (3)/(1) (6) Marginal Propensity to Consume (MPC) Δ(2)/Δ(1) (7) Marginal Propensity to Save (MPS) Δ(3)/Δ(1) (2) Consump- tion (C) (3) Saving (S) (1-2) Consumption and Saving • $370 • 390 • 410 • 430 • 450 • 470 • 490 • 510 • 530 • 550 $375 390 405 420 435 450 465 480 495 510 $-5 0 5 10 15 20 25 30 35 40 1.01 1.00 .99 .98 .97 .96 .95 .94 .93 .93 -.01 .00 .01 .02 .03 .04 .05 .06 .07 .07 .75 .75 .75 .75 .75 .75 .75 .75 .75 .25 .25 .25 .25 .25 .25 .25 .25 .25

  10. 500 475 450 425 400 375 45° 50 25 0 • 390 410 430 450 470 490 510 530 550 Consumption and Saving Consumption and Saving Schedules C Saving $5 Billion Consumption Schedule Consumption (billions of dollars) Dissaving $5 Billion • 390 410 430 450 470 490 510 530 550 Disposable Income (billions of dollars) Dissaving $5 Billion Saving Schedule S Saving (billions of dollars) Saving $5 Billion

  11. 45° Consumption and Saving Consumption and Saving Schedules C1 C0 C2 Consumption (billions of dollars) Disposable Income (billions of dollars) S2 Saving (billions of dollars) S0 S1

  12. Investment Involves RISKS F. Expected Rate of Return – anticipated profit from investment. r = is expected to be 10% (on a $1,000 investment = $100/$1,000) G. Real Interest Rate – expressed in dollars (adjusted for inflation) & = to nominal interest rate less the rate of inflation. i = $1,000 times 7% = $70 ($30 profit) -- The interest-Rate-Investment Relationship. -- Investment is expenditures on new plants, equipment, machinery, etc. -- Nominal interest rate is not adjusted for inflation.

  13. H. Investment Demand Curve Rates of Expected Return and Investment Expected Cumulative amount Rate of of investment having Return (r) this rate of return or higher (in billions) 25% $0 20 $10 15 20 10 30 5 40 0 50 Investment Demand Curve Inverse Relationship (sloping down) -- We move from a single firm’s investment to total demand by entire business sector. -- This shows the amount of investment forthcoming at each real interest rate. -- The level of investment depends on the expected rate of return & real interest rate.

  14. Shifts of the Investment Demand Curve I. Shifts 1. Operating costs. 2. Business taxes. 3. Tech changes. 4. Stock of goods. 5. Expectations. -- When these things change, the Demand Curve shifts. -- If businesses expect greater returns on their investments it increases investment demand and shifts the demand curve to the right (from ID₀ to ID₁). -- Expected lower rates of return moves the shift to the left (from ID₀ to ID₂).

  15. Interest Rate and Investment Shifts in the Investment Demand Curve Increase in Investment Demand r and i (percent) Decrease in Investment Demand ID1 ID0 ID2 0 Investment (billions of dollars)

  16. 6. Instability of investment. 7. Durability. 8. Irregularity of innovation. 9. Variability of profits. 10. “ of expectations.

  17. Interest Rate and Investment The Volatility of Investment Gross Investment Percentage Change GDP 1971 1975 1979 1983 1987 1991 1995 1999 2003 Year

  18. And vice versa! J. Multiplier Effect:  spending =  GDP. Multiplier = Δ in real GDP initial Δ in spending If investment rises by $30 billion and the GDP rises by $90 billion, we then know that the multiplier is 3 (= $90/30). -- Other things equal, there is a direct relationship between changes in spending and changes in real GDP. -- The multiplier determines how much larger that change will be. -- Or, Change in GDP = multiplier x initial change in spending.

  19. MPC & MPS are #D & E • $5 bill increase in the incomes of households • MPC in .75 • Raises consumption by $3.75 (.75 x $5) • Savings by $1.25 (= .25 x $5 bill) column 2&3. • 2nd round has $3.75 in consumption. • Consume .75 of $3.75 ($2.81 bill), and save .25 ($.94 bill) -- Initial change of investment spending of $5 bill creates and equal $5 bill of new income. -- The multiplier is 4 (= $20 bill/$5 bill).

  20. The MPC and the multiplier are directly related and the MPS and the multiplier are inversely related. Multiplier = 1 1 – MPC Multiplier = 1 MPS -- Remember that MPC + MPS = 1. -- Therefore, MPS = 1 – MPC.

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