I. Learning Objectives II. The Income-Consumption and Income-Saving Relationships

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Gyles Lucas
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I. Learning Objectives In this chapter students will learn: A. How changes in income affect consumption (and saving). B. About factors other than income that can affect consumption. C.

1 I. Learning Objectives In this chapter students will learn: A. How changes in income affect consumption (and saving). B. About factors other than income that can affect consumption. C. How changes in real interest rates affect investment. D. About factors other than the real interest rate that can affect investment. E. How changes in investment increase or decrease real GDP by a multiple amount. II. The Income-Consumption and Income-Saving Relationships A. Disposable income is the most important determinant of consumer spending. B. Saving is the part of disposable income not consumed. C. Figure 27.1 represents graphically the recent historical relationship between disposable income (DI), consumption (C), and saving (S) in the United States. 1. A 45-degree line represents all points where consumer spending is equal to disposable income; other points represent actual C and DI relationships for each year from The difference between the 45-degree line and consumption represents the amount of income that is saved. D. Conclusions 1. Households consume a large portion of their disposable income. 2. Both consumption and saving are directly related to the level of income.

2 E. The Consumption Schedule AP Macroeconomics Chapter 27

3 1. A hypothetical consumption schedule (Table 27.1 and Key Graph 27.2a) shows that households spend a larger proportion of a small income than of a large income; households with higher incomes save more than households with lower incomes. 2. A hypothetical saving schedule (Table 27.1 and Key Graph 27.2b) shows that dissaving occurs at low levels of disposable income, where consumption exceeds income and households must borrow or use up some of their wealth. F. Average and Marginal Propensities 1. Average Propensity to Consume (APC) a. % of income consumed b. APC = consumption / income 2. Average Propensity to Save (APS) a. % of income saved b. APS = saving / income 3. APC + APS = 1 (% consumed + % saved = 100% of income) 4. Global Perspective 27.1 shows the APCs for several nations in Note the high APCs for Australia, the United States, and Canada. 5. Marginal Propensity to Consume (MPC) a. % of a change in income that is consumed b. MPC = change in consumption / change in income 6. Marginal Propensity to Save (MPS) a. % of a change in income that is saved b. MPS = change in saving / change in income 7. MPC + MPS = 1 (% of change consumed + % of change saved = 100% of change in income) G. Nonincome Determinants of Consumption and Saving 1. The amount of disposable income is the primary determinant of the amounts households will spend and save, but other factors may cause households to consume more or less. a. Wealth An increase in wealth increases consumption and reduces saving. In recent years, major fluctuations in stock market values have increased the importance of this wealth effect. A reverse wealth effect occurred in 2008, when stock prices fell dramatically. b. Borrowing Increased borrowing increases consumption and reduces saving. But eventually loans must be repaid, so the cost of current consumption is forgone future consumption.

Real interest rates Lower interest rates increase the incentive to borrow and consume, and reduce the incentive to save.

4 c. Expectations Changes in expected future prices or income can affect current spending and saving. Households that expect inflation will increase current spending before prices rise; households that expect a recession will reduce current spending to save for expected bad times. d. Real interest rates Lower interest rates increase the incentive to borrow and consume, and reduce the incentive to save. Because most household spending is not interest sensitive, interest rate changes only have modest effects on spending. 2. Consider This The Great Recession and the Paradox of Thrift a. Concerned about reduced wealth, high debt, and potential job losses, households increased their saving and reduced their income in b. Paradox of thrift a recession can be made worse when households become thriftier and save in response to the economic downturn. Saving benefits the economy in the long run because it promotes investment and economic growth. But it hurts the economy in the short run, because when firms are pessimistic about future sales, they are less likely to engage in investment. c. When each household attempts to save more during a recession, the reduced demand for products lowers total income, which makes it more difficult for households to save. H. Other Important Considerations 1. Macroeconomic models focus more on real domestic output (real GDP) than on disposable income (Figure 27.4).

2. Movement from one point to another on a given schedule is a change in the amount consumed; a shift in the schedule is a change in consumption schedule, and is caused by nonincome determinants of

5 2. Movement from one point to another on a given schedule is a change in the amount consumed; a shift in the schedule is a change in consumption schedule, and is caused by nonincome determinants of consumption. 3. Consumption and saving schedules will always shift in opposite directions unless a shift is caused by a tax change. 4. Taxes shift both spending and saving in the same direction. Lower taxes increase both spending and saving, because households will spend part of a tax cut and save the rest. Increases in taxes reduce both savings and spending. 5. Economists believe that consumption and saving schedules are generally stable unless deliberately shifted by government action. III. The Interest Rate Investment Relationship A. Investment consists of spending on new plants, capital equipment, machinery, inventories, and construction. 1. The investment decision is based on marginal benefit and marginal cost. 2. The expected rate of return is the marginal benefit. 3. The interest rate the cost of borrowing funds is the marginal cost. B. Expected rate of return is found by comparing the expected economic profit (total revenue minus total cost) to the cost of the investment to get expected rate of return. 1. If a firm expects to make $100 profit on a $1000 investment, it has a 10% expected rate of return. Thus, the business would not want to pay more than a 10% interest rate on investment. 2. Remember that the expected rate of return is not a guaranteed rate of return. Investment carries risk. C. The real interest rate, i nominal rate corrected for expected inflation determines the cost of investment. 1. The interest rate represents either the cost of borrowed funds or the opportunity cost of investing your own funds, which is income forgone. 2. If the real interest rate exceeds the expected rate of return, the investment should not be made. D. The investment demand curve shows an inverse relationship between the interest rate and amount of investment (Figure 27.5).

6 1. As long as the expected return exceeds the interest rate, the investment is expected to be profitable. Fewer projects are expected to provide a high return, so less will be invested if interest rates are high. 2. Investment projects should be undertaken up to the point where r = i; the investment demand curve shows the amount of investment that will occur at each real interest rate. E. Shifts in investment demand occur when any determinant apart from the interest rate changes (Figure 27.6). Greater expected returns create more investment demand and shift the curve to the right; lower expected returns cause a leftward shift. 1. Higher acquisition, maintenance, and operating costs of capital goods lower the expected return. 2. Increased business taxes lower the expected return. 3. Improvements in technology lower costs, which would increase expected returns. 4. The stock of capital goods on hand will affect new investment. If firms have abundant idle capital on hand because of weak demand or recent investment, new investment would be less profitable. 5. Increases in planned inventories, because the firm is expecting an increase in product sales, would increase investment. 6. If firms have positive expectations about future economic and political conditions, the expected rate of return increases and firms would increase investment. F. Investment is the most volatile component of total spending. Most of the fluctuations in output and employment that happen over the course of the business cycle can be attributed to demand shocks from unexpected changes in investment (Figure 27.7).

1. Business expectations can change quickly. 2. Capital goods are durable, so spending can be postponed. 3. Innovation occurs irregularly. 4. Profits vary considerably. G.

7 1. Business expectations can change quickly. 2. Capital goods are durable, so spending can be postponed. 3. Innovation occurs irregularly. 4. Profits vary considerably. G. Consider This The Great Recession and the Investment Riddle 1. During the Great Recession of , real interest rates declined to virtually zero, but investment still substantially declined during this period. 2. The investment demand curve had shifted to the left, reflecting firms expectations that they would earn no (or negative) returns on investment; hence, they stopped investing. IV. The Multiplier Effect A. Multiplier effect a change in a component of total spending leads to a larger change in real GDP. 1. Multiplier = change in real GDP / initial change in spending. Alternatively, it can be rearranged to read: Change in real GDP = initial change in spending x multiplier. 2. Three points to remember about the multiplier: a. The initial change in spending is usually associated with investment because it is so volatile, but changes in consumption (unrelated to income), net exports, and government purchases also are subject to the multiplier effect. b. The initial change in investment spending results from a change in the real interest rate and/or a shift of the investment demand curve. c. The multiplier works in both directions (increasing or decreasing).

B. Rationale (Figure 27.8) AP Macroeconomics Chapter 27 1.

$Any change in income will change both consumption and saving in the same direction as the initial change in income, by a fraction of that change. a. Marginal propensity to consume (MPC) the fraction of the change in income that is spent.$

8 B. Rationale (Figure 27.8) AP Macroeconomics Chapter The economy has continuous flows of expenditures and income a ripple effect in which money spent by Person A becomes income for Person B, and Person B s spending becomes income for Person C. 2. Any change in income will change both consumption and saving in the same direction as the initial change in income, by a fraction of that change. a. Marginal propensity to consume (MPC) the fraction of the change in income that is spent. b. Marginal propensity to save (MPS) the fraction of the change in income that is saved. c. Multiplier = 1 / MPS or 1 / (1-MPC) C. The Multiplier and Marginal Propensities 1. The size of the MPC and the multiplier are directly related; the larger the proportion of income spent, the larger the multiplier effect (Figure 27.9).

9 2. The size of the MPS and the multiplier are inversely related; the larger the proportion of income saved, the smaller the multiplier effect. 3. The significance of the multiplier is that a small change in investment or consumption can trigger a much larger change in the equilibrium level of GDP. 4. Because of complications in the calculation of the multiplier (imports, taxes, inflation), the actual multiplier is somewhat different from the simple formula. Economists disagree about the size of the actual multiplier in the United States, with estimates ranging from 2.5 to zero. V. LAST WORD: Squaring the Economic Circle A. A decrease in consumption by one person sends ripple effects through the economy. B. Initial decreases in demand reduce output and employment in other industries, reducing output even further into a recessionary spiral.

CHAPTER TWENTY-SEVEN BASIC MACROECONOMIC RELATIONSHIPS

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