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3PBasicMacroeconomicRelationships.pptxBasic Macroeconomic Relationships Please listen to the audio as you work through the slides.
Creative Commons Attribution 4.0 License, Charles Hackner Houston Community College unless otherwise noted CC BY NC
Learning objectives
Students should be able to thoroughly and completely explain:
The relationships between Income, Consumptions, Saving, and GDP.
The relationships between Interest rates, Expected Rates of Return, and Investment spending.
The Multiplier, (including the 3 types discussed in the notes), and how the Multiplier works.
Topics
Household sector:
Income – consumption & saving relationship
Business sector:
Interest rate – Rate of return – investment
Magnification of changes:
The multiplier – very important concept!
U.S. Income Relationships 2007
Gross Domestic Product (GDP)
Less: Consumption of Fixed Capital
Equals: Net Domestic Product (NDP)
Less: Statistical Discrepancy
Plus: Net Foreign Factor Income
Equals: National Income (NI)
Less: Taxes on Production and Imports
Less: Social Security Contributions
Less: Corporate Income Taxes
Less: Undistributed Corporate Profits
Plus: Transfer Payments
Equals: Personal Income (PI)
Less: Personal Taxes
Equals: Disposable Income (DI)
$ 13,841
1687
$ 12,154
29
96
$ 12,221
1009
979
467
344
2237
$ 11,659
1482
$ 10,177
Income – Consumption Relationship and
Income – Saving Relationship
Definition of some terms:
Disposable Income (DI)
DI = C+S
Personal Saving (S) – “not spending”
Consumption (C) – Consumption spending
The Consumption Schedule (consumption function)
A schedule showing the various amounts that households would plan to consume at each of the various levels of DI that might prevail at some point in time
The Saving Schedule (saving function)
A schedule showing the various amounts that households would plan to save at each of the various levels of DI that might prevail as some point in time
Break-even Income – the level of income at which households plan to consume their entire incomes C=DI
Graphic representation of the income, consumption, saving relationship
500
475
450
425
400
375
45°
50
25
0
390 410 430 450 470 490 510 530 550
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
Disposable Income (billions of dollars)
Consumption (billions of dollars)
Saving
(billions of dollars)
Any point on the 45 degree
Reference line is equidistant
From each axis (DI = C)
Saving and consumption
Both are directly related to
Disposable income
Consumption and Saving Terminology
APC – average propensity to consume – fraction of income that is spent on consumption. Consumption / Income
APS – average propensity to save – fraction of income that is saved.
Saving / Income
APS+APC=1
MPC – marginal propensity to consume – the fraction of any change in
Income that will be consumed. Change in Consumption / Change in Income
MPS – marginal propensity to save – the fraction of any change in
Income that will be saved. change in Saving / change in Income
MPS+MPC=1
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
change
8
Non Income Determinants of
Consumption and Saving (curve shifters)
Wealth – value of real (houses and land) and financial assets (cash, bank accounts, securities, pensions)
Wealth Effects – causes consumption and saving to increase or decrease
Expectations – about inflation, recession, etc
Real Interest Rates (adjusted for inflation (nominal interest rate minus rate of inflation))
Household Debt – more debt enables more consumption
Taxation –
Consumption & saving move in same direction – taxes affect both
Consumer Debt 1999 to 2016
CC0
Terminology
Movement along a curve (change in amount consumed) vs. shift of a curve
Schedule Shifters
Wealth,
expectations,
interest rates,
household debt
Taxes – affect both C and S
Stability – consumption & savings functions relatively stable
TERMINOLOGY, SHIFTS, & STABILITY
Consumption and Saving
45°
C0
S0
Disposable Income (billions of dollars)
Consumption (billions of dollars)
Saving
(billions of dollars)
C2
C1
S1
S2
The Interest Rate – Investment Relationship
Listen to the audio for more info.
Relationship between real interest rates, expected rate of return, and investment.
Investment – expenditures on new plants, capital equipment, machinery, inventories, etc.
Investment decision – a MB MC decision.
MB is the expected rate of return businesses hope to realize.
MC is the interest rate that must be paid for borrowed funds.
Business will invest in all projects where expected rate of return exceed the interest rate.
The two basic determinants of investment spending!
Expected Rate of Return, r
Real Interest Rate:
i is the nominal rate adjusted for inflation.
Inverse relationship between Investment demand and the real interest rate. Please explain.
Interest Rate – Investment
Relationship
Graphically presented...
Investment Demand Curve
Expected
Rate of
Return (r)
Cumulative
Amount of
Investment
Having This
Rate of
Return or Higher
(I)
16%
14%
12%
10%
8%
6%
4%
2%
0%
$ 0
5
10
15
20
25
30
35
40
r and i (percent)
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 (percent)
0
Investment (billions of dollars)
ID0
ID1
ID2
Increase in
Investment Demand
Decrease in
Investment Demand
Investment Demand Curve
These affect Investment Demand
by way of the Expected Rate of Return
What would have to happen to each of these factors to cause a change in the Expected Rate of Return on a project?
Acquisition, Maintenance, and Operating Costs
Business Taxes
Technological Change
Stock of Capital Goods on Hand
Planned inventory changes
Expectations
Non-Interest Rate Determinants of Investment Demand
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
change
18
Durability of capital goods
Irregularity of Innovation
Variability of Profits
Variability of Expectations
Causes of Instability of Investment
February 2009
$800 Billion stimulus bill signed
Why $800 Billion?
Multipliers
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 multiplied amount
The Multiplier Effect
Some causes of the initial change in spending
Changes in Investment, Consumption
Government spending, Net Exports
Rationale
Dollars spent are received as income
Income received is spent (MPC)
Initial changes in spending cause a spending chain
The Multipliers – make sure you know these
Spending Multiplier = 1/MPS
An autonomous change in spending results in a change in aggregate production in the same direction.
Tax Multiplier = (MPC/MPS)
If, for example, the MPC is 0.75 (and the MPS is 0.25), then an autonomous $1 trillion change in taxes results in an opposite change in aggregate production of $3 trillion
Balanced Budget Multiplier = 1
The balanced-budget multiplier measures the combined impact on aggregate production of equal changes in government purchases and taxes. The simple balanced-budget multiplier has a value equal to one
http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=tax+multiplier
Change
in GDP
=
Multiplier
x
initial change
in spending
The Multiplier Spending Effect
Multiplier
=
Change in Real GDP
Initial Change in Spending
For Example…
The big picture:
We know we need to increase or decrease our GDP, but we don’t know by how much we need to change spending to get the desired result. How do we figure that out?
The Multiplier Effect
The following slide shows you
how the Multiplier operates.
Business Sector
(1)
Change in
Income
(2)
Change in
Consumption
(MPC = .75)
(3)
Change in
Saving
(MPS = .25)
Increase in Investment of $5
Second Round
Third Round
Fourth Round
Fifth Round
All other rounds
Total
$ 5.00
3.75
2.81
2.11
1.58
4.75
$ 20.00
$ 3.75
2.81
2.11
1.58
1.19
3.56
$ 15.00
$ 1.25
.94
.70
.53
.39
1.19
$ 5.00
Rounds of Spending
1
2
3
4
5
All
$20.00
15.25
13.67
11.56
8.75
5.00
$5.00
$3.75
$2.81
$2.11
$1.58
$4.75
ΔI=
$5 billion
The Multiplier Effect
Change in
GDP
=
Multiplier
x
initial change
in spending
Multiplier
=
or
1
MPS
1
1 - MPC
The Spending Multiplier Effect
Inverse relationship between:
Multiplier & MPS
Multiplier Effect and the Marginal Propensities
The Multiplier Effect
.9
.8
.75
.67
.5
10
5
4
3
2
MPC
Multiplier
MPC and the Multiplier
Rules of thumb
The Tax Multiplier
(- MPC/MPS)
You are the chief economic adviser to the president. You are instructed to devise a plan to reduce unemployment to an acceptable level without increasing the level of government spending.
You decide to cut taxes and maintain the spending level.
A tax cut increases disposable income which leads to increases in consumption.
Would the decrease in taxes affect aggregate output in the same way as an increase in government spending?
The Tax Multiplier
A tax decrease causes an income increase.
Consumption increases
Inventories decrease
Output increases in response.
Employment and income increase and lead to subsequent rounds of spending.
GDP will increase by a multiple of the decrease in taxes.
The multiplier for a change in taxes is not the same as the multiplier for an change in government spending.
