Basic Macroeconomics Relationships. Business, Computers, & Information Technology

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1 Basic Macroeconomics Relationships Business, Computers, & Information Technology Unit 3 Chapter 27 1

2 Remember Growth, Business Cycle, Recession, and Inflation? Macroeconomic Relationships help us explain these events. 1. Income, Consumption, and Saving 2. Interest Rates, Expected Rate of Return, and Investment. 3. Changes in Spending, and Real GDP LO1 27-2

3 1. Income, Consumption, and Saving Remember Personal Income Taxes = Disposable Income How many things can you do with your DI? DI = Consumption + Savings Direct relationship 45 line C = DI Points below are C Difference is Savings HHs spend a larger proportion of a small income than of a large income. LO1 27-4

4 Savings and Consumption Schedule Dissavings occur at low income levels. What do people do if Consumption > DI? Consumption (billions of dollars) Saving $5 billion C Consumption schedule Dissaving $5 billion LO1 27-6

5 Average Propensities Average propensity to consume (APC) Fraction of total income consumed Average propensity to save (APS) Fraction of total income saved APC = consumption income APS = saving income APC + APS = 1 (1) Level of Output and Income GDP=DI (4) Average Propensity to Consume (APC), (2)/(1) (5) Average Propensity to Save (APS), (3)/(1) (1) $ (2) (3) (4) (5) (6) (7) (8) (9) (10) Example: DI = $1B. and C = $96M: APC =.96 APS =.04 LO1 27-8

6 Global Perspective LO

Marginal Propensities Marginal propensity to consume (MPC) Proportion of a change in income consumed Marginal propensity to save (MPS) Proportion of a change in income saved Consumption MPC = 15 20 =.

7 Marginal Propensities Marginal propensity to consume (MPC) Proportion of a change in income consumed Marginal propensity to save (MPS) Proportion of a change in income saved Consumption MPC = =.75 DI ($20) C C ($15) MPC = MPS = change in consumption change in income change in saving change in income Saving MPS = 5 20 =.25 DI ($20) S ($5) Disposable income S So, MPC + MPS = 1 Ex: = 1 LO

8 2. Interest-Rate-Investment Relationship First, what is the Expected Rate of Return? Example: A new robot costs $1,000. Expected net revenue = $1,100. Expected profit = $100. Expected Rate of Return (r) = Profit/Cost x 100 r = $100/$1,000 x 100 r = 10% The real interest rate If the interest rate (i) to borrow capital is 7%, r = 3% What if i = 12%? r = -2% Businesses will invest in projects for which r > i LO

9 Investment Demand Curve (r) and (i) Investment (billions of dollars) 16% $ Expected rate of return, r and real interest rate, i (percents) Investment (billions of dollars) There is an inverse relationship between r and Quantity of Investments Demanded. Example: At point A, $10B quantity of investments will be demanded at a price of 12% i and a r of 12% or HIGHER. In other words, at an interest rate of 12%, investment will be $10 billion, because these are projects with expected rates of return between 12% and 13.99%. LO A Investment demand curve ID

10 Investment Volatility Compared to GDP Source: Bureau of Economic Analysis, LO

11 3. Spending Changes-RGDP The Multiplier Effect Consider this If spending increases and GDP is at its potential, what will happen? Remember this? If GDP has room to grow A change in spending changes real GDP more than the initial change in spending (Multiplier Effect) Multiplier = change in real GDP initial change in spending Change in GDP = multiplier x initial change in spending LO

12 The Multiplier Effect (1) Change in Income (2) Change in Consumption (MPC =.75) (3) Change in Saving (MPS =.25) Increase in investment of $5.00 $5.00 $3.75 $1.25 Second round Third round Fourth round Fifth round All other rounds Total $20.00 $15.00 $ change in real GDP $4.75 Multiplier = $1.58 initial change in spending Cumulative income, GDP (billions of dollars) $5.00 $3.75 $2.81 $2.11 Multiplier = $20 B All others LO $5 B What if MPC =.90? = 4

13 Multiplier and Marginal Propensities Multiplier and MPC are directly related Large MPC results in larger increases in spending Multiplier and MPS inversely related Large MPS results in smaller increases in spending Multiplier = MPC = Remember, MPC + MPS = 1 MPS = 1-MPC 1 Multiplier = MPS = 1 1 =.1 1/10 = 1.1 = 10 = 10 MPC Multiplier 10 LO

14 Let s Practice Consumers initiate a $7B increase in spending. Businesses increase investment by $4B. Government initiates a $3B expenditures. If the MPC is currently.60, what is the overall increase to RGDP? Step 1: Calculate the multiplier. Multiplier = MPC = 1 MPS = 1.4 Step 1: Calculate Change in GDP. Change in GDP = Multiplier x initial change in spending = 2.5 x $14B = $35B = 1 2/5 =

15 The Actual Multiplier Effect? Actual multiplier is lower than the model assumes Consumers buy imported products Households pay income taxes Inflation Multiplier may be 0 (U.S. estimate is between 2.5 and 0) LO

Basic Macroeconomic Relationships

8 Basic Macroeconomic Relationships 8-1 Chapter Objectives How Changes in Income Affect Consumption (and Saving). About Factors Other Than Income That Can Affect Consumption. How Changes in Real Interest