Chapter 27 - Basic macroeconomic relationships. The goal is for you to learn: Describe how changes in income affect consumption (and saving), list and explain factors other than income that can affect consumption, explain how changes in real interest rates affect investment, identify and explain factors other than the real interest rate that can affect investment, illustrate how changes in investment increase or decrease real GDP by a multiple amount.
Chapter 27 Basic Macroeconomic Relationships McGrawHill/Irwin Copyright © 2009 by The McGrawHill 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 Basic Relationships • Income and consumption • Income and saving • Disposable income (DI) • 45°line for reference –C = DI on the Line • S = DI - C 27-3 Income and Consumption Consumption (billions of dollars) 10000 9000 05 45° Reference Line C=DI 8000 04 03 7000 00 02 01 C 99 6000 Saving In 1992 5000 4000 3000 83 2000 84 97 91 90 89 88 87 86 85 98 96 95 94 93 92 Consumption In 1992 1000 45° 0 2000 4000 6000 8000 10000 Disposable Income (billions of dollars) Source: Bureau of Economic Analysis 27-4 Consumption and Saving • • • • The consumption schedule The saving schedule Break-even income Average propensity to consume (APC) • Average propensity to save (APS) Consumption APC = Income APS = Saving Income 27-5 Consumption and Saving • Marginal propensity to consume (MPC) • Marginal propensity to save (MPS) Change in Consumption MPC = Change in Income Change in Saving MPS = Change in Income 27-6 Consumption and Saving (1) (4) (5) (6) (7) Level of Average Average Marginal Marginal (2) Output Propensity Propensity Propensity Propensity Consump(3) And to Consume to Save to Consume to Save tion Saving (S) Income (APC) (APS) (MPC) (MPS) (C) (1) – (2) (GDP=DI) (2)/(1) (3)/(1) Δ(2)/Δ(1) Δ(3)/Δ(1) (1) $370 $375 $-5 1.01 -.01 (2) 390 390 1.00 00 (3) 410 405 99 01 (4) 430 420 10 98 02 (5) 450 435 15 97 03 (6) 470 450 20 96 04 (7) 490 465 25 95 05 (8) 510 480 30 94 06 (9) 530 495 35 93 07 (10) 550 510 40 93 07 MPC + MPS = 75 25 75 25 75 25 75 25 75 25 75 25 75 25 75 25 75 25 MPC and MPS measure slopes 27-7 Consumption (billions of dollars) Consumption and Saving 500 C 475 450 425 Saving $5 Billion 400 Consumption Schedule 375 Dissaving $5 Billion Saving (billions of dollars) 45° 370 390 410 430 450 470 490 510 530 550 Disposable Income (billions of dollars) 50 Dissaving Saving Schedule S $5 Billion 25 Saving $5 Billion 370 390 410 430 450 470 490 510 530 550 27-8 Average Propensity to Consume Selected Nations, with respect to GDP, 2006 80 85 90 95 1.00 United States Canada United Kingdom Japan Germany Netherlands Italy France Source: Statistical Abstract of the United States, 2006 27-9 Consumption and Saving • Nonincome determinants of consumption and saving – Wealth – Borrowing – Expectations – Real interest rates 27-10 Interest Rate and Investment • Expected rate of return (r) • The real interest rate (i) – Nominal rate less rate of inflation • Meaning of r = i • Investment demand curve 27-13 Investment Demand Curve 16% 14% 12% 10% 8% 6% 4% 2% 0% $ 10 15 20 25 30 35 40 16 14 r and i (percent) Expected Rate of Return (r) Cumulative Amount of Investment Having This Rate of Return or Higher (I) 12 10 ID 10 15 20 25 30 35 40 Investment (billions of dollars) 27-14 Investment Demand Curve • Shifts of the curve – Acquisition, maintenance, and operating costs – Business taxes – Technological change – Stock of capital goods on hand – Planned inventory changes – Expectations 27-15 Investment Demand Curve r and i (percent) Increase in Investment Demand Decrease in Investment Demand ID2 ID0 ID1 Investment (billions of dollars) 27-16 Investment Demand • Instability of investment – Durability – Irregularity of innovation – Variability of profits – Variability of expectations 27-17 Gross Investment Expenditure Percent of GDP, Selected Nations, 2006 10 20 30 South Korea Japan Canada Mexico France United States Sweden Germany United Kingdom Source: International Monetary Fund 27-18 Volatility of Investment Source: Bureau of Economic Analysis 27-19 The Multiplier Effect • More spending results in higher GDP • Initial change in spending changes GDP by a multiple amount Multiplier = Change in Real GDP Initial Change in Spending 27-20 The Multiplier Effect • Causes of the initial change in spending – Changes in investment – Other changes • Rationale – Dollars spent are received as income – Income received is spent (MPC) – Initial changes in spending cause a spending chain 27-21 The Multiplier Effect Increase in Investment of $5 Second Round Third Round Fourth Round Fifth Round All other rounds Total (2) (3) Change in Change in (1) Saving Change in Consumption (MPC = 75) (MPC = 25) Income $ 5.00 $ 3.75 $ 1.25 3.75 2.81 94 2.81 2.11 70 2.11 1.58 53 1.58 1.19 39 4.75 3.56 1.19 $ 20.00 $ 15.00 $ 5.00 $20.00 $4.75 15.25 13.67 11.56 8.75 5.00 $1.58 $2.11 $2.81 ΔI= $5 billion $3.75 $5.00 Rounds of Spending All 27-22 The Multiplier Effect Multiplier = 1 - MPC -orMultiplier = MPS 27-23 The Multiplier and the MPC MPC Multiplier 10 75 67 27-24 Squaring the Economic Circle • Humorist Art Buchwald and the multiplier • Suppose one person can’t buy a product • Others subsequently impacted and cannot buy other items • Multiple effects impact psyche • Ultimately causes multiple step impact upon the economy as a whole 27-25 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 27-26 Next Chapter Preview… The Aggregate Expenditures Model 27-27 ... $3.75 $5.00 Rounds of Spending All 2 7- 22 The Multiplier Effect Multiplier = 1 - MPC -orMultiplier = MPS 2 7- 23 The Multiplier and the MPC MPC Multiplier 10 75 67 2 7- 24 Squaring the Economic Circle... expected rate of return • investment demand curve • multiplier 2 7- 26 Next Chapter Preview… The Aggregate Expenditures Model 2 7- 27 ... effect on real GDP 2 7- 2 Basic Relationships • Income and consumption • Income and saving • Disposable income (DI) • 45°line for reference –C = DI on the Line • S = DI - C 2 7- 3 Income and Consumption