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Chapter 27
Basic Macroeconomic
Relationships
Income- Consumption-Saving Links
Let’s introduce some assumptions:
1. Two-sector economy: households and business:
• Aggregate spending = C + I only
• No G, No T: DI = PI
2. All savings are personal saving: No business
savings
3. Depreciation = 0; Gross I = Net I
4. Net foreign factor income = 0; Citizens earn as
much abroad as foreigners earn inside.
5. No Exports , No Imports : Closed economy.
Income- Consumption-Saving Links
•
•
•
•
•
Relationship between income & consumption (C).
Relationship between income & saving (S).
- What is saving ?
Relationship between consumption (C) & saving (S)
- Primarily determined by Disposable Income (DI)
S = DI – C
It has been approved that C is positively related to DI.
The 45o line represents points where each point on
this line would have C=DI.
Income- Consumption-Saving Links
C
45o
DI
Income- Consumption-Saving Links
Consumption & Saving Schedule
• Schedule shows the various amounts that households
would plan to consume at each various level of DI.
• Schedule shows the various amounts that households
would plan to save at each various level of DI.
• DI = C + S
• How much goes to C and S out of DI?
• We use consumption and saving schedule.
Income- Consumption-Saving Links
GDP=DI
$370
390
410
430
450
470
490
510
530
550
C
$375
390
405
420
435
450
465
480
495
510
S
$ -5
0
5
10
15
20
25
30
35
40
Income- Consumption-Saving Links
Based on the table;
• If C > DI, then there is a decline in savings (Dissaving)
• When can households’ C > households’ DI ?
( two reasons )
• When DI = C, then S = 0.
• This is “Break-even” income; where households plan
to consume their entire incomes (C=DI).
• What if DI=0? Will C=0 too?
• Autonomous consumption: level of C when DI =0.
(Independent C)
Consumption (billions of dollars)
Income- Consumption-Saving Links
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
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)
Income- Consumption-Saving Links
Average & Marginal Propensities
•
•
Average propensity to consume (APC)
is a Fraction of total income consumed
Average propensity to save (APS)
is a Fraction of total income saved
Note: APC falls and APS rises as DI increases (Check the table)
consumption
saving
APC =
APS =
income
income
APC + APS = 1
Income- Consumption-Saving Links
Average & Marginal Propensities
•
•
Marginal propensity to consume (MPC)
is a proportion of a change in income consumed
Marginal propensity to save (MPS)
is a proportion of a change in income saved
MPC =
change in consumption
change in income
MPS =
MPC + MPS = 1
change in saving
change in income
Income- Consumption-Saving Links
• MPC and MPS are slopes:
The slope of the consumption schedule = MPC,
the slope of the saving schedule = MPS.
• Even when DI=0, C≠0.
Consumption and Saving Schedules
Marginal Propensities (Slopes)
C
Consumption
15
MPC = 20 = .75
C ($15)
Saving
DI ($20)
MPS =
5
= .25
20
S
S ($5)
DI ($20)
Disposable income
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
Consumption and Saving Schedules
Consumption Schedule
C
Income (Y)
Break-Even Point (C=Y)
C
Saving
Dissaving
45o
DI
Consumption and Saving Schedules
Consumption Schedule
C
Income (Y)
Break-Even Point (C=Y)
C
Saving
Dissaving
45o
DI
Autonomous C (a)
Consumption and Saving Schedules
S
Saving Schedule
+
S
0
-
DI
Break-Even point (S=0)
Consumption and Saving Schedules
S
Saving Schedule
+
S
DI
-
Autonomous C (-a)
Break-Even point (S=0)
Determinants of Consumption and Saving
• The most important factor is income (DI): an increase
in DI will lead to an increase in C by (MPC.DI) and
increase in S by (MPS.DI).
• This will be a move along the C schedule and S
schedule.
• The same result applies when DI declines.
• DI is the only factor that leads to a move along the
lines.
Non-income Determinants
Non-income factors will shift the C and S schedules
1. Wealth:
an increase in wealth will increase C and reduces S
(shift the C schedule upward, S schedule
downward).
• This is the case since people save to accumulate
wealth.
• As wealth increases, no need to save as much as
before.
• This is called “wealth effect”.
Non-income Determinants
2. Expectations:
about future prices and income level.
• Expectations affect spending (C) and saving.
• Expectations of an increase in price level (or future
income): increase C and reduce S today, C schedule
shifts upward while S schedule shifts downward.
Non-income Determinants
3. Borrowing:
- household borrowing increases consumption, and
will shift both C schedule upward:
- since borrowing money allows C to shift upward,
but if the debt is large, then C may shift downward.
Non-income Determinants
4. Real Interest Rate:
- lower real interest rates encourage households to
borrow more, so consume more, & save less.
- lower real interest rates allow C to shifts upward,
but S shifts downward.
Other Important Considerations
•
Switching to real GDP
Change DI to Real GDP
• Changes along schedules
Differences between movements from point to point
along the curve versus upward/downward shift of the
entire schedulable
• Simultaneous shifts
The four non-economic factors will shift the
consumption schedule in a one direction and the
saving schedule to the other direction at the same
time.
Other Important Considerations
•
Taxation
Taxation factor will shift the consumption schedule
and the saving schedule in same direction.
•
Stability
The consumption schedule and the saving schedule
stay unchanged (stable) relatively unless major tax
increases.
Shifts of C & S Schedules
C1
C0
Saving
(billions of dollars)
Consumption
(billions of dollars)
C2
0
45°
S2
S0
S1
+
0
Real GDP (billions of dollars)
Interest-Rate-Investment
Recall the definition of I; spending on new plants,
capital equipment, machinery & inventories.
Expected rate of return
• is the marginal benefit from I.
• Expected rate of return is calculated be (Profit
expected after adopting the new machine / Cost of
that machine)
Interest-Rate-Investment
The Real Interest Rate
•
•
•
•
The Interest Rate (%) is the financial cost of
borrowing the money to purchase the machine.
The Interest cost is ( interest rate X amount borrowed
to purchase the machine)
if Expected Rate of Return > Interest Rate , then the
Investment should be undertaken (Profitable I ).
if Expected Rate of Return < Interest Rate , then the
Investment should not be undertaken(Unprofitable I)
Interest-Rate-Investment
•
•
•
•
The Real Interest Rate rather than the Nominal
Interest Rate is important in making investment
decisions.
The Real Interest Rate is ( Nominal Interest Rate Inflation)
if Expected Real Rate of Return > Real Interest Rate ,
then the Investment should be undertaken (Profitable
I ).
if Expected Real Rate of Return < Real Interest Rate ,
then the Investment should not be undertaken
(Unprofitable I).
Interest-Rate-Investment
Investment Demand Curve
• What determine the amount of funds that investors
borrow?
• Real interest rate (i): an increase in rr will increase the
cost of borrowing funds, thereby reducing the amount
of I demanded.
• A decline in (i) will reduce the cost of borrowing
funds, thereby increasing I demanded.
• At each amount of I demanded, there is a certain
expected rate of return (r) equals or exceeds (i).
(r)
and
(i)
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)
Investment Demand Curve
16
14
Investment
demand
curve
12
10
8
6
4
2
ID
0
5
10
15
20
25
30
35
Investment (billions of dollars)
40
Investment Demand Curve
• Changes in the level of Real interest rate (i) will lead
to a move in ID curve.
• This is the only factor leading to a move along the ID
curve.
• All other factors will shift the ID curve.
Shifts of Investment Demand
•
•
•
Acquisition, maintenance, and operating costs
The initial and then the operating cost of capital
affect the expected rate of return in I negatively
(Shifting ID to the left)
Business taxes
Increase in taxes will reduce expected profitability
(Shifting ID to the left)
Technological change
Stimulates investment and lower production costs
(Shifting ID to the right)
Shifts of Investment Demand
•
•
•
Stock of capital goods on hand
as inventories rise, expected rate of return on investment
increase (Shifting ID to the right)
Planned inventory changes
If a firm expects higher sales in the future, it would keep
more inventory in stock now. Thus increasing ID
(Shifting ID to the right)
Expectations
Expected rate of return depends on firm’s expectations
about its sales, future operation costs, future
profitability, thus optimistic outlook about the future
performance of the firm leads to higher I (Shifting ID to
the right), versus the pessimistic outlook.
Expected rate of return, r, and
real interest rate, i (percents)
Shifts of Investment Demand
Increase
in investment
demand
Decrease in
investment
demand
0
ID2 ID0 ID1
Investment (billions of dollars)
Instability of Investment
Source: Bureau of Economic Analysis, http://www.bea.gov.
Instability of Investment
Factors Explaining Variability in I
• Durability
The quicker capital goods need to be replaced, the
higher the level of I. The opposite in the case of
keeping older capital goods after repairing them.
•
Irregularity of innovation
Innovations in sectors such as railroads, electricity
occur quite irregularly, but if they occur it would lead
to a sharp growth of investment spending
Instability of Investment
•
Variability of profits
Expanding profits give firms greater incentives and
then greater means to invest, The opposite in the case
of declining profits.
•
Variability of expectations
Any change in expectations ( because of i.e economic
outlook, trade policy, exchange rate policy, stock
market, political reasons) would lead to a change in
business expectations and then reach instability in
investment spending.
The Multiplier Effect
•
•
•
More spending leads to more real GDP.
BUT!! a change in spending (i.e I) changes real GDP
more than the initial change in spending (i.e I)
Thus, the Multiplier states that how much larger that
change in Real GDP will be…
Multiplier =
change in real GDP
initial change in spending
Change in GDP = multiplier x initial change in spending
Example; if (I) in the economy rises by 30$ million and thus Real
GDP increases by 90$ million, what is the Multiplier?
The Multiplier Effect
(1)
Change in
Income
(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
2
3
4
5
All others
Multiplier and Marginal Propensities
•
•
Multiplier and MPC 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
Multiplier =
1
MPS
Note:
1) The lower MPS , the larger is the fraction of
(1/MPS), thus the greater the multiplier and the
greater the increase in income (Real GDP)
2) Think of MPC !!
Multiplier and Marginal Propensities
MPC
Multiplier
.9
10
.8
5
.75
4
.67
.5
3
2
The Actual Multiplier Effect?
In reality actual multiplier is lower than the model
assumes ( only two sectors Households Sector &
Business Sectors), this is because of ;
•
Consumers buy imported products
We should consider the external sector
• Households pay income taxes
We should consider the Government sector
• Inflation
Since we deal with Real GDP, this ignores people’s
behaviors (to save or to consume) when price
changes.