CHAPTER 8 Basic Macroeconomic Relationships 1 Slides prepared by Bruno Fullone, George Brown College © 2010 McGraw-Hill Ryerson Limited PART 3: MACROECONOMIC MODELS AND FISCAL POLICY

Chapter 82 Learning Objective 8.1: About the factors that determine consumption expenditure and saving Learning Objective 8.2 How changes in real interest rates affect investment Learning Objective 8.3 About factors other than the real interest rate that can affect investment Learning Objective 8.4 Why changes in investment increase or decrease real GDP by a multiple amount In This Chapter You Will Learn:

LO8.13 The Consumption Schedule o Reflects the direct consumption-disposable income relationship o higher income  higher consumption The Saving Schedule o Saving = Disposable Income – Consumption o higher income  higher saving Illustrated… 8.1 The Income-Consumption & Income-Saving Relationships

LO8.14

LO7.15 APC=consumptionincome APS=savingincome MPC= change in consumption change in income MPS= change in saving change in income APC + APS = 1 MPC + MPS = 1 Average and marginal propensities

LO8.16 (1) GDP (=DI) (2) C (3) S (1)-(2) (4) APC (2)/(1) (5) APS (3)/(1) (6) MPC  (2)/  (1) (7) MPS  (3)/  (1) = /370 = /370 = /20= /20 = Table 8-1

7LO8.1 Graphically presented…

8.1 Global Perspective

9LO8.1 Graphically presented…

10LO8.1 Wealth – dollar amount of all household debt minus its liabilities Wealth effect – downward shift of saving schedule and upward shift of consumption schedule due to higher asset wealth o Borrowing – when household borrow, it will increase consumption o Expectations – expectations of future prices and income affect current spending and saving o Real interest rates – when real interest rates (those adjusted for inflation) fall households tend to borrow more, consume more, and save less (and vice versa) Non-Income Determinants of Consumption and Saving

11LO8.1 Switch to Real GDP – generally the macro models focus on real GDP Changes along Schedules – movements along curve caused by changes in DI or real GDP Taxation – shift consumption and saving schedule in same direction; thus increase in taxes will reduce both C and S (taxes paid at expense of consumption and saving) Schedule Shifts – changes in wealth, borrowing, expectations, and real interest rates will shift entire consumption schedule as well as saving schedule (in opposite directions) Stability – both C and S are relatively stable More on Consumption and Saving Schedules

LO o C S Schedule Shifts 390 Consumption Saving Disposable Income Figure 8-4

LO o C C1C1 An increase in consumption Consumption Saving Disposable Income Schedule Shifts Figure 8-4 S

LO o C S C1C1 An increase in consumption... S1S1 Causes a decrease decrease in saving Consumption Saving Disposable Income Schedule Shifts Figure 8-4

LO o C C2C2 A decrease in consumption... Consumption Saving Disposable Income Schedule Shifts Figure 8-4 S

LO o C S C2C2 A decrease in consumption... S2S2 Causes an increase in saving Consumption Saving Disposable Income Schedule Shifts Figure 8-4 schedules are relatively stable

17LO8.2 Expected Rate of Return, r The Real Interest Rate o i = nominal rate – rate of inflation o crucial in making investment decisions Investment Demand Curve - illustrated 8.2 The Interest Rate-Investment

LO8.218 Investment (billions of dollars) Expected rate of net profit, r, and interest rate, i (percent) Investment demand curve ID Figure 8-5

LO8.319 Acquisition, Maintenance & Operating Costs – i.e. electricity costs go down, investment demand curve shifts right Business Taxes – after tax returns crucial to investment decisions, business taxes go up, ID shifts left Technological Change – stimulate investments Stock of Capital Goods on Hand Planned Inventory – investment includes inventories; inv increase/decrease depends on business conditions; investments include only planned inv changes; unplanned inv changes only occur when the unexpected happens Expectations 8.3 Shifts in the Invest Demand Curve

LO8.320 Investment (billions of dollars) Expected rate of net profit, r, and interest rate, i (percent) ID 1 Figure 8-6 Shifts in ID Curve ID 0 ID 2 Increase in investment demand Decrease in investment demand

LO8.321 Durability Irregularity of Innovation Variability of Profits Variability of Expectations Fluctuations of Investment

LO8.322 Figure 8-7 The Volatility of Investment

LO8.423 Or rearranging the formula … The “Initial Change in Spending” o associated with investment spending because of investment’s volatility o associated with investment spending results from either a change in the real interest rate or a shift of the ID curve o may create a multiple increase in GDP and a decrease in spending may be multiplied into a large decrease in GDP 8.4 The Multiplier Effect

LO8.424 Rationale: spending generates income change in income will cause both consumption & saving to change The Multiplier Effect

LO8.425 (1)  income (2)  C (MPC=.75) (3)  S (MPS=.25) I g increases $5$5.00$3.75$1.25 2nd round 3rd round 4th round 5th round All other rounds Total Table 8-3

LO8.426 (1)  income (2)  C (MPC=.75) (3)  S (MPS=.25) I g increases $5$5.00$3.75$1.25 2nd round3.75 3rd round 4th round 5th round All other rounds Total Table 8-3

LO8.427 (1)  income (2)  C (MPC=.75) (3)  S (MPS=.25) I g increases $5$5.00$3.75$1.25 2nd round rd round 4th round 5th round All other rounds Total Table 8-3

LO8.428 (1)  income (2)  C (MPC=.75) (3)  S (MPS=.25) I g increases $5$5.00$3.75$1.25 2nd round rd round th round th round All other rounds Total$20.00$15.00$5.00 Table 8-3

LO8.429 All other The Multiplier Process (MPC=.75)  I = $5 billion

30LO 8.4 Multiplier = 1 _____ or …. 1 – MPC Multiplier = ___ 1____ MPS The Multiplier and the Marginal

LO8.431 Figure 8-9The MPC & the Multiplier The larger the MPC (& the smaller the MPS), the greater the size of the multiplier

LO8.432 How large is the actual multiplier effect? In reality, consumption of domestic output increases in each round by a lesser amount than implied by MPS alone o imports & taxes actual multiplier: 1  (fraction of change in income that is not spent on domestic output) The Multiplier Effect

The Last Word: 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

Chapter The Income-Consumption and Income- Saving relationships 8.2 The Interest-Rate-Investment Relationship 8.3 Shifts in the Investment Demand 8.4 The Multiplier Effect Chapter 8 Summary