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McGraw-Hill/Irwin

Chapter 10

Basic Macroeconomic

Relationships

McGraw-Hill/Irwin

This chapter introduces three basic macroeconomic relationships. First, the focus is on the income-consumption and income-saving relationships. Second, the relationship between the interest rate and investment is examined. Finally, the multiplier concept is developed, relating changes in spending to changes in output.

Consumption and saving

Primarily determined by DI

Direct relationship

Consumption schedule

Planned household spending (in our model)

Saving schedule

DI minus C

Dissaving can occur

Income Consumption and Saving

LO1

DI represents disposable income (after-tax income) and is the most important determinant of C (consumption spending). What is not spent is called saving. Both consumption and saving are directly related to the level of income.

We can make the following conclusions:

Households consume a large portion of their disposable income and spend a larger proportion of a small disposable income than of a large disposable income.

Households save a smaller proportion of a small disposable income than of a large disposable income.

Dissaving is consuming in excess of disposable income. Households dissave by borrowing or by selling accumulated wealth (assets).

Income Consumption and Saving

LO1

This figure shows the consumption and disposable income for the U.S. for 1987–2012. Each dot in this figure shows consumption and disposable income in a specific year. The line, C, which generalizes the relationship between consumption and disposable income, indicates a direct relationship and shows that households consume most of their after-tax incomes.

This figure represents graphically the recent historical relationship between disposable income (DI), consumption (C), and saving (S) in the United States.

A 45-degree line represents all points where consumer spending is equal to disposable income. Other points represent actual C, DI relationships for each year.

If the actual graph of the relationship between consumption and income is below the 45-degree line, then the difference must represent the amount of income that is saved. Notice that consumption can exceed disposable income and personal saving can be negative.

Consumption and Saving Schedules

LO1

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
390	390	0	1.00	.00	.75	.25
410	405	5	.99	.01	.75	.25
430	420	10	.98	.02	.75	.25
450	435	15	.97	.03	.75	.25
470	450	20	.96	.04	.75	.25
490	465	25	.95	.05	.75	.25
510	480	30	.94	.06	.75	.25
530	495	35	.93	.07	.75	.25
(10) 550	510	40	.93	.07	.75	.25

This table shows the consumption and saving schedules and propensities to consume and save (propensities to consume and save will be presented in later slides).

A hypothetical consumption schedule shows that households spend a larger proportion of a small income than of a large income based on the APC. Note that “dissaving” occurs at low levels of disposable income, where consumption exceeds income and households must borrow or use up some of their wealth.

The break-even income is where C= DI and S= 0. In this table, the break-even income occurs when DI = $390.

Consumption and Saving Schedules

390 410 430 450 470 490 510 530 550

Consumption

schedule

Saving schedule

Saving $5 billion

Dissaving $5 billion

Dissaving

$5 billion

Saving $5 billion

Consumption (billions of dollars)

Saving

(billions of dollars)

Disposable income (billions of dollars)

LO1

This figure shows (a) consumption and (b) saving schedules. The two parts of this figure show the income-consumption and income-saving relationships graphically. The saving schedule in (b) is found by subtracting the consumption schedule in (a) vertically from the 45° line. Consumption equals disposable income (and saving, thus, equals zero) at $390 billion for this hypothetical data.

Average Propensities

Average propensity to consume (APC)

Fraction of total income consumed

Average propensity to save (APS)

Fraction of total income saved

APC + APS = 1

LO1

APC =

APS =

consumption

income

saving

The definition of the average propensity to consume (APC) is the fraction, or percentage, of income consumed (APC = consumption/income). If you multiply the fraction by 100 you can express this as a percentage. The definition of the average propensity to save (APS) is a the fraction, or percentage, of income saved (APS = saving/income). If you multiply the fraction by 100 you can express this as a percentage.

The Global Perspective shows the APCs for several nations in 2009. Note the high APCs for Australia, the U.S., and Canada.

Note that APC + APS = 1.

Global Perspective

LO1

This Global Perspective shows the average propensities to consume for selected nations. There are surprisingly large differences in the average propensities to consume (APCs) among nations. In 2011, Canada and the United States, in particular, had substantially higher APCs, and thus lower APSs, than several other advanced economies.

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 = 1

LO1

MPC =

MPS =

change in consumption

change in income

change in saving

Marginal propensity to consume (MPC) is the fraction or proportion of any change in income that is consumed. (MPC = change in consumption/change in income.) Marginal propensity to save (MPS) is the fraction or proportion of any change in income that is saved. (MPS = change in saving/change in income.) Note that MPC + MPS = 1.

Marginal Propensities

Disposable income

Consumption

Saving

MPC =

MPS =

= .75

C ($15)

DI ($20)

S ($5)

= .25

LO1

This figure shows the marginal propensity to consume and the marginal propensity to save as the slopes of the consumption and savings schedules. The MPC is the slope of the consumption schedule and the MPS is the slope of the saving schedule. The Greek letter delta means “the change in.”

Nonincome Determinants

Amount of disposable income is the main determinant

Other determinants

Wealth

Borrowing

Expectations

Real interest rates

LO2

Nonincome determinants of consumption and saving can cause people to spend or save more or less at various income levels, although the level of income is the basic determinant.

Wealth: An increase in wealth shifts the consumption schedule up and the saving schedule down. In recent years, major fluctuations in stock market values have increased the importance of this wealth effect. A “reverse wealth effect” occurred in 2000 and 2001 when stock prices fell dramatically.

Household debt: Lower debt levels shift the consumption schedule up and the saving schedule down.

Expectations: Changes in expected future prices or wealth can affect consumption spending today.

Real interest rates: Declining interest rates increase the incentive to borrow and consume, and reduce the incentive to save. Because many household expenditures are not interest sensitive – the electric bill, groceries, etc. – the effect of interest rate changes on spending are modest.

Other Important Considerations

Switching to real GDP

Changes along schedules

Simultaneous shifts

Taxation

Stability

LO2

Macroeconomic models focus on real domestic output (real GDP) more than on disposable income. The figure on the next slide reflects this change in the labeling of the horizontal axis.

Changes along schedules: Movement from one point to another on a given schedule is called a change in the amount consumed. A shift in the schedule is called a change in the consumption schedule and is caused by one of the non-income determinants of consumption.

Schedule shifts: Consumption and saving schedules will always shift in opposite directions unless a shift is caused by a tax change.

Taxation: Lower taxes will shift both schedules up since taxation affects both spending and saving and vice versa for higher taxes.

Stability: Economists believe that the consumption and saving schedules are generally stable unless deliberately shifted by government action.

Shifts of C & S Schedules

Real GDP (billions of dollars)

Consumption

(billions of dollars)

Saving

(billions of dollars)

LO2

This figure shows the shifts of the consumption and saving schedules. Normally, if households consume more at each level of real GDP, they are necessarily saving less. Graphically this means that an upward shift of the consumption schedule (C0 to C1) entails a downward shift of the saving schedule (S0 to S1). If households consume less at each level of real GDP, they are saving more. A downward shift of the consumption schedule (C0 to C2) is reflected in an upward shift of the saving schedule (S0 to S2). This pattern breaks down, however, when taxes change; then the consumption and saving schedules move in the same direction—opposite to the direction of the tax change.

Expected rate of return

The real interest rate

Investment demand curve

LO3

Interest-Rate-Investment Relationship

LO3

Investment consists of spending on new plants, capital equipment, machinery, inventories, construction, etc. The investment decision weighs marginal benefits and marginal costs. The expected rate of return is the marginal benefit and the interest rate (the cost of borrowing funds) represents the marginal cost.

The expected rate of return is found by finding the expected economic profit (total revenue minus total cost) as a percentage of the cost of investment. The text’s example gives $100 expected profit on a $1000 investment, for a 10% expected rate of return. Thus, the business would not want to pay more than a 10% interest rate on the investment. Remember that the expected rate of return is not a guaranteed rate of return. Investment carries risk.

The real interest rate, i (nominal rate corrected for expected inflation), determines the cost of investment.

The interest rate represents either the cost of borrowed funds or the opportunity cost of investing your own funds, which is income forgone. If the real interest rate exceeds the expected rate of return, the investment should not be made.

The investment demand schedule, or curve, shows an inverse relationship between the interest rate and the amount of investment. As long as the expected return exceeds the interest rate, the investment is expected to be profitable.

Investment Demand Curve

Investment

demand

curve

LO3

(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

This figure, which can be found in the Key Graph section, shows the investment demand curve. The investment demand curve is constructed by arraying all potential investment projects in descending order of their expected rates of return. The curve slopes downward, reflecting an inverse relationship between the real interest rate (the financial “price” of each dollar of investing) and the quantity of investment demanded.

Shifts of Investment Demand

Acquisition, maintenance, and operating costs

Business taxes

Technological change

Stock of capital goods on hand

Planned inventory changes

Expectations

LO4

Shifts in investment demand (see the next slide for the figure that represents the graph) occur when any determinant apart from the interest rate changes. Greater expected returns create more investment demand, shifting the curve to the right. The reverse causes a leftward shift.

Changes in expected returns result because:

Acquisition, maintenance, and operating costs of capital goods may change. Higher costs lower the expected return.

Business taxes may change. Increased taxes lower the expected return.

Technology may change. Technological change often involves lower costs, which would increase expected returns.

Stock of capital goods on hand will affect new investment. If there is abundant idle capital on hand because of weak demand or recent investment, new investments would be less profitable.

If firms are planning on increasing their inventories, investment demand shifts to the right. If firms are planning to decrease their inventories, investment demand shifts left. These planned inventory changes are based on expectations of either faster or slower sales. If the firm expects faster sales in the future, they will add to inventory. If the firm expects slower sales in the future, they will decrease inventories.

Expectations about future economic and political conditions, both in the aggregate and in certain specific markets, can change the view of expected profits.

Shifts of Investment Demand

Expected rate of return, r, and

real interest rate, i (percents)

Investment (billions of dollars)

ID0

ID1

ID2

Increase

in investment

demand

Decrease in

investment

demand

LO4

This figure shows the shifts of the investment demand curve. Increases in investment demand are shown as rightward shifts of the investment demand curve; decreases in investment demand are shown as leftward shifts of the investment demand curve.

Global Perspective

LO4

This Global Perspective shows gross investment expenditures as a percentage of GDP for selected nations for 2011. As a percentage of GDP, investment varies widely by nation. These differences, of course, can change from year to year.

Instability of Investment

Variability of expectations

Durability

Irregularity of innovation

Variability of profits

LO4

Investment is a very unstable type of spending. Ig is more volatile than GDP. Expectations of future business conditions are easily and quickly changed. Capital goods are durable, so spending can be postponed or not. Firms can choose to replace or fix older equipment and buildings. This is unpredictable. Innovation occurs irregularly; new products stimulate investment and create waves of investment spending that in time recede. Profits affect both the incentive and ability to invest and profits vary considerably from year-to-year, contributing to the instability of investment spending.

Instability of Investment

LO4

This figure shows the volatility of investment for the period 1973–2012. Annual percentage changes in investment spending are often several times greater than the percentage changes in GDP. (Data is represented in real terms. Investment is gross private domestic investment).

The Multiplier Effect

A change in spending changes real GDP more than the initial change in spending

Change in GDP = multiplier x initial change in spending

LO5

Multiplier =

change in real GDP

initial change in spending

Changes in spending ripple through the economy to generate even larger changes in real GDP. This is called the multiplier effect.

Multiplier = change in real GDP / initial change in spending. Alternatively, it can be rearranged to read: change in real GDP = initial change in spending x multiplier.

Points to remember about the multiplier:

The initial change in spending is usually associated with investment because it is so volatile, but changes in consumption (unrelated to income), net exports, and government purchases also are subject to the multiplier effect.

The initial change refers to an up-shift or down-shift in the aggregate expenditures schedule due to a change in one of its components, like investment.

The multiplier works in both directions (up or down).

It occurs because of the interconnectedness of the economy.

The Multiplier Effect

$5.00

$3.75

$2.81

$2.11

$1.58

$4.75

Cumulative income,

GDP (billions of dollars)

20.00

15.25

13.67

11.56

8.75

5.00

All others

LO5

(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

This figure illustrates the multiplier process with an MPC of .75. An initial change in investment spending of $5 billion creates an equal $5 billion of new income in round 1. Households spend $3.75 billion of this new income, creating $3.75 of added income in round 2. Of this $3.75 of new income, households spend $2.81 billion, and income rises by that amount in round 3. Such income increments over the entire process get successively smaller but eventually produce a total change of income and GDP of $20 billion. The multiplier therefore is 4.

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

LO5

Multiplier =

1- MPC

Multiplier =

MPS

The significance of the multiplier is that a small change in investment plans or consumption-saving plans can trigger a much larger change in the equilibrium level of GDP. The magnitude of the change in GDP is dependent on the size of the MPC and MPS.

Multiplier and Marginal Propensities

.67

.75

MPC

Multiplier

LO5

This figure illustrates the relationship between the MPC and the multiplier. The larger the MPC (the smaller the MPS), the greater the size of the multiplier.

The Actual Multiplier Effect?

Actual multiplier is lower than the model assumes

Consumers buy imported products

Households pay income taxes

Inflation

Multiplier may be 0

LO5

The actual multiplier in the U.S. (estimated to be between 2.5 and 0) is smaller than the model in this chapter because, in the U.S. economy, there are other leakages from the spending and income cycle besides just saving. Imports and taxes reduce the flow of money back into spending on domestically produced output, reducing the multiplier effect. Also, increases in spending can drive up prices (inflation) and at higher prices, any given amount of spending will buy less real output.

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

The central idea illustrated in this example is of the multiplier effect that exists in a market economic system. One independently determined change in spending has an effect on another’s income, which then sets in motion a chain of events whereby spending changes directly with the income changes. A decline in spending begins a chain of declines, or, in other words, the initial decrease in spending is multiplied in terms of the final effect of this single decision. This occurs because of the observation that any change in income causes a change in spending that is directly proportional to it. The multiplier effect helps us understand why there is a business cycle as opposed to a stable level of output growth from year to year. In the Buchwald piece, a “downturn” for one person became a downturn for everyone in that fictional economy. Likewise, if the story had begun with a burst of optimism and an increase in spending, it might have rippled through to expand everyone’s fortunes.

The multiplier intensifies the effect of a spending change, whether it is an increase or decrease.

The multiplier is based on two facts:

1. The economy has continuous flows of expenditures and income—a ripple effect—in which income received by one comes from money spent by another, and so forth.

2. Any change in income will cause both consumption and saving to vary in the same direction as the initial change in income.