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Chapter 27
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
27-2
Basic Relationships
• Income and consumption
• Income and saving
• Disposable income (DI)
• 45°line for reference
–C = DI on the Line
• S = DI - C
27-3
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)
Source: Bureau of Economic Analysis
27-4
Consumption and Saving
•
•
•
•
The consumption schedule
The saving schedule
Break-even income
Average propensity to consume
(APC)
• Average propensity to save (APS)
Consumption
APC =
Income
APS =
Saving
Income
27-5
Consumption and Saving
• Marginal propensity to
consume (MPC)
• Marginal propensity to save
(MPS)
Change in Consumption
MPC =
Change in Income
Change in Saving
MPS = Change in Income
27-6
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
27-7
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
27-8
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
27-9
Consumption and Saving
• Nonincome determinants of
consumption and saving
–Wealth
–Borrowing
–Expectations
–Real interest rates
27-10
Consumption and Saving
• Other important considerations
–Changes along schedules
–Switch to real GDP
–Schedule shifts
–Stability
–Taxation
27-11
Consumption and Saving
Consumption (billions of dollars)
C1
C0
C2
Saving
(billions of dollars)
45°
Disposable Income (billions of dollars)
S2
S0
S1
27-12
Interest Rate and Investment
• Expected rate of return (r)
• The real interest rate (i)
–Nominal rate less rate of inflation
• Meaning of r = i
• Investment demand curve
27-13
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)
27-14
Investment Demand Curve
• Shifts of the curve
–Acquisition, maintenance, and
operating costs
–Business taxes
–Technological change
–Stock of capital goods on hand
–Planned inventory changes
–Expectations
27-15
Investment Demand Curve
r and i (percent)
Increase in
Investment Demand
Decrease in
Investment Demand
ID2 ID0
ID1
0
Investment (billions of dollars)
27-16
Investment Demand
• Instability of investment
–Durability
–Irregularity of innovation
–Variability of profits
–Variability of expectations
27-17
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
27-18
Volatility of Investment
Source: Bureau of Economic Analysis
27-19
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
27-20
The Multiplier Effect
• Causes of the initial change in
spending
–Changes in investment
–Other changes
• Rationale
–Dollars spent are received as
income
–Income received is spent (MPC)
–Initial changes in spending cause
a spending chain
27-21
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
27-22
The Multiplier Effect
Multiplier =
1
1 - MPC
-orMultiplier =
1
MPS
27-23
The Multiplier and the MPC
MPC
Multiplier
.9
10
.8
5
.75
4
.67
.5
3
2
27-24
Squaring the Economic Circle
• Humorist Art Buchwald and the
multiplier
• Suppose one person can’t buy a
product
• Others subsequently impacted and
cannot buy other items
• Multiple effects impact psyche
• Ultimately causes multiple step impact
upon the economy as a whole
27-25
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
27-26
Next Chapter Preview…
The Aggregate
Expenditures Model
27-27