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27
Basic Macroeconomic
Relationships
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
The Great Depression
• The 1930s changed the view of economist
around the world who once believed that
markets would automatically adjust to
their long-run potentials and that longterm recessionary conditions were
impossible.
• The Great Depression changed that:
– 1929-1933: real GDP decreases by 30%
– 1933: Unemployment is 25%; by 1939 at 17%
John Maynard Keynes
• Economist; developed a theory that
explained long term unemployment and a
recipe to stimulate recovery.
• Keynes believed that spending motivated
firms to supply goods and services.
– If consumers and firms were pessimistic
about the future, firms would cut back
production.
– Essentially – less spending would lead to less
output.
Keynes cont’d.
• Rejected the belief that lower wages and interest
rates would get the economy back on track…
argued that wages and interest rates are highly
inflexible.
• Instead, he believed that powerful trade unions
and large corporations would be able to
maintain their wages and prices at a high level
and that’s what would reinvigorate the
economy.
• Also believe that lower interest rates would fail
to stimulate additional investment.
Output, Employment and
Keynes
• According to Keynes:
– Equilibrium takes place when total spending in the
economy is equal to current output.
• When this happens, firms can sell what they are currently
producing, inventories won’t rise or fall and they won’t have to
adjust their output.
– Believed that changes in output, not prices, would
stimulate economy towards equilibrium.
• Increase in consumption would leading to a reduction in
inventory and businesses would have to respond by increasing
their output which means more jobs (and vice versa)
Output and Employment
• Keynes believed that 1930s consumers
were unwilling to spend much because
reduction in stock prices and the value of
assets had reduced their wealth and
income. People were super pessimistic
about their future.
• Businesses responded by cutting output
and stopped investing which led to
underutilization and high unemployment.
Keynes and the Multiplier
Principle
• Keynes believed that market forces could not be
counted on to maintain spending levels consistent
with full employment because even minor
disturbances will often be amplified into major
disruptions.
• The multiplier principle explains this:
– Builds on the point that one individual’s expenditures
becomes the income of another.
– People will spend part of their income on consumption
which will generate income for others – eventually total
income will expand by a multiple of the initial increase in
spending.
Income Consumption and Saving
• Consumption and saving
• Primarily determined by Disposable Income
• Direct relationship (if DI increases,
consumption increases but so does saving)
– Consumption schedule
• Planned household spending – shows
relationship between DI and C
– Saving schedule
• DI minus C = savings
• Dissaving can occur (consuming in excess of
after-tax income)
LO1
27-8
Income, Consumption, and Saving
• The 45 deg. line shows where C = DI ; no economic
value just serves as a
reference
• The green line
Shows actual C
• In between the two
Lines is where
Savings occurs.
LO1
27-9
Consumption and Saving Schedules
Consumption and Saving Schedules (in Billions) and Propensities to Consume and Save
(4)
(1)
Level of
Output
and
Income
GDP=DI
(2)
Consumption
(C)
(3)
Saving
(S),
(1) – (2)
(1) $370
$375
(6)
Average
Propensity
to
Consume
(APC),
Average
Propensity
to Save
(APS),
(2)/(1)
$-5
(7)
Marginal
Propensity
to
Consume
Marginal
Propensity
to Save
(3)/(1)
(MPC),
(2)/(1)*
(MPS),
(3)/(1)*
1.01
-.01
.75
.25
(5)
(2)
390
390
0
1.00
.00
.75
.25
(3)
410
405
5
.99
.01
.75
.25
(4)
430
420
10
.98
.02
.75
.25
(5)
450
435
15
.97
.03
.75
.25
(6)
470
450
20
.96
.04
.75
.25
(7)
490
465
25
.95
.05
.75
.25
(8)
510
480
30
.94
.06
.75
.25
(9)
530
495
35
.93
.07
.75
.25
(10) 550
510
40
.93
.07
.75
.25
LO1
27-10
Consumption (billions of dollars)
Consumption and Saving Schedules
500
C
475
450
425
Saving $5 billion
Consumption
schedule
400
375
Dissaving $5 billion
$390 is
“break-even”
where C=DI
Saving
(billions of dollars)
45°
370 390 410 430 450 470 490 510 530 550
50
25
0
Dissaving Saving schedule
S
$5 billion
Saving $5 billion
370 390 410 430 450 470 490 510 530 550
Disposable income (billions of dollars)
LO1
27-11
Average Propensities
• It is fact that household will either consume or save
a proportion of their total income. We can measure
how much they C or S by creating proportions
(fractions)
– Average propensity to consume (APC)
•Fraction of total income consumed
– Average propensity to save (APS)
•Fraction of total income saved
consumption
APC =
income
APC + APS = 1
LO1
APS =
saving
income
Because DI is either C or S, the fraction consumed must
exhaust that income.
27-12
Example APC/APS
APC = 450/470 = 45/47 = .96 or 96%
APS = 20/470 = 2/47 = .4 or 4%
.96 + .4 = 1
Global Perspective
Here, we can see that in 2009 – Australia, the US and Canada all had much
higher APCs compared to other economically developed nations. This means
that on average, people were consuming more than they were saving in these
countries.
LO1
27-14
Food for thought…
• Just because households consume a certain
proportion of a particular total income does not
guarantee that they will always consumer their
same proportion of any change in income they
might receive.
• Keynes referred to this proportion of any change
in income consumed is called the marginal
propensity to consume (MPC). (Remember,
marginal means extra or a change in…)
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
MPC =
change in consumption
change in income
MPS =
change in saving
change in income
MPC + MPS = 1
Because a change in DI can be C or S, the sum of MPC and MPS for any change in
DI will be 1.
LO1
27-16
Example MPC/MPS
Let’s say that income levels rise by $20 billion.
MPC = 15/20 = ¾ or 75%
MPS = 5/20 = ¼ or 25%
.75 + .25 = 1
Marginal Propensities
C
15
MPC = 20 = .75
Consumption
The MPC is the
slope of the
consumption
schedule
C
____
DI
C ($15)
The MPS is the
slope of the
savings schedule
S
_____
DI
LO1
Saving
DI ($20)
MPS =
5
= .25
20
S
S ($5)
DI ($20)
Disposable income
27-18
Non-Income Determinants
• Amount of disposable income is the main determinant
of how much people will save or consume.
• Other determinants (cause entire schedule to shift)
• Wealth (total assets – total liabilities)
• Expectations (anticipation of future prices will affect saving and
spending today)
• Borrowing (Borrowing means that household can consume more today beyond
what would be possible if its spending limits where within its DI)
• Real interest rates (when real i fall; households borrow more,
consume more and save less. Lower i on mortgage lowers payments and
encourage consumers to buy cars for example. Higher i has the opposite
effect.)
•
LO2
These determinants cause consumption to go in one direction and
savings to go in another.
27-19
Because C+S=DI….
C1
Consumption
C0
Increases in
Consumption
Means…
o
45
o
Saving
Disposable Income
S0
S1
o
Disposable Income
A Decrease
In Saving
Because C+S=DI….
Consumption
C0
C2
Decreases in
Consumption
Means…
o
45
o
Disposable Income
Saving
S2
S0
o
Disposable Income
An Increase
In Saving
EXPENDITURE PLANS AND
REAL GDP
Figure 29.3 shows shifts in
the consumption function.
1. Consumption expenditure
increases and the
consumption function
shifts upward if
• The real interest rate falls
• Wealth increases
• Expected future income
increases
EXPENDITURE PLANS AND
REAL GDP
2. Consumption expenditure
decreases and the
consumption function shifts
downward if
•The real interest rate
rises
•Wealth decreases
•Expected future
income decreases
Other Important Considerations
• Switching to real GDP
– Economists will shift their focus from the relationship between C and S,
to how C(and S) impact real domestic output)
• Changes along schedules
– Movement along the consumption sched. Indicates a change in the
amount consumed; a total shift of the sched. Is caused by any nonincome determinants (WEBR)
• Simultaneous shifts
– If consumption and savings shift in the opposite direction, this will mean
big changes for real GDP
• Taxation
–
will cause schedules to shift in the same direction.
• Stability
– C & S schedules are generally stable unless there are major tax increases
LO2
or decreases. This is because C-S decisions are based on the long-term
(saving for emergencies or retirement).
27-24
Shifts of C & S Schedules
C1
C0
Consumption
(billions of dollars)
C2
Saving
(billions of dollars)
45°
LO2
0
S2
S0
S1
+
0
Real GDP (billions of dollars)
27-25
Interest-Rate-Investment
• Remember that firms invest in capital when their marginal
benefit outweighs their marginal costs.
– The “marginal benefit” is referred to as the “expected rate of return”
–
–
(what they hope to get out of the investment…profit)
The real interest rate is a factor for firms to consider as a “marginal
cost” of investing.
Expected returns (profits) and interest rates are determinants of
investments.
• Let’s say we want to invest in a new fryer for our restaurant that costs
$1,000 and has a useful life of 1 year. This new fryer will increase output
and sales revenue – the net expected revenue is $1,100. After we subtract
the cost of the investment from the net revenue (1100-100 = $100) we can
figure out the rate of return by profit/cost of investment. (100/1000 = .10 or
10%. The rate of return is 10% profit)
LO3
27-26
Interest-Rate-Investment
We can also calculate how interest rates will affect our decision to invest in
capital.
• Let’s say the i on the fryer machine was 7%. To calculate how much we will
pay in i you multiply the cost of the investment by the i (1000 x .07 = $70)
• When compared to our rate of return ($100), this i is favorable. After
paying our liabilities, we will profit $30.
• Generally, if the rate of return exceeds the i the investment should be
undertaken. But if the i exceeds the rate of return, the investment should
not be undertaken. Only real i, not nominal is critical to consider for I.
• But what about inflation? If the nominal i was 15 and real is 10 (15-10 = 5%
adjusted for inflation). Still profitable…
LO3
27-27
Investment Demand Curve
16%
Investment
(billions
of dollars)
$0
14
5
12
10
10
15
8
20
6
25
4
30
2
35
0
40
Expected rate of return, r
and real interest rate, i (percents)
(r)
and
(i)
Shows the amount of investment forthcoming at
each real i. The levels of investment depend on the
rate of return (r) and the real i.
16
14
Investment
demand
curve
12
10
8
6
4
2
ID
0
5
10
15
20
25
30
35
40
Investment (billions of dollars)
What is the relationship between r and i? If i were to fall from 6% to 4% what will
happen to investment?
LO3
27-28
Shifts of Investment Demand
• Movement along the investment demand curve indicates a
•
change in r and i and how that impacts investment.
There are other determinants that will shift the entire curve:
–
Taxes: increases in taxes lower business profitability and investments; shifts
curve to the left/
and
– Technological Changes: stimulate investment and shift curve to the right
– Acquisition, maintenance, and operating costs: the costs of capital goods and
the cost to maintain them can affect the r; when costs rise, investment demand
will fall (left) and vice versa.
– Planned inventory changes: if firms are planning to increase inventory,
investment demand will increase and vice versa.
– Expectations: If executive become more optimistic about future sales, costs and
profits, investment demand will increases and vice versa.
– Stock of capital goods on hand: When the economy is overstocked with
production facilities, the need for new production decreases and investment
demand falls and vice versa.
LO4
27-29
Expected rate of return, r, and
real interest rate, i (percents)
Shifts of Investment Demand
Increase
in investment
demand
Decrease in
investment
demand
0
LO4
ID2 ID0 ID1
Investment (billions of dollars)
27-30
Instability of Investment
• We have to keep in mind that investments can
be relatively unstable – it’s a volatile
component of total spending because you can
guarantee rates of return.
– Variability of expectations: changes in exchange rates, trade barriers,
–
–
–
LO4
laws, stock market prices, wars, etc. all impact businesses and can
impact their expectations.
Durability: capital goods have an indefinite life span. Can’t be
guaranteed any sort of return.
Irregularity of innovation: waves of investment in time recede because
the “new” wears off…
Variability of profits: can’t guarantee profits from year to year.
27-31
Instability of Investment
Changes in investment spending is
often greater than changes in GDP
in any given year.
Source: Bureau of Economic Analysis, http://www.bea.gov.
LO4
27-32
Keynes and the Multiplier
Principle
• Keynes believed that market forces could not be
counted on to maintain spending levels consistent
with full employment because even minor
disturbances will often be amplified into major
disruptions.
• The multiplier principle explains this:
– Builds on the point that one individual’s expenditures
becomes the income of another.
– People will spend part of their income on consumption
which will generate income for others – eventually total
income will expand by a multiple of the initial increase in
spending.
The Multiplier Effect
• A change in spending changes real GDP more
than the initial change in spending itself.
– More spending = higher GDP; Less spending = lower
–
GDP
But investment can lead to more output and income,
which would lead to more spending and that would be
larger than just the investment itself.
• The multiplier determines how much larger that
change will be. It is the ratio of change in GDP to the
change in spending.
Multiplier =
change in real GDP
initial change in spending
Change in GDP = multiplier x initial change in spending
LO5
27-34
The Multiplier Effect
Multiplier =
change in real GDP
initial change in spending
• Let’s say that an investment economy rises by $30
billion and GDP increases by $90 billion, then the
multiplier is…
• 90/30 = 3 (multiplier)
LO5
27-35
The Multiplier Effect
Multiplier =
change in real GDP
initial change in spending
• The multiplier effect shows us that there is a chain
of spending that occurs, that however small at
each step, will cumulate to a multiple change in
GDP.
• Essentially, initial changes in spending will produce
magnified changes in output and income over time.
LO5
27-36
The Multiplier Effect
(1)
Change in
Income (in
bill.)
(2)
Change in
Consumption
(MPC = .75)
(3)
Change in
Saving
(MPS = .25)
$5.00
$3.75
$1.25
Second round
3.75
2.81
.94
Third round
2.81
2.11
.70
Fourth round
2.11
1.58
.53
Fifth round
1.58
1.19
.39
All other rounds
4.75
3.56
1.19
$20.00
$15.00
$5.00
Increase in investment of $5.00
Total
Cumulative income,
GDP (billions of
dollars)
20.00
$4.75
15.25
13.67
$1.58
$2.11
11.56
$2.81
8.75
$3.75
5.00
$5.00
1
LO5
2
3
4
5
All others
27-37
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 =
1
1- MPC
Because MPC + MPS = 1, we can also
write the multiplier formula as:
LO5
Multiplier =
1
MPS
27-38
Multiplier and Marginal Propensities
MPC
Multiplier
.9
10
.8
5
.75
4
.67
.5
LO5
3
2
27-39
The Actual Multiplier Effect?
• Actual multiplier is lower than the examples
provided:
– Consumers buy imported products (impacts GDP)
– Households pay income taxes (affects spending
–
–
LO5
ability)
Inflation (sometimes inflation is assumed to be the
culprit rather than actual changes in real GDP;
increased consumption can actually drive prices up –
not always inflation)
Multiplier may be 0 (Economists actually disagree
about the multiplier effect – range from 2.5 to 0. )
27-40