8 Basic Macroeconomic Relationships

Chapter Objectives How Changes in Income Affect Consumption (and Saving) About Factors Other Than Income That Can Affect Consumption How Changes in Real Interest Rates Affect Investment About Factors Other Than the Real Interest Rate That Can Affect Investment Why Changes in Investment Increase or Decrease Real GDP by a Multiple Amount

Income-Consumption and Income-Saving Relationships When we examine relationship between income and consumption we are also in effect looking at income-saving relationship S = DI - C

Income and Consumption Consumption and Disposable Income, 1983-2005 83 86 85 84 88 89 91 90 87 92 93 94 95 01 97 96 99 98 00 02 05 03 04 45° Reference Line C=DI C Saving In 1992 Consumption (billions of dollars) Consumption In 1992 45° Disposable Income (billions of dollars)

Direct relationship between saving and DI Smaller proportion of DI spend on consumption as income increases-Proportion of saving is increasing Dissaving occurs only at very low levels of income

Consumption and Saving (1) Level of Output And Income (GDP=DI) (2) Consump- tion (C) (3) Saving (S) (1-2) (4) Average Propensity to Consume (APC) (2)/(1) (5) to Save (APS) (3)/(1) (6) Marginal (MPC) Δ(2)/Δ(1) (7) (MPS) Δ(3)/Δ(1) $370 390 410 430 450 470 490 510 530 550 $375 390 405 420 435 450 465 480 495 510 $-5 5 10 15 20 25 30 35 40 1.01 1.00 .99 .98 .97 .96 .95 .94 .93 -.01 .00 .01 .02 .03 .04 .05 .06 .07 .75 .25

Consumption and Saving Consumption and Saving Schedules 500 475 450 425 400 375 45° C Saving $5 Billion Consumption Schedule Consumption (billions of dollars) Dissaving $5 Billion 390 410 430 450 470 490 510 530 550 Disposable Income (billions of dollars) 50 25 390 410 430 450 470 490 510 530 550 Dissaving $5 Billion Saving Schedule (billions of dollars) Saving S Saving $5 Billion

APC and APS Average Propensity to Consume: Fraction of income consumed Average Propensity to Save : Fraction of income saved APS + APC = 1 APC = Consumption Income APS = Saving Income

MPC and MPS Marginal Propensity to Consume: Proportion of any change in income consumed Marginal Propensity to Save: Fraction of any change in income that is saved MPC + MPS = 1 MPC = Change in Consumption Change in Income MPS = Change in Saving Change in Income

Consumption and Saving (1) Level of Output And Income (GDP=DI) (2) Consump- tion (C) (3) Saving (S) (1-2) (4) Average Propensity to Consume (APC) (2)/(1) (5) to Save (APS) (3)/(1) (6) Marginal (MPC) Δ(2)/Δ(1) (7) (MPS) Δ(3)/Δ(1) $370 390 410 430 450 470 490 510 530 550 $375 390 405 420 435 450 465 480 495 510 $-5 5 10 15 20 25 30 35 40 1.01 1.00 .99 .98 .97 .96 .95 .94 .93 -.01 .00 .01 .02 .03 .04 .05 .06 .07 .75 .25

MPC and MPS as slopes MPC is the slope of consumption schedule MPS is the slope of saving schedule Diagram (example)

Nonincome Determinants of Consumption and Saving Wealth : Real and financial assets that households own -Saving is in order to accumulate wealth -If value of wealth goes up households save less and consume more -Wealth effect : Consumption schedule shifts up, Saving Schedule shifts down 2) Expectations: -If future prices are expected to rise, spend more -If recession expected in future

Nonincome Determinants of Consumption and Saving 3) Real Interest Rate : If real interest rate falls, households borrow more, consume more and save less -Less return on savings -Higher interest rates do the opposite -Very modest changes

Nonincome Determinants of Consumption and Saving 4) Household Debt : If household debt as percentage of DI increases, consumption increases

Other important considerations Switch to real GDP: When developing models look at relationship between consumption and real GDP (or real output) -Horizontal axis Changes along schedules: Movement along schedule is change in amount consumed and is due to change in GDP

Schedule shifts: Changes in non-income determinants Have opposite effects on consumption and savings

Consumption and Saving Consumption and Saving Schedules C1 45° C0 C2 Consumption (billions of dollars) Disposable Income (billions of dollars) S2 (billions of dollars) Saving S0 S1

Taxation: Shifts both in same direction -Taxes paid partly at expense of consumption and partly savings Stability: Usually stable except for taxes -Non income determinants usually move in opposite direction and cancel out effects

Interest Rate-Investment Relationship Marginal benefit: Expected Rate of Return Marginal Cost : Interest Rate paid on borrowed funds Expected rate of Return Cost of machine : 1000, Net profit : 1100 Expected rate of return=100/1000 Expected rate of return not guaranteed: risk

Real Interest Rate You borrowed the 1000 at rate of 6 % Expected return was 10% so favourable In general -If expected return> rate of interest-Profitable -If expected return<rate of interest-Unprofitable -So invest till the point both are equal Real interest rate rather than nominal is crucial for investment decision

Real Interest Rate Suppose an investment is expected to yield 10% real rate of return and nominal rate is 15%. Is it profitable if there is no inflation? Is it profitable if there is inflation of 10%

Investment Demand Curve Move from single firms investment decision to total demand for investment goods by business sector Cumulate data

Interest Rate and Investment The Investment Demand Curve Expected Rate of Return (r) Cumulative Amount of Investment Having This Return or Higher (i) r and i (percent) 16 14 12 10 8 6 4 2 5 10 15 20 25 30 35 40 Investment (billions of dollars) 16% 14% 12% 10% 8% 6% 4% 2% 0% $ 0 5 10 15 20 25 30 35 40 ID

Shifts in the Investment Interest Rate and Investment Shifts in the Investment Demand Curve Increase in Investment Demand r and i (percent) Decrease in Investment Demand ID2 ID0 ID1 Investment (billions of dollars)

Shifts of the Investment Demand Curve Rightward shift : Businesses expect greater rates of return Leftward Shift: Lower rate of return SHIFT FACTORS: Acquisition, Maintenance, and Operating Costs: If they rise, expected return falls (higher electricity cost) Business Taxes: Expected returns after taxes

Shifts of the Investment Demand Curve 3)Technological Change: Development of new products and machinery stimulates investments 4)Stock of capital goods on hand: Excessive inventories and capital stock-Lower return on new investment 5)Expectations: If optimistic about business conditions, political climate-Higher return

Interest Rate and Investment The Volatility of Investment Gross Investment Percentage Change GDP 1971 1975 1979 1983 1987 1991 1995 1999 2003 Year

Instability of Investment Durability: Capital goods have indefinite life so there is choice between replacing old machinery or repairing Irregularity of Innovation: Creates a surge and then recedes e.g. computers Variability of Profits : Expanding profits give greater incentive and means to invest Variability of Expectations: Stock market is speculative

The Multiplier Effect Relationship between changes in spending and changes in GDP Multiplier effect : A change in component of total spending leads to larger change in GDP Multiplier : How large will the change in GDP be Change in Real GDP Initial Change in Spending Multiplier =

The Multiplier Effect Usually the change is due to change in investment due to its volatility but changes can also be due to consumption Change in investment usually due to change in interest rate or shift of investment schedule Like increase , decrease can also be multiplied

Rationale Economy supports repetitive and continuous flows of expenditures and income Any change in income will change both savings and consumption Spending chain : Cumulates to multiple changes in GDP, magnified changes in output and income

The Multiplier Effect Tabular and Graphical Views (2) Change in Consumption (MPC = .75) (3) Change in Saving (MPC = .25) (1) Change in Income 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 $20.00 $4.75 15.25 $1.58 13.67 $2.11 11.56 $2.81 8.75 ΔI= $5 billion $3.75 5.00 $5.00 1 2 3 4 5 All Rounds of Spending

The Multiplier and the Marginal Propensities MPC and multiplier are directly related MPS and multiplier are conversely related 1 1 - MPC Multiplier = -or- 1 MPS Multiplier =

A large MPC means rounds of consumption spending diminish slowly and add up to a large change in income A small MPC means rounds diminish quickly leading to a smaller change in income and smaller multiplier

The Multiplier Effect The MPC and the Multiplier MPC Multiplier .9 10 .8 5 .75 4 .67 3 .5 2