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Basic Macroeconomic Relationships

8. Basic Macroeconomic Relationships. Chapter Objectives. How Changes in Income Affect Consumption (and Saving) About Factors Other Than Income That Can Affect Consumption How Changes in Real Interest Rates Affect Investment

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Basic Macroeconomic Relationships

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  1. 8 Basic Macroeconomic Relationships

  2. Chapter Objectives • How Changes in Income Affect Consumption (and Saving) • About Factors Other Than Income That Can Affect Consumption • How Changes in Real Interest Rates Affect Investment • About Factors Other Than the Real Interest Rate That Can Affect Investment • Why Changes in Investment Increase or Decrease Real GDP by a Multiple Amount

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

  4. Income-Consumption and Income-Savings Relationships • Relationship b/w income and saving • Personal saving = DI-C (disposable income-consumption) • Most significant factor in determining nation’s level of C and S is DI • 45 degree line is a reference line b/c it bisects the 90 degree angle formed by the 2 graph axes • Dot on line represents C and DI in for one year

  5. 05 04 03 02 01 00 99 98 97 96 95 94 93 92 91 90 89 88 87 86 85 84 83 45° Income and Consumption Consumption and Disposable Income, 1983-2005 45° Reference Line C=DI C Saving In 1992 Consumption (billions of dollars) Consumption In 1992 Disposable Income (billions of dollars)

  6. O 8.1 Consumption Saving APC = APS = Income Income Consumption and Saving • The Consumption Schedule • The Saving Schedule • Break-Even Income • Average Propensity to Consume (APC) • Average Propensity to Save (APS)

  7. The Consumption Schedule • Hypothetical consumption schedule • Shows various amounts that households would plan to consume at each of the various levels of DI that might prevail at some specific time • In aggregate: • Households inc. spending as DI inc • Spend a larger proportion of a small DI than of a large DI

  8. The Saving Schedule • To find amount saved, subtract C from DI (S=DI-C) • Direct relationship b/w saving and DI • Saving is a smaller proportion of a smaller DI than of a large DI • Dissaving (consuming in excess of after-tax income) will occur at relatively low Dis

  9. Break-Even Income • Break-even income: income level at which households plan to consume their entire incomes • Graphically: • Consumption schedule cuts the 45 degree line • Saving schedule cuts the horizontal axis (saving is zero)

  10. Average and Marginal Propensities • Average propensity to consume: fraction or % or total income that is consumed • APC=consumption/income • Average propensity to save-fraction of total income that is saved • APS=saving/income • APS+APC = 1

  11. Change in Consumption MPC = Change in Income Change in Saving MPS = Change in Income Consumption and Saving • Marginal Propensity to Consume (MPC) – fraction of any change in income consumed • Marginal Propensity to Save (MPS) – fraction of any change in income saved • MPC+MPS =1

  12. (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

  13. 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

  14. 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

  15. W 8.1 Consumption and Saving • MPC + MPS = 1 • MPC and MPS as Slopes • Nonincome Determinants of Consumption and Saving • Wealth Effect • Expectations • Real Interest Rates • Household Debt

  16. Nonincome Determinants of Consumption and Savings • Determinants other than income may determine how much households will spend or save • 1. wealth – existing wealth that they have already accumulated; wealth effect shifts consumption schedule upward and saving schedule downward • 2. Expectations – about future prices and saving; if prices are expected to rise, people will spend more, save less; if recession is expected, people will save more, spend less

  17. 3. Real Interest Rates – when interest rates fall, people spend more save less and vice versa • 4. Household debt – increased borrowing shifts C curve upward and vice cersa

  18. G 8.1 Consumption and Saving • Other Important Considerations • Changes Along Schedules – movement from one point to another along schedule • Switch to Real GDP • Schedule Shifts – caused by changes in wealth, expectations, interest rates, and debt and will shift both curves • Stability – curves tend to be relatively stable • Taxation – increase in taxes will shift both curves downward and vice versa

  19. 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

  20. O 8.2 G 8.2 Interest Rate and Investment • Expected Rate of Return (r) • The Real Interest Rate (i) • Meaning of r = i • Investment Demand Curve

  21. Interest-Rate-Investment Relationship • Relationship b/w the real interest rate and investment • Expected rate of return – represented by letter “r”

  22. The Real Interest Rate • Interest – the financial cost of borrowing money • If the expected rate of return exceeds the interest rate, the investment should be undertaken • If the interest rate exceeds the expected rate of return, the investment should not be undertaken • Should invest up to point where r=I • If inflation is occurring, must use REAL interest rate

  23. 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) Interest Rate and Investment The Investment Demand Curve 16% 14% 12% 10% 8% 6% 4% 2% 0% $ 0 5 10 15 20 25 30 35 40 ID

  24. Investment Demand Curve • How many dollars’ worth of investment projects have an expected rate of return of a certain %? See ex. p. 154 • Can graph the amount of investment at each expected rate of return and real interest rate • Investment demand curve shows the amount of investment at each real interest rate

  25. Interest Rate and Investment • Shifts of the Investment Demand Curve • Acquisition, Maintenance, and Operating Costs • Business Taxes • Technological Change • Stock of Capital Goods on Hand • Expectations

  26. 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)

  27. Non-Interest Rate Determinants of Investment Demand • Inc in investment demand, shift right • Dec in investment demand, shift left • Determinants: • 1. acquisitions, maintenance, and operating costs – higher operating costs shift curve left, vice versa

  28. 2. business taxes – taxes inc, investment demand curve shifts left, reduction of bus. Taxes shifts right • 3. Technological change – new technology, shift right

  29. 4. stock of capital goods on hand – excess productive capacity decreases demand, vice versa • 5. expectations – of future sales, political climate, pop growth, etc…if expectations optimistic then investment demand increases and vice versa

  30. Interest Rate and Investment • Instability of Investment • Durability • Irregularity of Innovation • Variability of Profits • Variability of Expectations

  31. Instability of Investment • Investment is the most volatile component of total spending • Why? • 1. durability – indefinite life of capital goods • 2. irregularity of innovation – difficult to predict the arrival of new inventions • 3. variability of profits – expectation of future profit is influenced by current profits • 4. Variability of expectations – possible changes in business conditions

  32. GLOBAL PERSPECTIVE Interest Rate and Investment Gross Investment Expenditures as a Percent of GDP, Select Nations Percent of GDP, 2004 0 10 20 30 South Korea Japan Mexico Canada France United States Germany United Kingdom Sweden Source: World Bank

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

  34. Change in Real GDP Initial Change in Spending 1 1 - MPC 1 MPS W 8.2 The Multiplier Effect Multiplier = The Multiplier and the Marginal Propensities Multiplier = -or- Multiplier = Graphically…

  35. The Multiplier Effect • This will be discussed again in Ch. 9 • Direct relationship b/w changes in spending and changes in real GDP • The multiplier effect – a change in a component of total spending leads to a larger change in GDP • See formula on previous slide

  36. The Multiplier • “initial change in spending” usually deals with investment, but could also include G,C or NX • Change in spending results from change in real interest rate or shifts in the investment demand curve • Multiplier works in both directions (inc/dec)

  37. Rationale • 1. economy supports repetitive and continuous flows of income and expenditures • 2. any change in income will alter consumption and spending in the same direction as the change in income • - any change in income will set off a spending chain throughout economy

  38. The Multiplier and Marginal Propensities • MPC and multiplier are directly related • MPS and multiplier are inversely related • Multiplier = 1/1-MPC or • Multiplier = 1/MPS

  39. The Multiplier Effect Tabular and Graphical Views (2) Change in Consumption (MPC = .75) (3) Change in Saving (MPC = .25) (1) Change in Income 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

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

  41. Squaring the Economic Circle Last Word • Humorist Art Buchwald and the Multiplier • One Person Can’t Buy a Product • Others Subsequently Impacted and Cannot Buy Other Items • Multiple Effects Impact Psyche • Ultimately Causes Multiple Step Impact Upon the Economy as a Whole

  42. 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

  43. Next Chapter Preview… The Aggregate Expenditures Model Chapter 9!

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