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BasicMacroeconomicRelationships
Chapter 10
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 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
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000
0 2000 4000 6000 8000 10000
Co
nsu
mp
tio
n (
bil
lio
ns
of
do
llar
s)
Disposable Income (billions of dollars)
45° Reference LineC=DI
83
8685
84
8889
9190
87
9293
9495
01
9796
9998
00
02
05
03
04
ConsumptionIn 1992
SavingIn 1992
45°
C
Source: Bureau of Economic Analysis10-5
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)
APS =SavingIncome
APC =Consumption
Income10-7
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 ConsumptionChange in Income
MPS =Change in SavingChange in Income
10-8
Average and Marginal Propensities to consume and save
• RememberAPC + APS = 1
MPC + MPS = 1
Consumption and Saving(1)
Level ofOutput
AndIncome
(GDP=DI)
(2)Consump-
tion(C)
(3)Saving (S)
(1) – (2)
(4)Average
Propensityto Consume
(APC)(2)/(1)
(5)Average
Propensityto Save(APS)(3)/(1)
(6)Marginal
Propensityto Consume
(MPC)Δ(2)/Δ(1)
(7)Marginal
Propensityto Save(MPS)
Δ(3)/Δ(1)
(1) $370
(2) 390
(3) 410
(4) 430
(5) 450
(6) 470
(7) 490
(8) 510
(9) 530
(10) 550
$375
390
405
420
435
450
465
480
495
510
$-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 + MPS = 1 MPC and MPS measure slopes10-10
500
475
450
425
400
375
45°
Consumption and Saving
50
25
0
370 390 410 430 450 470 490 510 530 550
370 390 410 430 450 470 490 510 530 550
C
S
ConsumptionSchedule
Saving Schedule
Saving $5 Billion
Dissaving $5 Billion
Dissaving$5 Billion
Saving $5 Billion
Disposable Income (billions of dollars)
Co
nsu
mp
tio
n (
bil
lio
ns
of
do
llar
s)S
avin
g(b
illi
on
s o
f d
oll
ars
)
10-11
Average Propensity to Consume
Source: Statistical Abstract of the United States, 2006
Selected Nations, with respect to GDP, 2006
United States
Canada
United Kingdom
Japan
Germany
Netherlands
Italy
France
.80 .85 .90 .95 1.00
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
ExpectedRate of
Return (r)
CumulativeAmount ofInvestmentHaving This
Rate ofReturn or Higher
(I)
16%14%12%10%
8%6%4%2%0%
$ 05
10152025303540
r a
nd
i (
pe
rce
nt)
16
14
12
10
8
6
4
2
05 10 15 20 25 30 35 40
Investment (billions of dollars)
ID
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
r a
nd
i (
per
cen
t)
0
Investment (billions of dollars)
ID0ID1ID2
Increase in Investment Demand
Decrease in Investment Demand
Investment Demand Curve
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
Source: International Monetary Fund
Percent of GDP, Selected Nations, 2006
South Korea
Japan
Canada
Mexico
France
United States
Sweden
Germany
United Kingdom
0 10 20 30
10-28
Volatility of Investment
Source: Bureau of Economic Analysis 10-29
The Multiplier Effect
Multiplier =Change in Real GDP
Initial Change in Spending
• More spending results in higher GDP
• Initial change in spending changes GDP by a multiple amount
10-30
(1)Change in
Income
(2)Change in
Consumption(MPC = .75)
(3)Change in
Saving(MPC = .25)
Increase in Investment of $5Second RoundThird RoundFourth RoundFifth RoundAll other rounds Total
$ 5.003.752.812.111.584.75
$ 20.00
$ 3.752.812.111.581.193.56
$ 15.00
$ 1.25.94.70.53.39
1.19$ 5.00
Rounds of Spending1 2 3 4 5 All
$20.00
15.2513.67
11.56
8.75
5.00$5.00
$3.75
$2.81
$2.11$1.58
$4.75
ΔI=$5 billion
The Multiplier Effect
10-31
The Multiplier Effect
Multiplier =1
1 - MPC
Multiplier =1
MPS
-or-
10-32
The Multiplier and the MPC
10
5
4
3
2.5
.67
.75
.8
.9
MPC Multiplier
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 AggregateExpenditures Model
10-35