Basic Macroeconomic Relationships Chapter 10 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved

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


• 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°


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


• 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


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


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


• 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


• 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


• 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


• 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


–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


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


10-31


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

Next Chapter Preview…

The AggregateExpenditures Model

10-35

Documents

Basic Macroeconomic Relationships Chapter 10 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved