10 Basic Macroeconomic Relationships McGraw-Hill/Irwin Copyright © 2012 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 27-2 Income Consumption and Saving • Consumption and saving • Primarily determined by DI • Direct relationship • Consumption schedule • Planned household spending (in our mod • Saving schedule • DI minus C • Dissaving can occur LO1 10-3 Income, Consumption, and Saving LO1 10-4 Average Propensities • Average propensity to consume (APC) • Fraction of total income consumed • Average propensity to save (APS) • Fraction of total income saved consumption APC = income APS = saving income APC + APS = LO1 10-5 Saving (billions of dollars) Consumption (billions of dollars) Consumption and Saving Schedules LO1 C Saving $5 billion Consumption schedule Dissaving $5 billion 370 390 410 430 450 470 490 510 530 550 Dissaving Saving schedule S $5 billion Saving $5 billion Disposable income (billions of dollars) 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 = change in consumption change in income MPS = change in saving change in income MPC + MPS = LO1 10-8 Marginal Propensities C Consumption 15 MPC = 20 = 75 ∆C ($15) Saving ∆DI ($20) MPS = = 25 20 S ∆S ($5) ∆DI ($20) Disposable income LO1 10-9 Consumption and Saving Schedules Consumption and Saving Schedules (in Billions) and Propensities to Consume and Save (4) (1) Level of Output and Income GDP=DI (2) Consumption (C) (3) Saving (S), (1) – (2) (1) $370 $375 (6) (7) Marginal Propensity to Consume (3)/(1) (MPC), ∆(2)/∆(1)* Marginal Propensity to Save 1.01 -.01 75 25 (5) Average Propensity to Consume (APC), Average Propensity to Save (APS), $-5 (2)/(1) (MPS), ∆(3)/∆(1)* (2) 390 390 1.00 00 75 25 (3) 410 405 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 10-10 Shifts of C & S Schedules C1 C0 Saving (billions of dollars) Consumption (billions of dollars) C2 LO2 S2 S0 S1 + Real GDP (billions of dollars) 10-15 Interest-Rate-Investment • Expected rate of return • The real interest rate • Investment demand curve LO3 10-16 Investment Demand Curve (r) and (i) 16% LO3 Investment (billions of dollars) $0 14 12 10 10 15 20 25 30 35 40 Investment demand curve ID 10-17 Shifts of Investment Demand • Acquisition, maintenance, and • • • • • LO4 operating costs Business taxes Technological change Stock of capital goods on hand Planned inventory changes Expectations 10-18 Shifts of Investment Demand Expected rate of return, r, and real interest rate, i (percents) Increase in investment demand Decrease in investment demand LO4 ID2 ID0 ID1 Investment (billions of dollars) 10-19 Global Perspective LO4 10-20 Instability of Investment • Variability of expectations • Durability • Irregularity of innovation • Variability of profits LO4 10-21 Instability of Investment Source: Bureau of Economic Analysis, http://www.bea.gov LO4 10-22 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 10-23 The Multiplier Effect (1) Change in Income (2) Change in Consumption (MPC = 75) (3) Change in Saving (MPS = 25) $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 $20.00 $15.00 $5.00 Increase in investment of $5.00 Total Cumulative income, GDP (billions of dollars) 20.00 $4.75 15.25 13.67 $1.58 $2.11 11.56 $2.81 8.75 $3.75 5.00 $5.00 LO5 All others 10-24 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 = LO5 1- MPC Multiplier = MPS 10-25 Multiplier and Marginal Propensities MPC Multiplier 10 75 67 LO5 10-26 The Actual Multiplier Effect? • Actual multiplier is lower than the • • • • LO5 model assumes Consumers buy imported products Households pay income taxes Inflation Actual Multiplier is estimated at 2.5 or less 10-27 Squaring the Economic Circle • Humorous small town example of the • • • multiplier One person in town decides not to buy a product Creates a ripple effect of people not spending, following the first decision Ultimately the entire town experiences an economic downturn 10-28 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 27-29 ... http://www.bea.gov LO4 10- 22 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... Proportion of a change in income consumed • Marginal propensity to save (MPS) • Proportion of a change in income saved MPC = change in consumption change in income MPS = change in saving change in... Other Important Considerations • Switching to real GDP • Changes along schedules • Simultaneous shifts • Taxation • Stability LO2 10- 14 Shifts of C & S Schedules C1 C0 Saving (billions of dollars)