McGraw-Hill/Irwin

Chapter 10

Basic Macroeconomic Relationships

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 Income Saving 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

10000 9000 8000 7000 6000 5000 4000 3000 2000

45

°

C=DI Reference Line

03 04 00 01 02 99

Saving In 1992

83 84 87 85 86 90 88 89 91 93 94 92 95 96 97 98

Consumption In 1992 C

05 1000 0 0 45

°

2000 4000 6000 8000 10000 Disposable Income (billions of dollars)

Source: Bureau of Economic Analysis

10-5

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)

APC = Consumption 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

MPC = Change in Consumption Change in Income MPS = Change in Saving 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 Output And Income (GDP=DI) (2) Consump tion (C) (3) Saving (S) (1) – (2) (4) Average Propensity to Consume (APC) (2)/(1) (5) Average Propensity to Save (APS) (3)/(1) (6) Marginal Propensity to Consume (MPC) Δ(2)/Δ(1) (7) Marginal Propensity to Save (MPS) Δ(3)/Δ(1) (1) $370 (2) 390 (3) (4) 410 430 (5) (6) 450 470 (7) (8) (9) 490 510 530 (10) 550 $375 390 405 420 435 450 465 480 495 510 MPC + MPS = 1 $-5 0 5 10 15 20 25 30 35 40 1.01

1.00

.99

.98

.97

.96

.95

.94

.93

.93

-.01

.00

.01

.02

.03

.04

.05

.06

.07

.07

.75

.75

.75

.75

.75

.75

.75

.75

.75

.25

.25

.25

.25

.25

.25

.25

.25

.25

MPC and MPS measure slopes

10-10

Consumption and Saving

500 475 450 425

Saving $5 Billion

400 375

Schedule Dissaving $5 Billion C Consumption

50 25 0 45

°

370 390 410 430 450 470 490 510 530 550 Disposable Income (billions of dollars)

Dissaving $5 Billion Saving Schedule S Saving $5 Billion

370 390 410 430 450 470 490 510 530 550

10-11

Average Propensity to Consume

Selected Nations, with respect to GDP, 2006 United States Canada United Kingdom Japan Germany Netherlands Italy France .80 .85 .90 .95 1.00

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 rate of return for borrowed funds • The real interest rate rate

(i)

is the determinant of whether the expected rate of return is profitable – Nominal rate less rate of inflation is the real interest – This interest rate represents either the cost of borrowed funds or the opportunity cost of investing your own funds, which is income forgone

(r)

– The marginal benefit from investment is the expected – The marginal cost is the interest rate that must be paid 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

Expected Rate of Return (r) Cumulative Amount of Investment Having This Rate of Return or Higher (I) 16% 14% 12% 10% 8% 6% 4% 2% 0% $ 0 5 10 15 20 25 30 35 40 16 14 12 10 2 0 8 6 4

ID

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

Increase in Investment Demand

0

Decrease in Investment Demand ID 2 ID 0 ID 1

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

P ercent of GDP, Selected Nations, 2006 South Korea 0 10 20 30 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

Change in Real GDP Multiplier = 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 $20.00

15.25

13.67

11.56

8.75

5.00

ΔI= $5 billion $5.00

$3.75

$2.81

(1) Change in Income $ 5.00

3.75

2.81

2.11

1.58

4.75

$ 20.00

(2) Change in Consumption (MPC = .75) (3) Change in Saving (MPC = .25) $ 3.75

2.81

2.11

1.58

1.19

3.56

$ 15.00

$ 1.25

.94

.70

.53

.39

1.19

$ 5.00

$2.11

$1.58

$4.75

1 2 3 4 Rounds of Spending 5 All

10-31

The Multiplier Effect

Multiplier = 1 1 - MPC

-or-

Multiplier = 1 MPS

10-32

The Multiplier and the MPC

MPC .9

.8

.75

.67

.5

2 3 4 5 Multiplier 10

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

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The Aggregate Expenditures Model

10-35