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9 Basic
C HAPT E R
Macroeconomic
Relationships
The Income-Consumption and
Income-Saving Relationships
• Disposable income is the most important
determinant of consumer spending
(consumption).
• What is not spent is called saving.
• Disposable Income (DI) = C + S
S = saving
Saving = DI – C
•
•
•
Note:
(disposable income in Kuwait = personal
income since there is no income tax)
A 45-degree line: each point on the line is
equidistant from the two axes. Therefore,
represents all points where consumer spending
is equal to disposable income.
•
Or each point represent a situation where;
C + S = DI
•
Any vertical distance from the horizontal axis
to the 450 line measures DI
Income and Consumption
10000
9000
Consumption (billions of dollars)
05
45° Reference Line
C=DI
8000
04
03
01
7000
02
00
C
99
6000
Saving
In 1992
5000
98
97
96
95
94
93
92
4000
3000
83
2000
84
88
87
86
85
91
90
89
Consumption
In 1992
1000
45°
0
0
2000
4000
6000
8000
10000
Disposable Income (billions of dollars)
Source: Bureau of Economic Analysis
Consumption Schedule
• Reflects the direct consumptiondisposable income relationship
• Note: households tend to spend a larger
proportion of a small DI than of a larger
DI.
The saving schedule
• Reflects the direct relationship between S
and DI
• Saving is a smaller proportion of small DI
than of a large DI
• Dissaving: when households consume more
than their DI. They do that by liquidating
their wealth (assets) or by borrowing
Consumption and Saving Schedules
Disposable Income
350
370
390
410
430
450
470
490
510
530
550
Consumption
360
375
390
405
420
435
450
465
480
495
510
Saving
-10
-5
0
5
10
15
20
25
30
35
40
CONSUMPTION AND SAVING
Consumption
SAVING
C
Consumption
schedule
C
DISSAVING
o
45
MPC = Slope of C
o
MPC + MPS = 1
Saving
Disposable Income
DISSAVING
Saving
schedule
MPS = Slope of S
S
SAVING
o
S
Disposable Income
Break even income:
• The income level at which households plan
to consume their entire income, (C=DI).
• At break even:
Consumption schedule cuts the 450 line.
- Saving schedule cuts the horizontal axis .
- Saving = zero
- APC = 1
- APS = zero
Consumption and Saving
(1)
Level of
(2)
Output
ConsumpAnd
tion
Income
(C)
(GDP=DI)
(1) $370
(3)
Saving (S)
(1) – (2)
(4)
Average
Propensity
to Consume
(APC)
(2)/(1)
(5)
Average
Propensity
to Save
(APS)
(3)/(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
(6)
Marginal
Propensity
to Consume
(MPC)
Δ(2)/Δ(1)
(7)
Marginal
Propensity
to Save
(MPS)
Δ(3)/Δ(1)
.75
.25
.75
.25
.75
.25
.75
.25
.75
.25
.75
.25
.75
.25
.75
.25
.75
.25
MPC and MPS measure slopes
Average and marginal propensities to
consume and save
• Average propensity to consume (APC) is
the fraction or % of income consumed
APC = consumption/income
• Average propensity to save (APS) is the
fraction or % of income saved
APS = saving/income
• Marginal propensity to consume (MPC)
is the fraction or proportion of any change
in income that is consumed
MPC = change in consumption/change in
income
• Marginal propensity to save (MPS) is
the fraction or proportion of any change
in income that is saved
MPS = change in saving/change in income
Note:
• As DI increases; APS rises and APC falls.
• APC + APS = 1
• MPC + MPS = 1
Because: ∆DI = ∆C + ∆S
Non-income determinants of consumption
1. Wealth: An increase in wealth shifts the
consumption schedule up and saving schedule
down.
Wealth Effects: when assets boast,
households feel wealthy, they save less and
consumer more, and vice versa.
2. Expectations: Changes in expected future
prices or wealth can affect consumption
spending today.
3.Real interest rates: Declining interest rates
increase the incentive to borrow and consume,
and reduce the incentive to save. Because many
household expenditures are not interest sensitive
– the light bill, groceries, etc. – the effect of
interest rate changes on spending are modest.
4.Household debt: Lower debt levels shift
consumption schedule up and saving schedule
down. But if debt is too high, they will reduce
their consumption to pay off some of their loans.
Terminology, shifts and stability
1. Terminology: Movement from one point to another
on a given schedule is called a change in amount
consumed; a shift in the schedule is called a change in
consumption schedule.
2. Schedule shifts: Consumption and saving schedules
will always shift in opposite directions unless a shift is
caused by a tax change (move together).
3. Stability: Economists believe that consumption and
saving schedules are generally stable unless
deliberately shifted by government action.
TERMINOLOGY, SHIFTS, & STABILITY
Consumption
C1
C0
Increases in
Consumption
Means…
o
45
o
Saving
Disposable Income
A Decrease
S0
S1 In Saving
o
Disposable Income
Consumption
TERMINOLOGY, SHIFTS, & STABILITY
C0
C2
Decreases in
Consumption
Means…
o
45
o
Saving
Disposable Income
S2 An Increase
S0
In Saving
o
Disposable Income
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
The Interest Rate – Investment Relationship
•
Investment consists of spending on new plants, capital
equipment, machinery, inventories, construction, etc.
•
The investment decision weighs marginal benefits (r)
and marginal costs (i).
1. Expected Rate of Return, r: This is marginal benefit
of investment.
•
Expected Rate of Return = expected profit/cost of
capital
• If expected profit on a $1000 investment is $100. This is
a 10% expected rate of return. Thus, this business
would not want to pay more than a 10% interest rate on
investment.
• Remember that the expected rate of return is not a
guaranteed rate of return. Investment carries risk.
2. Real Interest Rate, i: This is the marginal cost of
investment (nominal rate corrected for expected
inflation)
Real interest rate = nominal interest rate – expected
inflation
• The interest rate represents either the cost of borrowed
funds or the opportunity cost of investing your own
funds, which is income forgone.
• If real interest rate exceeds the expected rate of return,
the investment should not be made, example:
• If expected rate of return r = 10%
• Nominal interest rate = 15%
• Inflation rate = 10%
• This investment is profitable since
• 10% > (i = 15%-10%) 5%
• Expected return > real interest rate
Investment demand curve
Interest rates
Expected rate of return
16%
14%
12%
10%
8%
6%
4%
2%
0%
Cumulative investment
0
5
10
15
20
25
30
35
40
Investment demand schedule, or curve, shows an
inverse relationship between the interest rate and
amount of investment.
• As long as expected return exceeds interest rate, the
investment is expected to be profitable
• if rate of interest is 12%, businesses will undertake all
investment opportunities that yield 12% or more.
• If rate of interest is less, more investment will be
undertaken
• If rate of interest is more, less investments will be
undertaken
Interest Rate – Investment
Relationship
and interest rate, i (percents)
Expected rate of return,
r,
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)
Shifts of investment demand
1. Acquisition, Maintenance, and Operating
Costs:
Initial costs of capital, operating costs and
maintenance affect the expected rate of return
– When they fall, prospective investment projects
increase (shift to the RHS)
– When they increase, prospective investment projects
decrease (shift to the LHS)
2. Business Taxes
When tax increases, expected (after tax) return
decreases, shifts the investment curve to the LHS
and vice versa.
3. Technological Change
Technological progress (more efficient
machines). Technological change often involves
lower costs, which would increase expected
returns and stimulates investment (shifts the
investment curve to the RHS, and vice versa).
4. Stock of capital goods on hand
Relative to output and sales, if there is abundant idle
capital on hand because of weak demand or recent
investment (overstock), expected return on new
machines declines (would be less profitable) and
investment curve shifts to the LHS and vice versa.
5. Expectations about future economic and political
conditions
can change the view of expected returns.
– Optimistic expectations about the return, shifts the investment
curve to the RHS
– Pessimistic expectations shifts the investment curve to the
LHS
Instability of investment
Investment schedule is unstable, it shifts upward or
downward quite often. Investment is the most volatile
component of total spending.
Reasons for instability of investment
1. Durability of capital and variability of expectations
Within limits, purchases of capital goods are
discretionary and therefore, can be postponed.
Optimism about future may prompt firms to replace
older capital. Pessimism about the future lead to small
investment as firms repair old capital.
2. Irregularity of Innovation
Technological progress is a major determinant of
investment. But major innovations occur quite
irregularly. When they happen, they induce vast
investments. e.g., the new information technology
3. Variability of expectations
Expectations are influenced by:
- Current profit levels,
- Changes in exchange rates,
- Outlook for international peace,
- Changes in government policies
- Stock market prices…etc
4. Variability of profits:
Profits are highly variable. This contributes to
the volatile incentive to invest. Also profits are a
major source of investment finance (internal
source), if they are variable, investment will be
instable.
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
Volatility of Investment
Source: Bureau of Economic Analysis
27-33
The Multiplier Effect
• Changes in spending ripple through the economy to
generate even larger changes in real GDP. This is
called the multiplier effect.
Multiplier = change in real GDP / initial change in
spending.
Alternatively, it can be rearranged to read
Change in real GDP = initial change in spending ×
multiplier.
Three points to remember about the multiplier:
a. The initial change in spending is usually
associated with investment because it is so
volatile.
b. The initial change refers to an upward shift or
downward shift in the aggregate expenditures
schedule due to a change in one of its
components, like investment.
c. The multiplier works in both directions (up or
down).
Rationale: The multiplier is based on two facts
1. The economy has continuous flows of expenditures and
income—a ripple effect—in which income received by
Ali comes from money spent by Ahmad. Ahmad’s
income, in turn, came from money spent by Said, and
so forth.
2. 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.
a. The fraction of the change in income that is spent is
called the marginal propensity to consume (MPC).
b. The fraction of the change in income that is saved is
called the marginal propensity to save (MPS).
THE MULTIPLIER EFFECT
Multiplier
Change
in GDP
Change in Real GDP
= Initial Change in Spending
= Multiplier x
initial change
in spending
For Example…
THE MULTIPLIER EFFECT
(2)
(3)
Change in
Change in
(1)
Saving
Change in Consumption
Income (MPC = .75) (MPS = .25)
Increase in
Investment of $5
$ 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
Total
THE MULTIPLIER EFFECT
Multiplier Effect and the
Marginal Propensities
Inverse relationship between:
Multiplier & MPS
Multiplier
Change in
GDP
=
1
1
or 1 - MPC
MPS
= Multiplier x
initial change
in spending
THE MULTIPLIER EFFECT
MPC and the Multiplier
MPC
Multiplier
.9
10
.8
5
.75
4
.67
.5
3
2
• The size of the MPC and the multiplier are directly
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. For example, the actual multiplier is derived
by including taxes and imports as well as savings in the
equation. In other words, the denominator is the
fraction of a change in income not spent on domestic
output.