Basic Macroeconomic Relationships

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1 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 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. 8-2 Basic Relationships Income-Consumption. Disposable income is the most important determinant of consumer spending. Income-Saving. What is not spent is called saving. 45 Line. A 45-degree line represents all points where consumer spending is equal to disposable income. C = DI on the 45 Line. S = DI C

2 000 Income and Consumption Consumption and Disposable Income, Consumption (billions of dollars) Reference Line C=DI Saving In Consumption In 1992 C Disposable Income (billions of dollars) The Consumption Schedule. The Saving Schedule. Break-Even Income. Average Propensity to Consume (APC). Average Propensity to Save (APS). APC = Consumption Income APS = Saving Income 8-5 Marginal Propensity to Consume (MPC). Marginal Propensity to Save (MPS). MPC = MPS = Change in Consumption Change in Income Change in Saving Change in Income 8-6 2

3 (1) Level of Output (2) And Consumption Income (GDP=DI) (C) (3) Saving (S) (1-2) (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) (1) $370 (2) 390 (3) 4 (4) 430 (5) 450 (6) 470 (7) 490 (8) 5 (9) 530 () 550 $ $ Consumption (billions of dollars) Schedules Saving $5 Billion C Consumption Schedule Dissaving $5 Billion 8-8 Saving (billions of dollars) Disposable Income (billions of dollars) Dissaving $5 Billion Saving Schedule S Saving $5 Billion Global Perspective Average Propensities to Consume Select Nations GDPs Average Propensities to Consume United States.963 Canada.958 United Kingdom.953 Japan.942 Germany.896 Netherlands.893 Italy.840 France Source: Statistical Abstract of the United States,

4 MPC + MPS = 1 APC + APS = 1 MPC and MPS as Slopes. MPC is the slope of the consumption schedule MPS is the slope of the saving schedule Non-income Determinants of. Wealth Effect. An increase in wealth shifts the consumption schedule up and saving schedule down. Expectations. Changes in expected future prices or wealth can affect consumption spending today. Real Interest Rates. Declining interest rates increase the incentive to borrow and consume, and reduce the incentive to save. Household Debt. Lower debt levels shift consumption schedule up and saving schedule down. Other Important Considerations: Changes Along Schedules. Movement from one point to another on a given schedule is called a change in the amount consumed; a shift in the schedule is called a change in consumption schedule, and is caused by non-income determinants of consumption. Switch to Real GDP Macroeconomic models focus on real domestic output (real GDP) more than on disposable income

5 Schedule Shifts Consumption and saving schedules will always shift in opposite directions unless a shift is caused by a tax change. Stability Economists believe that consumption and saving schedules are generally stable unless deliberately shifted by government action. Taxation Lower taxes will shift both schedules up since taxation affects both spending and saving, and vice versa for higher taxes Schedules Consumption (billions of dollars) C 1 C 0 C 2 45 Saving (billions of dollars) Disposable Income (billions of dollars) S 2 S 0 S Investment consists of spending on new plants, capital equipment, machinery, inventories, construction, etc. The investment decision weighs marginal benefits and marginal costs. The expected rate of return is the marginal benefit. The interest rate (the cost of borrowing funds) represents the marginal cost

6 Expected Rate of Return (r). Expected rate of return is found by comparing the expected economic profit (total revenue minus total cost) to cost of investment to get expected rate of return. The Real Interest Rate (i). The real interest rate, i (nominal rate corrected for expected inflation), determines the cost of investment. Meaning of r = i. If real interest rate exceeds the expected rate of return, the investment should not be made. Investment Demand Curve 8-16 The Investment Demand Curve Expected Rate of Return (r) 16% 14% 12% % 8% 6% 4% 2% 0% Cumulative Amount of Investment Having This Rate of Return or Higher (i) $ r and i (percent) ID Investment (billions of dollars) 8-17 Shifts of the Investment Demand Curve. Greater expected returns create more investment demand; shift curve to right. The reverse causes a leftward shift. Changes in expected returns result because: Acquisition, Maintenance, and Operating Costs. Business Taxes. Technological Change. Stock of Capital Goods on Hand. Expectations

7 Shifts in the Investment Demand Curve Increase in Investment Demand 0r and i (percent) Decrease in Investment Demand Investment (billions of dollars) ID 0 ID 1 ID Instability of Investment Durability. Irregularity of Innovation. Variability of Profits. Variability of Expectations Global Perspective Gross Investment Expenditures as a Percent of GDP, Select Nations Percent of GDP, South Korea Japan Mexico Canada France United States Germany United Kingdom Sweden Source: World Bank 7

8 The Volatility of Investment Percentage Change Gross Investment GDP Year 8-22 The Multiplier Effect Changes in spending ripple through the economy to generate event larger changes in real GDP. This is called the multiplier effect. The multiplier is based on two facts: The economy has continuous flows of expenditures and income a ripple effect in which income received by one person comes from money spent by another. Any change in income will cause both consumption and saving to vary in the same direction as the initial change in income, and by a fraction of that change The Multiplier Effect Change in Real GDP Multiplier = Initial Change in Spending The Multiplier and the Marginal Propensities Multiplier = -or- Multiplier = MPC 1 MPS Graphically

9 The Multiplier Effect Tabular and Graphical Views Increase in Investment of $5 Second Round Third Round Fourth Round Fifth Round All other rounds Total $ ΔI= $5 billion 5.00 $5.00 $3 (1) Change in Income $ $ $2.81 $2.11 (2) Change in Consumption (MPC = ) $ $ $1.58 $4 (3) Change in Saving (MPC = ) $ $ All Rounds of Spending The Multiplier Effect The MPC and the Multiplier MPC Multiplier The Multiplier Effect The size of the MPC and the multiplier are directly related; the size of the MPS and the multiplier are inversely related. The significance of the multiplier is that a small change in investment plans or consumption-saving plans can trigger a much larger change in the equilibrium level of GDP. The simple multiplier given above can be generalized to include other leakages from the spending flow besides savings

10 45 (degree) line Consumption schedule Saving schedule Break-even income Average propensity to consume (APC) Average propensity to save (APS) Key Terms Marginal propensity to consume (MPC) Marginal propensity to save (MPS) Wealth effect Expected rate of return Investment demand curve Multiplier 8-28 Next Chapter Preview The Aggregate Expenditures Model Chapter

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