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Chapter 10
Basic
Macroeconomic
Relationships
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• Effect of changes in income on
consumption (and saving)
• Other factors that affect consumption
• Effect of changes in real interest rates
on investment
• Other factors that affect investment
• Changes in investment have a
multiplier effect on real GDP
10-2
Income-Consumption and IncomeSaving Relationships
• Disposable income is the most important
factor in how much spending consumers
do
• What is not spent (consumed) is saved
Basic Relationships
• Income and consumption are related; as
income increases, consumption increases
• Income and saving are also related; as
income increases, savings increases
• Assume all disposable income is totally
consumed
– On a graph showing consumption of the “Y”
axis, and disposable income on the “X” axis,
a 45°reference line would result
– Anywhere on that line, C=DI
• Remember S = DI - C
10-4
Income and Consumption
Consumption (billions of dollars)
10000
9000
05
45° Reference Line
C=DI
8000
04
03
01
7000
02
00
C
99
6000
Saving
In 1992
5000
4000
3000
83
2000
84
98
97
96
95
94
93
92
91
90
89
88
87
86
85
Consumption
In 1992
1000
45°
0
0
2000
4000
6000
8000
10000
Disposable Income (billions of dollars)
10-5
Source: Bureau of Economic Analysis
Interpreting the graph
• The consumption schedule (or curve) indicates
increasing consumption with increasing income
• The saving schedule (or curve) is the difference
between disposable income (DI) and actual
consumption
– For example, if the DI is $7000 (billions) and actual
consumption was $6000 (billion), then savings =
$7000-$6000 = $1000 (billion)
– Or, on the graph, savings are the difference between
the consumption curve (c) and the 45 degree
reference line
– For most years, savings were positive; however, in
2005 personal saving was a negative $33.5 billion!
Consumption and Saving
• Break-even income is when consumers spend their
entire disposal income on consumption
– Break-even income is represented anywhere along
the 45 degree reference line
• The fraction or percentage of total income that is
consumed is the average propensity (or willingness) to
consume (APC)
• The fraction or percentage of total income that is saved
is the average propensity to save (APS)
Consumption
APC =
Income
APS =
Saving
Income
10-7
Consumption and Saving
• Marginal propensity to consume or MPC is a
measurement of the willingness to consume
with a marginal increase in disposable income
– MPC may change with increases in DI
• Marginal propensity to save or MPS is a
measurement of the willingness to save
– It also may vary
Change in Consumption
MPC =
Change in Income
Change in Saving
MPS = Change in Income
10-8
Average and Marginal Propensities to
consume and save
• Remember
APC + APS = 1
MPC + MPS = 1
Consumption and Saving
(1)
Level of
(2)
Output
ConsumpAnd
tion
Income
(C)
(GDP=DI)
(1) $370
(4)
(5)
(6)
(7)
Average
Average
Marginal
Marginal
Propensity Propensity Propensity Propensity
(3)
to Consume to Save
to Consume to Save
Saving (S)
(APC)
(APS)
(MPC)
(MPS)
(1) – (2)
(2)/(1)
(3)/(1)
Δ(2)/Δ(1)
Δ(3)/Δ(1)
$375
$-5
1.01
-.01
(2)
390
390
0
1.00
.00
(3)
410
405
5
.99
.01
(4)
430
420
10
.98
.02
(5)
450
435
15
.97
.03
(6)
470
450
20
.96
.04
(7)
490
465
25
.95
.05
(8)
510
480
30
.94
.06
(9)
530
495
35
.93
.07
(10) 550
510
40
.93
.07
MPC + MPS = 1
.75
.25
.75
.25
.75
.25
.75
.25
.75
.25
.75
.25
.75
.25
.75
.25
.75
.25
MPC and MPS measure slopes
10-10
Consumption (billions of dollars)
Consumption and Saving
500
C
475
450
425
Saving $5 Billion
Consumption
Schedule
400
375
Dissaving $5 Billion
Saving
(billions of dollars)
45°
370 390 410 430 450 470 490 510 530 550
Disposable Income (billions of dollars)
50
Dissaving
Saving Schedule
S
25 $5 Billion
Saving $5 Billion
0
370 390 410 430 450 470 490 510 530 550
10-11
Average Propensity to Consume
Selected Nations, with respect to GDP, 2006
.80
.85
.90
.95
1.00
United States
Canada
United Kingdom
Japan
Germany
Netherlands
Italy
France
Source: Statistical Abstract of the United States, 2006
10-12
Consumption and Saving
• Non-income determinants of
consumption and saving
• There are other factors which
influence households to consume
more or less at each possible level
of income
– That would change the shape of the
consumption and saving schedules
(curves)
10-13
Other factors which influence consumption
and spending
Wealth: a households wealth is the
dollar amount of all assets its owns
minus the dollar amount of all its
liabilities
• The larger the stock of wealth of a
household, the larger will be its
consumption
• Greatly increased wealth often results in
an increase in spending on consumption
and a decrease of savings.
• Upturns in the stock market will cause
people to consume much more and
save much less
Other factors which influence consumption and
spending
Borrowing money by households will
influence their consumption and
spending
• By borrowing, a household can
increase current consumption beyond
what they could if limited to DI
• However, while borrowing increases
present consumption, it lowers
consumption in the future when debts
such as credit cards and loans have
to be repaid
Other factors which influence consumption
and spending
Real interest rates have been adjusted for
inflation
• For example, nominal interest rate
minus rate of inflation = real interest rate
• When real interest rates fall, households
tend to borrow more, consume more,
and save less
• However, the real effect on consumption
and savings is somewhat modest
• They mainly shift consumption toward
products bought on credit and away from
items that cannot be bought on credit
Other factors which influence consumption
and spending
• Household expectations about
future prices may affect current
spending and saving
• If households expect prices to go up
soon, they may hurry and spend more
today but save less
• If a recession is anticipated, leading to
lower future income, households may
reduce consumption and save more
Consumption and Saving
• Other important considerations
• Macroeconomic models use real GDP instead of
Disposable Income
– When plotting real GDP against Consumption
(Figure 10.4) , changes in points along the
schedule curve reflect changes in the amount
consumed caused by a change in GDP
• However, if the entire consumption curve shifts
upward or downward, that shift is caused by
changes in one or more of the non-income factors
just discussed
10-18
Consumption and Saving
• When taxes are increased or decreased, the
consumption and saving curves shift in the same
direction
• Taxes are paid partly at the expense of
consumption and partly at the expense of savings
• An increase in taxes will reduce both consumption
and saving, shifting both the savings and
consumption curves downward
• If taxes were reduced, households will partly
consume and partly save any money saved in
decreased taxes, shifting both savings and
consumption curves upwarad
Interest Rate and Investment
• When firms invest, the benefit they expect to get
from that investment is the expected rate of return (r)
– The marginal benefit from investment is the expected
rate of return
– The marginal cost is the interest rate that must be paid
for borrowed funds
• The real interest rate (i) is the determinant of
whether the expected rate of return is profitable
– Nominal rate less rate of inflation is the real interest
rate
– This interest rate represents either the cost of
borrowed funds or the opportunity cost of investing
your own funds, which is income forgone
10-20
Interest Rate and Investment
• If a firm expects a rate of return of 7% on
an investment of $10,000 or $700; it
would not want to borrow money at any
rate higher than 7%
– For money borrowed at any rate above 7%,
the firm would lose money
– For money borrowed at any rate below 7%,
the form would make money
– This general rule applies; the Rate of Return
must equal the real interest rate or the
investment should not be undertaken
Investment demand curve
• There is a predictable relationship
between how much money companies
want to invest, their expected rate of
return, and the real interest rate of the
money they need to borrow for their
investment
– The amount of money invested will increase
as the real interest rate is decreased
Investment Demand Curve
16%
14%
12%
10%
8%
6%
4%
2%
0%
$ 0
5
10
15
20
25
30
35
40
16
14
r and i (percent)
Expected
Rate of
Return (r)
Cumulative
Amount of
Investment
Having This
Rate of
Return or Higher
(I)
12
10
8
6
4
ID
2
0
5
10
15
20
25
30
35
40
Investment (billions of dollars)
10-23
Investment Demand Curve
• The investment curve may shift
– Greater expected returns create more
investment demand and the curve
shifts to the right
– The reverse causes a shift to the left
– Acquisition, maintenance, and
operating costs may change; higher
costs lower the expected return
– Business taxes may change;
increased taxes lower the expected
return
10-24
Investment Demand Curve
– Technological change often involves
lower costs, which would increase
expected returns
– If there is too much capital goods (i.e.,
inventory) on hand because of weak
demand, new investments would be
less profitable
– Expectations about the future
economic climate can change the view
of expected profits
Investment Demand Curve
r and i (percent)
Increase in
Investment Demand
Decrease in
Investment Demand
ID2 ID0
ID1
0
Investment (billions of dollars)
10-26
Investment Demand
• Difficulty in predicting success
of investment
– Capital goods are durable, so
spending can be postponed;
firms will fix old machinery
– Irregularity of innovation;
inventions can turn up any time
– Variability of profits
– Expectations can easily change
10-27
Gross Investment Expenditure
Percent of GDP, Selected Nations, 2006
0
10
20
30
South Korea
Japan
Canada
Mexico
France
United States
Sweden
Germany
United Kingdom
Source: International Monetary Fund
10-28
Volatility of Investment
Source: Bureau of Economic Analysis
10-29
The Multiplier Effect
• More spending results in higher
GDP
• Initial change in spending changes
GDP by a multiple amount
Multiplier =
Change in Real GDP
Initial Change in Spending
10-30
The Multiplier Effect
Increase in Investment of $5
Second Round
Third Round
Fourth Round
Fifth Round
All other rounds
Total
(2)
(3)
Change in
Change in
(1)
Saving
Change in Consumption
(MPC = .75) (MPC = .25)
Income
$ 5.00
$ 3.75
$ 1.25
3.75
2.81
.94
2.81
2.11
.70
2.11
1.58
.53
1.58
1.19
.39
4.75
3.56
1.19
$ 20.00
$ 15.00
$ 5.00
$20.00
$4.75
15.25
13.67
11.56
8.75
5.00
$1.58
$2.11
$2.81
ΔI=
$5 billion
$3.75
$5.00
1
2
3
4
Rounds of Spending
5
All
10-31
The Multiplier Effect
Multiplier =
1
1 - MPC
-orMultiplier =
1
MPS
10-32
The Multiplier and the MPC
MPC
Multiplier
.9
10
.8
5
.75
4
.67
.5
3
2
10-33
Key Terms
• 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
10-34
Next Chapter Preview…
The Aggregate
Expenditures Model
10-35