Basic Macroeconomic Relationships

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Income Consumption and Saving

• Consumption and saving –Primarily determined by disposable income (DI)

• Consumption schedule –Planned household spending (in our model)

• Saving schedule –Disposable income minus consumption

–Dissaving can occur

LO1 10-2

Income, Consumption, and Saving

LO1 10-3

Consumption and Saving Schedules Consumption and Saving Schedules (in Billions) and Propensities to Consume and Save

(1)

Level of

Output

and

Income

GDP=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 LO1 10-4

Consumption and Saving Schedules

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

Consumption schedule

Saving schedule

Saving $5 billion

Dissaving $5 billion

Dissaving $5 billion

Saving $5 billion

Co

ns

um

pti

on

(b

illi

on

s o

f d

oll

ars

)

Sa

vin

g

(bil

lio

ns

of

do

lla

rs)

Disposable income (billions of dollars) LO1 10-5

Average Propensities

• Average propensity to consume (APC)

• Fraction of total income consumed

• Average propensity to save (APS)

• Fraction of total income saved

APC = APS = consumption

income income

saving

APC + APS = 1

LO1 10-6

Global Perspective

LO1 10-7

Marginal Propensities

• Marginal propensity to consume (MPC)

•Proportion of a change in income

consumed

• Marginal propensity to save (MPS)

•Proportion of a change in income

saved

MPC = MPS = change in consumption

change in income change in income

change in saving

MPC + MPS = 1

LO1 10-8

Marginal Propensities

Disposable income

Co

ns

um

pti

on

S

avin

g

S

C

MPC =

MPS =

15

20 = .75

C ($15)

DI ($20)

DI ($20)

S ($5)

5

20 = .25

LO1 10-9

Nonincome Determinants

• Amount of disposable income

is the main determinant

• Other determinants –Wealth (wealth drives C up)

–Expectations (inflation drives C up)

–Real interest rates (decrease drives C up)

–Household debt (increase drives C up)

LO2 10-10

Other Important Considerations

• Switching to real GDP (see x-axis)

• Simultaneous shifts (C up, S down)

• Taxation (C and S move together)

• Stability (consumption and saving

schedules are relatively stable unless

altered by major tax changes).

LO2 10-11

Shifts of C & S Schedules

45°

C0

S0

Real GDP (billions of dollars)

Co

ns

um

pti

on

(bil

lio

ns

of

do

lla

rs)

Sa

vin

g

(bil

lio

ns

of

do

lla

rs)

C2

C1

S1

S2

0

0

-

+

LO2 10-12

Interest-Rate-Investment

• Expected rate of return (r)

• The real interest rate (i)

• Investment demand curve

LO3 10-13

Investment Demand Curve

Ex

pe

cte

d r

ate

of

retu

rn, r

an

d r

ea

l in

tere

st

rate

, i

(pe

rce

nts

) 16

14

12

10

8

6

4

2

0

5 10 15 20 25 30 35 40

Investment (billions of dollars)

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

Investment

demand

curve

LO3 10-14

Shifts of Investment Demand

• Acquisition, maintenance,

and operating costs

• Business taxes

• Technological change

• Stock of capital goods on hand

• Planned inventory changes

• Expectations

LO4 10-15

Shifts of Investment Demand

Exp

ecte

d r

ate

of

retu

rn,

r, a

nd

re

al in

tere

st

rate

, i (p

erc

en

ts)

0

Investment (billions of dollars)

ID0 ID1 ID2

Increase

in investment

demand

Decrease in

investment

demand

LO4 10-16

Global Perspective

LO4 10-17

Instability of Investment

• Investment is unstable,

rising and falling quite often. –Durability

– Irregularity of innovation

–Variability of profits

–Variability of expectations

LO4 10-18

Instability of Investment

Source: Bureau of Economic Analysis, http://www.bea.gov.

LO4 10-19

The Multiplier Effect

• A change in spending changes real

GDP more than the initial change in

spending

Multiplier = change in real GDP

initial change in spending

Change in GDP = multiplier x initial change in spending

LO5 10-20

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

Cu

mu

lati

ve

in

co

me

,

GD

P (

billi

on

s o

f

do

lla

rs)

20.00

15.25

13.67

11.56

8.75

5.00

2 3 5 4 All others 1

LO5 10-21

Multiplier and Marginal Propensities

• Multiplier and MPC directly related

• Large MPC results in larger

increases in spending

• Multiplier and MPS inversely related

• Large MPS results in smaller

increases in spending

Multiplier = 1

1- MPC Multiplier =

1

MPS

LO5 10-22

Multiplier and Marginal Propensities

10

5

4

3

2 .5

.67

.75

.8

.9

MPC Multiplier

LO5 10-23

The Actual Multiplier Effect?

• Actual multiplier is lower

than the model assumes

• Consumers buy imported products

• Households pay income taxes

• Inflation

LO5 10-24