Basic Macroeconomic Relationships Chapter 27 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

27-2 Chapter Objectives Effect of changes in income on consumption (and saving) Other factors that affect consumption Effect of changes in real interest rates on investment Other factors that affect investment Changes in investment have a multiplier effect on real GDP

27-3 Basic Relationships What are the two things we can do with our income? –Consume (spend) or Save Disposable income (DI) –After taxes 45°line for reference –C = DI on the Line –*****turn to pg. 542 S = DI - C

27-4 Income and Consumption Consumption (billions of dollars) Disposable Income (billions of dollars) 45° Reference Line C=DI Consumption In 1992 Saving In ° C Source: Bureau of Economic Analysis

27-5 Consumption and Saving The consumption schedule The saving schedule Break-even income Average propensity to consume (APC) Average propensity to save (APS) APS = Saving Income APC = Consumption Income

Fallacy of Composition The false assumption that what is true for a part will also be true for the whole. –Your experience is YOUR experience… –…Here, we are measuring the aggregate. BE CAREFUL NOT TO GENERALIZE BASED ON YOUR OWN EXPERIENCE!! 27-6

27-7 Consumption and Saving Marginal propensity to consume (MPC) Marginal propensity to save (MPS) MPC = Change in Consumption Change in Income MPS = Change in Saving Change in Income

27-8 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) Average Propensity to Save (APS) (3)/(1) (6) Marginal Propensity to Consume (MPC) Δ(2)/Δ(1) (7) Marginal Propensity to Save (MPS) Δ(3)/Δ(1) (1)$370 (2) 390 (3) 410 (4) 430 (5) 450 (6) 470 (7) 490 (8) 510 (9) 530 (10) 550 $ $ MPC + MPS = 1 MPC and MPS measure slopes

° Consumption and Saving C S Consumption Schedule Saving Schedule Saving $5 Billion Dissaving $5 Billion Dissaving $5 Billion Saving $5 Billion Disposable Income (billions of dollars) Consumption (billions of dollars) Saving (billions of dollars)

27-10 Average Propensity to Consume Source: Statistical Abstract of the United States, 2006 Selected Nations, with respect to GDP, 2006 United States Canada United Kingdom Japan Germany Netherlands Italy France

27-11 What do you notice about the early 2000’s? Consumption (billions of dollars) Disposable Income (billions of dollars) 45° Reference Line C=DI Consumption In 1992 Saving In ° C Source: Bureau of Economic Analysis

27-12 Non-income determinants of consumption and saving Wealth –When wealth suddenly increases, people consume more Borrowing –Easy credit increases consumption, sometimes above disposable income…but debt needs repaid in the future Expectations Real interest rates

27-13 Consumption and Saving Other important considerations –Switch to real GDP –Changes along schedules –Schedule shifts –Stability –Taxation

° Consumption and Saving C0C0 S0S0 Disposable Income (billions of dollars) Consumption (billions of dollars) Saving (billions of dollars) C2C2 C1C1 S1S1 S2S2

27-15 Interest Rate and Investment Expected rate of return (r) The real interest rate (i) –Nominal rate less rate of inflation Meaning of r = i –Firms will invest as long as r ≥ i Investment demand curve

27-16 Investment Demand Curve Expected Rate of Return (r) Cumulative Amount of Investment Having This Rate of Return or Higher (I) 16% 14% 12% 10% 8% 6% 4% 2% 0% $ r and i (percent) Investment (billions of dollars) ID

27-17 Investment Demand Curve Shifts of the curve –Acquisition, maintenance, and operating costs –Business taxes –Technological change –Stock of capital goods on hand –Planned inventory changes –Expectations

27-18 r and i (percent) 0 Investment (billions of dollars) ID 0 ID 1 ID 2 Increase in Investment Demand Decrease in Investment Demand Investment Demand Curve

27-19 Investment Demand Instability of investment –Durability –Irregularity of innovation –Variability of profits –Variability of expectations

27-20 Gross Investment Expenditure Source: International Monetary Fund P ercent of GDP, Selected Nations, 2006 South Korea Japan Canada Mexico France United States Sweden Germany United Kingdom

Volatility of Investment Source: Bureau of Economic Analysis 27-21

27-22 The Multiplier Effect Multiplier = Change in Real GDP Initial Change in Spending More spending results in higher GDP Initial change in spending changes GDP by a multiple amount Change in GDP = Multiplier x Initial Change in Spending

27-23 The Multiplier Effect Causes of the initial change in spending –Most prevalent - Changes in investment Become increases in wage, rent, interest, profit –Other changes – C, G, X Rationale –Dollars spent are received as income –Income received is spent (MPC) –Initial changes in spending cause a spending chain

27-24 (1) Change in Income (2) Change in Consumption (MPC =.75) (3) Change in Saving (MPS =.25) Increase in Investment of $5 Second Round Third Round Fourth Round Fifth Round All other rounds Total $ $ $ $ $ $ 5.00 Rounds of Spending 12345All $ $5.00 $3.75 $2.81 $2.11 $1.58 $4.75 ΔI= $5 billion The Multiplier Effect

27-25 The Multiplier Effect Multiplier = MPC Multiplier = 1 MPS -or-

27-26 The Multiplier and the MPC MPCMultiplier

27-27 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

27-28 Key Terms 45°(degree) line consumption schedule saving schedule break-even income average propensity to consume (APC) average propensity to save (APS) marginal propensity to consume (MPC) marginal propensity to save (MPS) wealth effect expected rate of return investment demand curve multiplier

27-29 Next Chapter Preview… The Aggregate Expenditures Model