Bell Ringer In your opinion how is consuming and saving affected by increases in income? What if you lose your income? What if you already have a lot of wealth? What if your taxes go up? What if you expect prices to go up on needed items—how would you change your habits today?

Basic Macroeconomic Relationships Chapter 27

The Income-Consumption and Income-Saving Relationships When examining the relationship between income and consumption you have to consider savings too Savings (S) = disposable income (DI) not consumed [DI – money left after taxes] S = DI - Consumption (C) ($ spent) If [DI – C] is equaled to zero, it means nothing was saved—also called the break-even income Are you at break-even at the end of month?

The Income-Consumption and Income-Saving Relationships DI – C = S Dashed line represents every instance where C = DI (break-even) Red line represents actual consumption at different levels of income—in other words, from this we can see the more we make the more we spend Loss, or dissavings, occurs here Savings occur here C

The Income-Consumption and Income-Saving Relationships Average Propensity to Consume (APC) is the percentage of total income that is consumed APC = C / Income (I) I make $45,000 per year (income) I spend (consume) $35,000 per year APC = 35000/45000 APC = 0.778

The Income-Consumption and Income-Saving Relationships Average Propensity to Save (APS) is the percentage of total income saved APS = S / I I save $10,000 per year I make $45,000 per year APS = 10000/45000 APS = 0.222 APC + APS = 1 0.778 + 0.222 = 1

The Income-Consumption and Income-Saving Relationships Delta (Δ) represents change Marginal Propensity to Consume (MPC) shows how much additional income is consumed as your income goes up MPC = Δ in consumption Δ change in income

The Income-Consumption and Income-Saving Relationships EX: I1 = 470 C1 = 450 I2 = 490 C2 = 465 Δ I = (490 – 470) = 20 Δ C = (465 – 450) = 15 MPC = 15/20 = .75 Now calculate Marginal Propensity to Save (MPS) S1 = 20 S2 = 25 Δ S = (25 – 20) = 5 MPS = 5/20 = .25 MPC (.75) + MPS (.25) = 1

The Income-Consumption and Income-Saving Relationships Income is not the only factor that goes into how people save and consume Wealth--if you have preexisting assets (house, savings, cars, stocks, etc.) and the value of them goes up, you will consume more and save less Expectations—if higher prices are expected in the future, people will consume more and save less now

The Income-Consumption and Income-Saving Relationships Other factors Real Interest Rates—When interest rates drop, people tend to borrow more, consume more, and save less If interest rates go up? Household Debt—When you first start going into debt consumption goes up, when debt gets too high, consumption has to go down to pay for previous consumption Taxation—If taxes go up, consuming and saving goes down…if taxes go down, consuming and saving go up

The Income-Consumption and Income-Saving Relationships This graph represents a change in the amount consumed This graph represents a SHIFT in consumption Same concept for saving B A C1 C2

Interest-Rate—Investment Relationship Investments are expenditures on things such as: new facilities (buildings), capital equipment, machinery, inventories, etc. When businesses decided to make new investments it’s called the marginal-benefit-marginal-cost decision The marginal-benefit is the expected return on investment The marginal-cost is the interest rate that must be paid to borrow the needed funds A business will always invest in new items if their return on investment exceeds the interest rate

Interest-Rate—Investment Relationship First rule of for-profit business—if you aren’t doing it for money, then why are you doing it? ALL businesses are looking out for the bottom line ($$$) They will buy investments when they believe it will make a profit for the company EX: Cabinetmaking shop wants to buy a new sander that costs $1000. They conclude that after they pay for the cost of the sander, it will have increased their profits by $100 Their expected rate of return (r), = what they expect to earn/what they paid for the investment 100/1000 = 10% Understand expected is just that, it’s not a guarantee!

Interest-Rate—Investment Relationship In order to fully understand the cost of spending money on investments, we have to take interest into account If you borrow the money, there is an interest rate charged If you pull the money from savings, you’re giving up interest that could have been earned Either way, you are losing funds to make new purchases in the form of interest Back to the sander—say your interest rate (i) to borrow was 7% i = 0.07 x 1000 = 70 Your interest rate will cost you $70 for the sander Remember you expect to make $100 which, including interest still has you at positive $30

Interest-Rate—Investment Relationship Anytime your interest rate is lower than your expected return rate, the business should invest If the interest rate is higher than the rate of return, the business should not invest You should continue investing up to the point where r = i Understand that you need to use real interest rates not nominal interest rates

Interest-Rate—Investment Relationship An investment demand curve is just another demand curve You start with an investment demand schedule Real Interest Rate (i) Amount Companies are willing to invest at (i) 16% 14 5 12 10 15 8 20 6 25 4 30 2 35 40

Interest-Rate—Investment Relationship The higher the interest rate, the less willing companies overall are likely to invest in new items 16 14 12 10 8 6 4 2 Real Interest Rate ID 5 10 15 20 25 30 35 40 Investment (billions of dollars)

Interest-Rate—Investment Relationship Just like any other demand curve, the investment demand curve can completely shift places due to certain issues If the initial cost of an item goes up, if it is more expensive to maintain than before, or if it is more expensive to operate, investment will go down Which way will the line shift? If taxes go up? If the economy overproduces? New technology is introduced Future sales are expected to be good?

Interest-Rate—Investment Relationship Investments are the most volatile (unstable) parts of total spending There are several reasons: Durability—goods last longer than projected due to patch-ups, etc. or goods don’t last as long as expected and are replaced sooner than desired Irregularity of Innovation—can’t guarantee someone will invent something like the car, electricity, or fiber optics everyday Profits—can’t guess how many people will buy the product Expectations—businesses make projections, but things change—stock market is best example

Sell more chairs (GDP goes up) The Multiplier Effect The Multiplier shows you how much a change in spending is going to affect the economy The initial change in spending is usually associated with investment The change comes from a change in the real interest rate or a shift of the investment demand curve Multiplier = Change in RGDP Initial change in spending The multiplier shows you how much additional spending will take place in each round of spending Round 1 Purchase a sander Sell more chairs (GDP goes up) Pay employees more Round 2 They spend more money

The Multiplier Effect Imagine the economy sees a $5B increase in investment spending Assume MPC (Marginal Propensity to Consume) for this change is .75 This $5B increase initially raises consumption by $3.75B .75 x 5B = 3.75B That $3.75B flows to other households as income who will increase their consumption by $2.81B .75 x 3.75B = 2.81B This process continues until there is no additional income to spend This process will eventually produce a change in GDP of $20B, therefore the multiplier is 4 (add up change in RGDP) 20B / (initial change in spending) 5B = 4

The Multiplier Effect Alternate ways to find the Multiplier: The MPC and the Multiplier are directly related Large MPC = Large Multiplier Multiplier = 1/1-MPC The Multiplier and the MPS are negatively related Large MPS = Small Multiplier Multiplier = 1/MPS