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Basic Macroeconomic Relationships

Basic Macroeconomic Relationships. Topics Income – consumption & saving relationship Interest rate – rate of return – investment The multiplier – very important concept!. $ 13,841 1687 $ 12,154 29 96 $ 12,221 1009 979 467 344 2237 $ 11,659 1482 $ 10,177.

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Basic Macroeconomic Relationships

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  1. BasicMacroeconomic Relationships

  2. Topics Income – consumption & saving relationship Interest rate – rate of return – investment The multiplier – very important concept!

  3. $ 13,841 1687 $ 12,154 29 96 $ 12,221 1009 979 467 344 2237 $ 11,659 1482 $ 10,177 U.S. Income Relationships 2007 Gross Domestic Product (GDP) Less: Consumption of Fixed Capital Equals: Net Domestic Product (NDP) Less: Statistical Discrepancy Plus: Net Foreign Factor Income Equals: National Income (NI) Less: Taxes on Production and Imports Less: Social Security Contributions Less: Corporate Income Taxes Less: Undistributed Corporate Profits Plus: Transfer Payments Equals: Personal Income (PI) Less: Personal Taxes Equals: Disposable Income (DI)

  4. Income – Consumption Relationship and Income – Saving Relationship • Disposable Income (DI) • DI = C+S • Personal Saving (S) – “not spending” • Consumption (C) – Consumption spending • The Consumption Schedule (consumption function) • A schedule showing the various amounts that households would plan to consume at each of the various levels of DI that might prevail at some point in time • The Saving Schedule (saving function) • A schedule showing the various amounts that households would plan to save at each of the various levels of DI that might prevail as some point in time • Break-even Income– the level of income at which households plan to consume their entire incomes C=DI

  5. o o 45 45 • Graphic representation of the relationship • 45-Degree Line – reference line • Measuring C and DI Reference line Any point on the 45 degree Reference line is equidistant From each axis (DI = C) Saving and consumption Both are directly related to Disposable income SAVING C Consumption Consumption schedule DISSAVING Disposable Income

  6. Consumption and Saving Terminology Lsnh9 start here on 3/29 APC – average propensity to consume – fraction of income that is consumed. Consumption / Income Alief macro start here 3/30 APS – average propensity to save – fraction of income that is saved. Saving / Income APS+APC=1 MPC – marginal propensity to consume – the fraction of any change in Income that will be consumed. Change in Consumption / Change in Income MPS – marginal propensity to save – the fraction of any change in Income that will be saved. change in Saving / change in Income MPS+MPC=1

  7. 500 475 450 425 400 375 45° 50 25 0 • 390 410 430 450 470 490 510 530 550 Consumption and Saving 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

  8. Average Propensity to Consume Selected Nations, with respect to GDP, 2006 .80 .85 .90 .95 1.00 United States Canada United Kingdom Japan Germany Netherlands Italy France Source: Statistical Abstract of the United States, 2006

  9. Non Income Determinants of Consumption and Saving • Wealth – value of real (houses and land) and financialassets (cash, bank accounts, securities, pensions) • Wealth Effects – causes consumption and saving to increase or decrease • Expectations – about inflation, recession, etc • Real Interest Rates (adjusted for inflation) • Household Debt – more debt enables more consumption • Taxation – • Consumption & saving move in same direction – taxes affect both

  10. TERMINOLOGY, SHIFTS, & STABILITY • Terminology • Movement along a curve (change in amount consumed) vs. shift of a curve • Schedule Shifts • Wealth, • expectations, • interest rates, • household debt • Taxes – affect both C and S • Stability – consumption & savings functions relatively stable Lsmh 10:30 start here 3/29

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

  12. The Interest Rate – Investment Relationship Relationship between real interest rates and investment. Investment – expenditures on new plants, capital equipment, machinery, inventories, etc. Investment decision – a MB MC decision. MB is the expected rate of return businesses hope to realize. MC is the interest rate that must be paid for borrowed funds. Business will invest in all projects where expected rate of return exceed the interest rate. The two basic determinants of investment spending!

  13. Interest Rate – Investment Relationship Expected Rate of Return, r Real Interest Rate: i is the nominal rate adjusted for inflation. Inverse relationship between Investment demand and the real interest rate. Graphically presented...

  14. Cumulative Amount of Investment Having This Rate of Return or Higher (I) 16 14 12 10 8 6 4 2 0 Expected Rate of Return (r) r and i (percent) 5 10 15 20 25 30 35 40 Investment (billions of dollars) Investment Demand Curve 16% 14% 12% 10% 8% 6% 4% 2% 0% $ 0 5 10 15 20 25 30 35 40 ID

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

  16. Non-Interest Rate Determinants of Investment Demand • The affect Investment Demand by way of the Expected Rate of Return • Acquisition, Maintenance, and Operating Costs • Business Taxes • Technological Change • Stock of Capital Goods on Hand • Planned inventory changes • Expectations

  17. Gross Investment Expenditure Percent of GDP, Selected Nations, 2006 0 10 20 30 South Korea Japan Canada Mexico France United States Sweden Germany United Kingdom Source: International Monetary Fund

  18. Causes of Instability of Investment • Durability of capital goods • Irregularity of Innovation • Variability of Profits • Variability of Expectations

  19. Change in Real GDP Initial Change in Spending The Multiplier Effect • More spending results in higher GDP • Initial change in spending changes GDP by a multiple amount Multiplier =

  20. The Multiplier Effect • Causes of the initial change in spending • Changes in investment • Other changes – such as? • Rationale • Dollars spent are received as income • Income received is spent (MPC) • Initial changes in spending cause a spending chain

  21. The Multipliers • Spending Multiplier = 1/MPS • An autonomous change in spending results in a change in aggregate production in the same direction. • Tax Multiplier = - (MPC/MPS) • If, for example, the MPC is 0.75 (and the MPS is 0.25), then an autonomous $1 trillion change in taxes results in an opposite change in aggregate production of $3 trillion • Balanced Budget Multiplier = 1 • The balanced-budget multiplier measures the combined impact on aggregate production of equal changes in government purchases and taxes. The simple balanced-budget multiplier has a value equal to one http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=tax+multiplier

  22. Change in Real GDP = Multiplier Initial Change in Spending initial change in spending Change in GDP = x Multiplier The Multiplier Spending Effect For Example…

  23. The Multiplier Effect (3) Change in Saving (MPC = .25) (1) Change in Income (2) Change in Consumption (MPC = .75) Increase in Investment of $5 Second Round Third Round Fourth Round Fifth Round All other rounds Total $ 5.00 3.75 2.81 2.11 1.58 4.75 $ 20.00 $ 3.75 2.81 2.11 1.58 1.19 3.56 $ 15.00 $ 1.25 .94 .70 .53 .39 1.19 $ 5.00 $20.00 $4.75 15.25 $1.58 13.67 $2.11 11.56 $2.81 8.75 ΔI= $5 billion $3.75 5.00 $5.00 1 2 3 4 5 All Rounds of Spending

  24. 1 1 = or Multiplier 1 - MPC MPS x = initial change in spending Change in GDP Multiplier The Spending Multiplier Effect Multiplier Effect and the Marginal Propensities Inverse relationship between: Multiplier & MPS

  25. .9 10 .8 5 .75 4 .67 3 .5 2 The Multiplier Effect MPC and the Multiplier MPC Multiplier

  26. The Tax Multiplier • (- MPC/MPS) • You are the chief economic adviser to the president. You are instructed to devise a plan to reduce unemployment to an acceptable level without increasing the level of government spending. • You decide to cut taxes and maintain the spending level. • A tax cut increases disposable income which leads to increases in consumption. • Would the decrease in taxes affect aggregate output in the same way as an increase in government spending?

  27. The Tax Multiplier • A tax decrease causes an income increase. • Consumption increases • Inventories decrease • Output increases in response. • Employment and income increase and lead to subsequent rounds of spending. • GDP will increase by a multiple of the decrease in taxes. • The multiplier for a change in taxes is not the same as the multiplier for an change in government spending.

  28. The Tax Multiplier • Why does the tax multiplier differ from the Government spending multiplier? • Compare how each works its way through the economy. • First an increase in G. • The increase in G leads to an immediate and direct impact on total spending. • Because G is a component of GDP, an increase in G leads to a dollar for dollar increase in GDP. • If G increases by $1, GDP initially increases by $1.

  29. The Tax Multiplier • The tax cut case • When taxes are cut there is no direct impact on spending. • Taxes first have an impact on a household’s disposable income which influences household consumption spending (an element of total spending) • The tax cut flows through households before affecting aggregate expenditure. • If the tax cut = $1, by how much would spending increase?

  30. The Tax Multiplier • If the MPC = .75, spending will increase by $0.75. • Because the initial increase in GDP is smaller for a tax cut than for an increase in Government spending, the final effect on the equilibrium level of GDP will be smaller. • The tax multiplier = - (MPC/MPS)

  31. The Balanced Budget Multiplier • Balanced Budget Multiplier = 1

  32. 45-degree line consumption schedule saving schedule break-even income average propensity to consume (APC) average propensity to save (APS) marginal propensity to consume (MPC) marginal propensity to save (MPS) wealth effect expected rate of return investment demand curve multiplier KEY TERMS

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