1. There is a positive or direct relationship between consumption and disposable income (after-tax income) because as disposable income increases so does consumption. Saving is disposable income not spent for consumer goods. Disposable income is the most important determinant of both consumption and saving. The relationship among disposable income, consumption, and saving can be shown by a graph with consumption on the vertical axis and disposable income of the horizontal axis. The 45-degree line on the graph would show where consumption would equal disposable income. If consumption is less than disposable income, the difference is saving.
a. The consumption schedule shows the amounts that households plan to spend for consumer goods at various levels of income, given a price level. Break-even income is where consumption is equal to disposable income.
b. The saving schedule indicates the amounts households plan to save at different income levels, given a price level.
c. The average propensity to consume (APC) and the average propensity to save (APS) and the marginal propensity to consume (MPC) and the marginal propensity to save (MPS) can be computed from the consumption and saving schedules.
(1) The average propensity to consume (APC) and the average propensity to save (APS) are, respectively, the percentage of income spent for consumption and saved, and they sum to 1.
(2) The marginal propensity to consume (MPC) and the marginal propensity to save (MPS) are, respectively, the percentage of additional income spent for consumption and saved, and sum to 1.
(3) The MPC is the slope of the consumption schedule, and the MPS is the slope of the saving schedule when the two schedules are graphed.
d. In addition to income, there are several other important nonincome determinants of consumption and saving. Changes in these nonincome determinants will cause the consumption and saving schedules to change. An increase in spending will shift the consumption schedule upward and a decrease in spending will shift it downward. Similarly, an increase in saving will shift the saving schedule upward and a decrease in saving will shift it downward.
(1) The amount of wealth affect the amount that households spend and save. Wealth is the difference between the values of a household’s assets and its liabilities. If household wealth increases, people will spend more because they think they have more assets from which to support current consumption possibilities (the wealth effect) and they will save less.
(2) The level of household borrowing influences consumption. Increased borrowing will increase current consumption possibilities, which shift the consumption schedule upward. But borrowing reduces wealth by increasing debt, which in turn reduces future consumption possibilities because the borrowed money must be repaid.
(3) expectations about the future affect spending and saving decisions. If prices are expected to rise in the future, people will spend more today and save less.
e. Several other considerations need to be noted:
(1) Macroeconomists are more concerned with the effects of changes in consumption and saving on real GDP, so it replaces disposable income on the horizontal axis of the consumption or saving schedules.
(2) A change in the amount consumer (or save) is a movement along the consumption (or saving) schedule, but a change in consumption (or saving schedule) due to a change in one of the nonincome determinants is a shift in the entire consumption (or saving) schedule.
(3) Changes in wealth, borrowing, expectations, and real interest rates shift consumption and saving schedules in opposite directions. For example, an increase in wealth will increase consumption and will decrease saving as people consume more out of current income. If households borrow they can expand current consumption, but that will decrease current saving. Expectations of rising future prices will increase current consumption and decrease current saving. A fall in real interest rates increases current consumption and provide less incentive for current saving.
(4) Changers in taxes shift the consumption and saving schedules in the same direction. An increase in taxes will reduce both consumption and saving; a decrease in taxes will increase both consumption and saving.
(5) Both consumption and saving schedules tend to be stable over time unless changed by major tax increases or decreases. The stability arises from long-term planning and because some nonincome determinants cause shifts that offset each other.
2. The investment decision is a marginal benefit and marginal cost decision that depends on the expected rate of return from the purchase of additional capital goods and the real rate of interest that must be paid for borrowed funds.
a. The expected rate of return is directly related to the net profits (revenues less operating costs) that are expected to result from an investment. It is the marginal benefit of investment for a business.
b. The real rate of interest is the price paid for the use of money. It is the marginal cost of investment for a business. When the expected real rate of return is greater (less) than the real rate of interest, a business will (will not) invest because the investment will be profitable (unprofitable).
c. For this reason, the lower (higher) the real rate of interest, the greater (smaller) will be the level of investment spending in the economy; the investment demand curve shows this inverse relationship between the real rate of interest and the level of spending for capital goods. The amount of investment by the business sector is determined at the point where the marginal benefit of investment equals the marginal cost.
d. There are at least six noninterest determinants of investment demand, and a change in any of these determinants will shift the investment demand curve.
(1) If the acquisition, maintenance, and operating costs for capital goods change, then this change in costs will change investment demand. Rising costs decrease investment demand and declining costs increase it.
(2) Changes in business taxes are like a change in costs so they have similar effect on investment demand as the previous item.
(3) An increase in technological progress will stimulate investment and increase investment demand.
(4) The stock of existing capital goods will influence investment decisions. If the economy is overstocked, there will be a decrease in investment demand, and if the economy is understocked, there will be an increase in investment demand.
(5) Planned changes in inventories affect investment demand. If there is a planned increase in inventories, then investment demand will increase; a planned decrease in inventories will decrease investment demand.
(6) Expectations of the future are important. If expectations are positive because of more expected sales or profits, there is likely to be an increase in investment demand. Negative expectations will have an opposite effect on investment demand.
e. Unlike consumption and saving, investment is inherently unstable. Four factors explain this instability.
(1) Capital goods are durable, so when they get replaced may depend on the optimism or pessimism of business owners. If owners are more optimistic about the future they will likely spend more to obtain new capital goods.
(2) Innovation is not regular, which means that technological progress is highly variable and contributes to instability in investment spending decisions.
(3) Profit expectations influence the investment spending of businesses, but profits are highly variable.
(4) Other expectations concerning such factors as exchange rates, the state of the economy, and the stock market can create positive or negative expectations that change investment spending
3. There is a direct relationship between a change in spending and a change in real GDP, assuming that prices are sticky. An initial change in spending, however, results in a change in real GDP that is greater than the initial change in spending. This outcome is called the multiplier effect. The multiplier is the ratio of the change in the real GDP to the initial change in spending. The initial change in spending typically comes from investment spending, but changes in consumption, net exports, or government spending can also have multiplier effects.
a. The multiplier effect occurs because a change in the dollars spent by one person alters the income of another person in the same direction, and because any change in the income of one person will change the person’s consumption and saving in the same direction by a fraction of the change in income. For example, assuming a marginal propensity to consumer (MPC) of 0.75, a change in investment spending of $5.00 will cause a change in consumption of $3.75. The change in consumption ($3.75) will become someone else’s income in the second round. The process will continue through successive rounds, but the amount of income in each round will diminish by 25 percent because that is the amount saved from each change in income. After all rounds are completed, the initial change of $5 in investment spending produces a total of $20 change because the multiplier was 4.
b. There is a formula for calculating the multiplier. The multiplier is directly related to the MPC and inversely related to the MPS. The multiplier is equal to [1/(1-MPC)]. It is also equal to (1/MPS). The significance of the multiplier is that relatively small changes in the spending plans of business firms or households bring about large changes in the equilibrium real GDP.
c. The simple multiplier that has been described differs from the actual multiplier for the economy. In the simple case the only factor that reduced income in successive rounds was the fraction that went to savings. For the domestic economy, there are other leakages from consumption besides saving, such as spending on imports, payment of taxes, or inflation. These factors reduce the value of the multiplier. For the U.S. economy the multiplier is estimated to be about 2.
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