Chapter 27 Basic Macroeconomic Relationships Mc Graw-Hill Irwin Copyright

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

Consumption (billions of dollars) Income and Consumption 05 45° Reference Line C=DI 04 03 00 99 Saving In 1992 83 84 91 90 89 88 87 86 85 97 01 02 C 98 96 95 94 93 92 Consumption In 1992 45° 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 Marginal (2) Output Propensity (3) Consump. And to Consume to Save Saving (S) tion Income (APC) (APS) (MPC) (MPS) (1) – (2) (C) (GDP=DI) (2)/(1) (3)/(1) Δ(2)/Δ(1) Δ(3)/Δ(1) $370 $375 $-5 1. 01 -. 01 (2) 390 0 1. 00 (3) 410 405 5 . 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 = 1 . 75 . 25 MPC and MPS measure slopes 27 -7

Consumption (billions of dollars) Consumption and Saving 500 C 475 450 425 Saving $5 Billion Consumption Schedule 400 375 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 25 $5 Billion 0 Saving Schedule S 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

Consumption and Saving • Other important considerations – Switch to real GDP – Changes along schedules – Schedule shifts – Stability – Taxation 27 -11

Consumption and Saving Consumption (billions of dollars) C 1 C 0 C 2 Saving (billions of dollars) 45° Disposable Income (billions of dollars) S 2 S 0 S 1 27 -12

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% $ 0 5 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 8 6 4 ID 2 0 5 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 ID 2 ID 0 ID 1 0 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 0 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 – C, G, X • 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 (1) Saving Change in Consumption (MPC =. 75) (MPS =. 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 $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 1 2 3 4 Rounds of Spending 5 All 27 -22

The Multiplier Effect Multiplier = 1 1 - MPC -or. Multiplier = 1 MPS 27 -23

The Multiplier and the MPC Multiplier . 9 10 . 8 5 . 75 4 . 67. 5 3 2 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