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 = PI2. All savings are personal saving: No business savings3. Depreciation = 0; Gross I = Net I4. 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.
GDP=DIGDP=DI CC SS$370$370 $375$375 $ -5$ -5390390 390390 00410410 405405 55430430 420420 1010450450 435435 1515470470 450450 2020490490 465465 2525510510 480480 3030530530 495495 3535550550 510510 4040
Income- Consumption-Saving Links
Income- Consumption-Saving Links
Based on the table; • If C > DI, then there is a decline in savings (Dis-saving)• 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)
Income- Consumption-Saving Links
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
Con
sum
ptio
n (b
illio
ns o
f dol
lars
)Sa
ving
(bill
ions
of d
olla
rs)
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)
APC = APS =consumption
income incomesaving
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 = MPS =change in consumption
change in income change in income
change in saving
MPC + MPS = 1
• 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.
Income- Consumption-Saving Links
Consumption and Saving Schedules
Disposable income
Con
sum
ptio
nSa
ving
S
CMPC =
MPS =
1520 = .75
C ($15)
DI ($20)
DI ($20)
S ($5)
520 = .25
Marginal Propensities (Slopes)
Consumption and Saving Schedules
Consumption and Saving Schedules (in Billions) and Propensities to Consume and Save
(1)Level of Output
and IncomeGDP=DI
(2)Consumption
(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),
(2)/(1)*
(7)Marginal
Propensity to Save(MPS),
(3)/(1)*
(1) $370 $375 $-5 1.01 -.01 .75 .25(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 Schedule
45o
C
Dissaving
Saving
Income (Y)
C
DI
Break-Even Point (C=Y)
Consumption and Saving Schedules
Consumption Schedule
45o
C
Dissaving
Saving
Income (Y)C
DI
Break-Even Point (C=Y)
Autonomous C (a)
Consumption and Saving Schedules
Consumption and Saving Schedules
Saving Schedule
S
+
-
0 DI
S
Break-Even point (S=0)
Saving ScheduleS
+
-
DI
S
Break-Even point (S=0)
Autonomous C (-a)
Consumption and Saving Schedules
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 levelincrease 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 shiftsThe 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.
• StabilityThe consumption schedule and the saving schedule stay unchanged (stable) relatively unless major tax increases.
Shifts of C & S Schedules
C0
S0
Real GDP (billions of dollars)
Con
sum
ptio
n(b
illio
ns o
f dol
lars
)Sa
ving
(bill
ions
of d
olla
rs)
C2
C1
S1
S2
0
0
-
+
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).
Investment Demand Curve
ID
(r) and (i)
Investment(billions
of dollars) 16% $ 0
14 5
12 10
10 15
8 20
6 25
4 30
2 35
0 40
Investmentdemandcurve
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 costsThe initial and then the operating cost of capital affect the expected rate of return in I negatively (Shifting ID to the left)
• Business taxesIncrease in taxes will reduce expected profitability (Shifting ID to the left)
• Technological changeStimulates 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 changesIf a firm expects higher sales in the future, it would keep more inventory in stock now. Thus increasing ID (Shifting ID to the right)
• ExpectationsExpected 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.
Shifts of Investment Demand E
xpec
ted
rate
of r
etur
n, r,
and
real
inte
rest
rate
, i (p
erce
nts)
0 Investment (billions of dollars)
ID0ID1ID2
Increasein investmentdemand
Decrease in investmentdemand
Instability of Investment
Source: Bureau of Economic Analysis, http://www.bea.gov.
Instability of InvestmentFactors 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 innovationInnovations 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 expectationsAny 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…
Example; if (I) in the economy rises by 30$ million and thus Real GDP increases by 90$ million, what is the Multiplier?
Multiplier =change in real GDP
initial change in spending
Change in GDP = multiplier x initial change in spending
The Multiplier Effect(1)
Change in Income
(2)Change in
Consumption (MPC = .75)
(3)Change in
Saving(MPS = .25)
Increase in investment of $5.00 $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
Total $20.00 $15.00 $5.00
$5.00
$3.75
$2.81
$2.11$1.58
$4.75
Cum
ulat
ive
inco
me,
GD
P (b
illio
ns o
f do
llars
)
20.00
15.2513.67
11.56
8.75
5.00
2 3 54 All others1
Multiplier and Marginal Propensities
• Multiplier and MPC directly relatedLarge MPC results in larger increases in spending
• Multiplier and MPS inversely relatedLarge MPS results in smaller increases in spending
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 =1
1- MPCMultiplier =
1MPS
Multiplier and Marginal Propensities
10
5
4
3
2.5
.67
.75
.8
.9
MPC Multiplier
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 taxesWe 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.