Basic Macroeconomic Relationships

Copyright 2008 The McGraw-Hill Companies8-1

8Basic MacroeconomicBasic Macroeconomic

RelationshipsRelationships


Learning objectivesLearning objectives • In this chapter students will learn:In this chapter students will learn:

1.1. How changes in income affect consumption and saving.How changes in income affect consumption and saving.2.2. About factors other than income that can affect About factors other than income that can affect consumption.consumption.3.3. How changes in real interest rates affect investment.How changes in real interest rates affect investment.4.4. About factors other than the real interest rate that can About factors other than the real interest rate that can affect investment.affect investment.5.5. Why changes in investment increase or decrease real Why changes in investment increase or decrease real GDP by a multiple amount.GDP by a multiple amount.


II.II. The Income-Consumption and Income-Saving The Income-Consumption and Income-Saving RelationshipsRelationships

• Disposable income is the most important determinant of consumer spending (consumption). Note that What is not spent on consumption is called saving.

• Disposable Income (DI) = C + SC= consumption and S = saving

Saving = DI – C

• Note:• (disposable income in Kuwait = personal income since there is

no income tax)

• The 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; Or each point represent a situation where; C + S = DIC + S = DI

• Any vertical distance from the horizontal axis to the 45Any vertical distance from the horizontal axis to the 4500 line line measures measures DI=C+SDI=C+S

• Consumption ScheduleConsumption Schedule• Reflects the direct consumption-disposable income relationshipReflects the direct consumption-disposable income relationship• Note: households tend to spend a Note: households tend to spend a largerlarger proportion of a small DI proportion of a small DI

than of a larger DI.than of a larger DI.

• The saving scheduleThe saving schedule• Reflects the direct relationship between S and DIReflects the direct relationship between S and DI• Saving is a Saving is a smallersmaller proportion of small DI than of a large DI proportion of small DI than of a large DI• Dissaving: when households consume more than their DI. They Dissaving: when households consume more than their DI. They

do that by do that by liquidating their wealthliquidating their wealth ( (previous savingprevious saving) or by ) or by borrowing (borrowing (use the savings of othersuse the savings of others))


• Note that “dissaving” occurs at low levels of disposable income, where consumption exceeds income and households must borrow or use up some of their wealth.

• Definitions:• 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 consumedMPC = 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:Note:• As DI increases; APS rises and APC falls. As DI increases; APS rises and APC falls.

• APC + APS = 1APC + APS = 1

• MPC + MPS = 1MPC + MPS = 1Because: Because: • ∆∆DI = ∆C + ∆SDI = ∆C + ∆S

• Global Perspective 8.1 shows the APCs for several nations in Global Perspective 8.1 shows the APCs for several nations in 2006. Note the high APCs for the U.S., Canada, and the 2006. Note the high APCs for the U.S., Canada, and the United Kingdom.United Kingdom.


Disposable Income Consumption Saving 350 360 -10 370 375 -5 390 390 0 410 405 5 430 420 10 450 435 15 470 450 20 490 465 25 510 480 30 530 495 35 550 510 40

Consumption and Saving SchedulesC=97.5+0.75xDI C=-97.5+0.25xDI


Con

sum

ptio

nSa

ving

o

o 45o

C

S

Consumptionschedule

Savingschedule

C

S

Disposable Income

Disposable Income

SAVING

SAVING

DISSAVING

DISSAVING

MPC = Slope of C

MPS = Slope of S

MPC + MPS = 1CONSUMPTION AND SAVING

C=-97.5+0.25xDI

C=97.5+0.75xDI


Break even income:Break even income: • The income level at which households plan to consume their The income level at which households plan to consume their

entireentire income, (C = DI). income, (C = DI).

• At break even:At break even:- Consumption schedule cuts the 45Consumption schedule cuts the 4500 line. line.- Saving schedule cuts the horizontal axis . Saving schedule cuts the horizontal axis . - Saving = zeroSaving = zero- APC = 1APC = 1- APS = zeroAPS = zero


Consumption and SavingConsumption 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


500

475

450

425

400

375

45°

Consumption and Saving Consumption and Saving SchedulesSchedules

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)

Con

sum

ptio

n (b

illio

ns o

f dol

lars

)Sa

ving

(bill

ions

of d

olla

rs)


GLOBAL PERSPECTIVE

Consumption and SavingConsumption and Saving

Source: Statistical Abstract of the United States, 2006

Average Propensities to ConsumeSelect Nations GDPs

United States

Canada

United Kingdom

Japan

Germany

Netherlands

Italy

France

.80 .85 .90 .95 1.00

.963

.958

.953

.942

.896

.893

.840

.833

Average Propensities to Consume


Nonincome determinants of consumption and saving:Nonincome determinants of consumption and saving: can cause can cause people to spend or save more or less at various income levels, people to spend or save more or less at various income levels, although the level of income is the basic determinant.although the level of income is the basic determinant.

1.1. Wealth:Wealth: An increase in wealth shifts the consumption schedule An increase in wealth shifts the consumption schedule up and saving schedule down. up and saving schedule down. Wealth Effects:Wealth Effects: when assets boast, households feel when assets boast, households feel wealthywealthy, they , they save less and consumer more, and vice versa.save less and consumer more, and vice versa.

2.2. Expectations:Expectations: Changes in expected future prices or wealth can Changes in expected future prices or wealth can affect consumption spending today. affect consumption spending today.

3.3. Real interest rates:Real interest rates: Declining interest rates increase the Declining interest rates increase the incentive to borrow and consume, and reduce the incentive to incentive to borrow and consume, and reduce the incentive to save. Because many household expenditures are not interest save. Because many household expenditures are not interest sensitive – the light bill, groceries, etc. – the effect of interest sensitive – the light bill, groceries, etc. – the effect of interest rate changes on spending are modest.rate changes on spending are modest.

4.4. Household debt:Household debt: Lower debtLower debt levels shift consumption schedule levels shift consumption schedule up and saving schedule down. But if debt is up and saving schedule down. But if debt is too hightoo high, they will , they will reduce their consumption to pay off some of their loans.reduce their consumption to pay off some of their loans.


Other important considerations: Other important considerations: • Macroeconomic models focus on real domestic output (real Macroeconomic models focus on real domestic output (real

GDP) more than on disposable income.GDP) more than on disposable income.• Changes along schedules: Movement from one point to another Changes along schedules: Movement from one point to another

on a given schedule is called a change in the amount consumed, on a given schedule is called a change in the amount consumed, this is due to disposable income; a shift in the schedule is called this is due to disposable income; a shift in the schedule is called a change in consumption schedule, and is caused by a change in consumption schedule, and is caused by non-incomenon-income determinants of consumption.determinants of consumption.

• Schedule shifts: Consumption and saving schedules will always Schedule shifts: Consumption and saving schedules will always shift in opposite directions unless a shift is caused by a shift in opposite directions unless a shift is caused by a tax tax change, it will shift them both in the same directionchange, it will shift them both in the same direction..

• Taxation: Lower taxes will shift both schedules up since taxation Taxation: Lower taxes will shift both schedules up since taxation affects both spending and saving, and vice versa for higher affects both spending and saving, and vice versa for higher taxes.taxes.

• Stability: Economists believe that consumption and saving Stability: Economists believe that consumption and saving schedules are generally stable unless deliberately shifted by schedules are generally stable unless deliberately shifted by government action. government action.


45°

Consumption and SavingConsumption and SavingConsumption and Saving SchedulesConsumption and Saving Schedules

C0

S0

Disposable Income (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


The Interest Rate – Investment RelationshipThe 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 interest 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 real 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


Interest rates Expected rate of return

Cumulative investment

16% 014% 5

if i=12% 1010% 158% 20

If i = 6% 254% 302% 350% 40

Investment demand curve


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 e.g., 6%, more investment will be undertaken

• If rate of interest is more, less investments will be undertaken


Interest Rate and InvestmentInterest Rate and Investment

ExpectedRate of

Return (r)

CumulativeAmount ofInvestmentHaving This

Rate ofReturn or Higher

(i)

16%14%12%10%8%6%4%2%0%

$ 05

10152025303540

r an

d i (

perc

ent)

16

14

12

10

8

6

4

2

05 10 15 20 25 30 35 40

Investment (billions of dollars)

The Investment Demand CurveThe Investment Demand Curve

ID


• Shifts in investment demand (Figure 8.6) occur when any Shifts in investment demand (Figure 8.6) occur when any determinant apart from the interest rate changes. determinant apart from the interest rate changes.

1. 1. Greater expected returnsGreater expected returns create more investment demand; create more investment demand; shift curve to right. The reverse causes a leftward shift.shift curve to right. The reverse causes a leftward shift.

• Changes in expected returnsChanges in expected returns result because of: result because of:a. 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 (ID Shift to the RHS)

– When they increase, prospective investment projects decrease (ID shift to the LHS)


2. Business TaxesWhen tax increases, expected (after tax) return decreases, shifts the investment curve to the LHS and vice versa.

3. Technological ChangeTechnological 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).


4. Stock of capital goods on handRelative 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 conditionscan 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 investmentInvestment schedule is unstable, it shifts upward or downward quite often. Investment is the most volatile component of total spending.

• Reasons for instability of investmenta. Durability of capital

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 and postpone new.


b. Irregularity of InnovationTechnological 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

c. 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.


d. 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


GLOBAL PERSPECTIVEInterest Rate and InvestmentInterest Rate and Investment

Source: World Bank

Gross Investment Expenditures as aGross Investment Expenditures as aPercent of GDP, Select NationsPercent of GDP, Select Nations

South Korea

Japan

Mexico

Canada

France

United States

Germany

United Kingdom

Sweden

0 10 20 30Percent of GDP, 2004


Interest Rate and InvestmentInterest Rate and Investment

-30

-20

-10

0

10

20

30

40

1971 1975 1979 1983 1987 1991 1995 1999 2003

GDP

Gross Investment

The Volatility of InvestmentThe Volatility of Investment

Perc

enta

ge C

hang

e

Year


IV.IV. The Multiplier EffectThe Multiplier EffectA.A. Changes in spending Changes in spending ripple throughripple through the economy to generate the economy to generate

event larger changes in real GDP. This is called the event larger changes in real GDP. This is called the multiplier multiplier effecteffect..

• MultiplierMultiplier = change in real GDP / initial change in spending= change in real GDP / initial change in spending. . Alternatively, it can be rearranged to read:Alternatively, it can be rearranged to read:

• Change in real GDPChange in real GDP = initial change in spending x multiplier= initial change in spending x multiplier..• Three points to remember about the multiplier:Three points to remember about the multiplier:a.a. The initial change in spending is usually associated with The initial change in spending is usually associated with

investmentinvestment because it is so volatile, but changes in because it is so volatile, but changes in consumption (unrelated to income), net exports, and consumption (unrelated to income), net exports, and government purchases also are subject to the multiplier government purchases also are subject to the multiplier effect.effect.

b.b. The initial change refers to an The initial change refers to an upshift or downshiftupshift or downshift in the in the aggregate expenditures schedule due to a change in one of its aggregate expenditures schedule due to a change in one of its components, like investment.components, like investment.

c.c. The multiplier works in The multiplier works in both directionsboth directions (up or down). (up or down).


• The multiplier is based on two facts.The multiplier is based on two facts.1.1. The economy has continuous flows of expenditures and incomeThe economy has continuous flows of expenditures and income

—a ripple effect—in which income received by X comes from —a ripple effect—in which income received by X comes from money spent by Y. Y’s income, in turn, came from money money spent by Y. Y’s income, in turn, came from money spent by Z, and so forth.spent by Z, and so forth.

2.2. Any change in income will cause both consumption and saving Any change in income will cause both consumption and saving to vary in the same direction as the initial change in income, to vary in the same direction as the initial change in income, and by a fraction of that change. Note that:and by a fraction of that change. Note that:

a.a. The fraction of the change in income that is spent is called the The fraction of the change in income that is spent is called the marginal propensity to consume (MPC).marginal propensity to consume (MPC).

b.b. The fraction of the change in income that is saved is called the The fraction of the change in income that is saved is called the marginal propensity to save (MPS).marginal propensity to save (MPS).

c.c. This is illustrated in Table 8.3, and Figure 8.8 that is derived This is illustrated in Table 8.3, and Figure 8.8 that is derived from the Table.from the Table.

d. The d. The sizesize of the MPC and the multiplier are of the MPC and the multiplier are directlydirectly related; related; the size of the the size of the MPSMPS and the multiplier are and the multiplier are inverselyinversely related. related. See Figure 8.9 for an illustration of this point. In equation See Figure 8.9 for an illustration of this point. In equation form Multiplier = 1 / MPS or 1 / (1-MPC).form Multiplier = 1 / MPS or 1 / (1-MPC).


• The significance of the multiplier is that a small change in The significance of the multiplier is that a small change in investment plans or consumption-saving plans can trigger a investment plans or consumption-saving plans can trigger a much much larger changelarger change in the equilibrium level of GDP. in the equilibrium level of GDP.

• The simple multiplier given above can be generalized to include The simple multiplier given above can be generalized to include other “other “leakagesleakages” from the spending flow besides savings. For ” from the spending flow besides savings. For example, the actual multiplier is derived by including taxes and example, the actual multiplier is derived by including taxes and imports as well as savings in the equation. In other words, the imports as well as savings in the equation. In other words, the denominator is the fraction of a change in income not spent on denominator is the fraction of a change in income not spent on domestic output. (Key Question 9)domestic output. (Key Question 9)


The Multiplier Effect

(1)Change in

Income

(2)Change in

Consumption(MPC = .75)

(3)Change in

Saving(MPs = .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

Tabular and Graphical Views

Rounds of Spending1 2 3 4 5 All

$20.00

15.2513.6711.56

8.75

5.00 $5.00$3.75

$2.81$2.11

$1.58$4.75

ΔI=$5 billion


The Multiplier EffectThe MPC and the Multiplier

10

5

4

3

2.5

.67

.75

.8

.9

MPC Multiplier


Squaring the Economic CircleSquaring the Economic Circle

• Humorist Art Buchwald and the MultiplierHumorist Art Buchwald and the Multiplier• One Person Can’t Buy a ProductOne Person Can’t Buy a Product• Others Subsequently Impacted and Cannot Buy Other Others Subsequently Impacted and Cannot Buy Other

ItemsItems• Multiple Effects Impact PsycheMultiple Effects Impact Psyche• Ultimately Causes Multiple Step Impact Upon the Economy Ultimately Causes Multiple Step Impact Upon the Economy

as a Wholeas a Whole

Last

Word


Key Terms• 45° (degree) line• consumption schedule• saving schedule• break-even income• average propensity to co

nsume (APC)• average propensity to sa

ve (APS)

• marginal propensity to consume (MPC)

• marginal propensity to save (MPS)

• wealth effect• expected rate of re

turn• investment deman

d curve• multiplier


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Basic Macroeconomic Relationships