Mehdi Arzandeh, University of Manitoba PowerPoint Presentation by

10-2 © 2016 McGraw ‐ Hill Education Limited LEARNING OBJECTIVES LO10.1Describe how changes in income affect consumption (and saving). LO10.2List and explain factors other than income that can affect consumption. LO10.3Explain how changes in real interest rates affect investment. LO10.4Identify and explain factors other than the real interest rate that can affect investment. LO10.5Illustrate how changes in investment (or one of the components of total spending) increase or decrease real GDP by a multiple amount. 10 Basic Macroeconomic Relationships

Consumption and saving Primarily determined by Disposable Income (DI) Direct relationship Consumption schedule (C) Planned household spending (in our model) Saving schedule (S) DI minus C Dissaving can occur LO1 © 2016 McGraw ‐ Hill Education Limited 10.1 The Income-Consumption and Income-Saving Relationship 10-3

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 10-1 Consumption and Disposable Income, The line C, which generalizes the relationship between consumption and disposable income, indicates a direct relationship and shows that households consume most of their income.

© 2016 McGraw ‐ Hill Education Limited LO TABLE 10-1 Consumption and Saving Schedules and Propensities to Consume and Save (billions of dollars) (1) Level of Output and Income GDP=DI (2) Consumption (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),  (2)/  (1)* (7) Marginal Propensity to Save (MPS),  (3)/  (1)* (1) $370$375$ (2) (3) (4) (5) (6) (7) (8) (9) (10) *The Greek letter , delta, means “the change in”.

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 10-2 KEY GRAPH - Consumption and Saving Schedule C S Consumption schedule Saving schedule Saving $5 billion Dissaving $5 billion Dissaving $5 billion Saving $5 billion Consumption (billions of dollars) Saving (billions of dollars) Disposable income (billions of dollars)

Average and Marginal Propensities LO1 © 2016 McGraw ‐ Hill Education Limited 10.1 The Income-Consumption and Income-Saving Relationship 10-7 APC= consumption income APS= saving income MPC= change in consumption change in income MPS= change in saving change in income APC + APS = 1 MPC + MPS = 1 Table 10.1

10.1 GLOBAL PERSPECTIVE Average Propensities to Consume, Selected Nations © 2016 McGraw ‐ Hill Education Limited LO1 10-8

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 10-3 The Marginal Propensity to Consume and the Marginal Propensity to Save Disposable income Consumption Saving S C MPC = MPS = =.75  C ($15)  DI ($20)  S ($5) 5 20 =.25

WEALTH BORROWING EXPECTATIONS REAL INTEREST RATES LO2 © 2016 McGraw ‐ Hill Education Limited 10.2 Non-Income Determinants of Consumption and Saving 10-10

Other Important Considerations Switching to Real GDP Changes Along Schedules Simultaneous Shifts Taxation Stability LO2 © 2016 McGraw ‐ Hill Education Limited 10.2 Non-Income Determinants of Consumption and Saving 10-11

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 10-4 KEY GRAPH – Shifts in the Consumption and Saving Schedules C0C0 S0S0 Real GDP (billions of dollars) Consumption (billions of dollars) Saving (billions of dollars) C2C2 C1C1 S1S1 S2S

Expected Rate of Return, r The Real Interest Rate i = nominal rate - rate of inflation crucial in making investment decisions Investment Demand Curve LO3 © 2016 McGraw ‐ Hill Education Limited 10.3 The Interest Rate-Investment Relationship 10-13

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 10-5 KEY GRAPH – The Investment Demand Curve ID (r) and (i) Investment (billions per year) 16%$ Investment demand curve

Acquisition, Maintenance & Operating Costs Business Taxes Technological Change Stock of Capital Goods on Hand Planned Inventory Expectations LO4 © 2016 McGraw ‐ Hill Education Limited 10.4 Shifts in the Investment Demand Curve 10-15

Fluctuations of Investment Variability of Expectations Durability Irregularity of Innovation Variability of Profits LO4 © 2016 McGraw ‐ Hill Education Limited 10.4 Shifts in the Investment Demand Curve 10-16

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 10-6 Shifts in the Investment Demand Curve Expected rate of return, r, and real interest rate, i (percents) 0 Investment (billions of dollars) ID 0 ID 1 ID 2 Increase in investment demand Decrease in investment demand

10.2 GLOBAL PERSPECTIVE Gross Investment Expenditures as a Percentage of GDP, Selected Nations © 2016 McGraw ‐ Hill Education Limited LO

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 10-7 The Volatility of Investment,

A change in spending changes real GDP more than the initial change in spending LO5 © 2016 McGraw ‐ Hill Education Limited 10.5 The Multiplier Effect Multiplier = change in real GDP initial change in spending Change in GDP = multiplier x initial change in spending

The “Initial Change in Spending” Associated with investment spending because of investment’s volatility Associated with investment spending results from either a change in the real interest rate or a shift of the ID curve May create a multiple increase in GDP and a decrease in spending may be multiplied into a large decrease in GDP Simple multiplier, closed economy multiplier LO5 © 2016 McGraw ‐ Hill Education Limited 10.5 The Multiplier Effect 10-21

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 10-8 The Multiplier Process (MPC = 0.75) $2.11 $2.81 (1) Change in Income (2) Change in Consumption (MPC =.75) (3) Change in Saving (MPS =.25) Increase in investment of $5.00$5.00$3.75$1.25 Second round Third round Fourth round Fifth round All other rounds Total $20.00$15.00$5.00 $3.75 $1.58 $4.75 Cumulative income, GDP (billions of dollars) All others 1

The Multiplier and the Marginal Propensities Multiplier and MPC directly related Large MPC results in larger increases in spending Multiplier and MPS inversely related Large MPS results in smaller increases in spending LO5 © 2016 McGraw ‐ Hill Education Limited 10.5 The Multiplier Effect Multiplier = 1 1- MPC Multiplier = 1 MPS

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 10-9 The MPC and the Multiplier MPCMultiplier

How Large is the Actual Multiplier Effect? Actual multiplier is lower than the model assumes Consumers buy imported products Households pay income taxes Inflation Multiplier may be close to zero LO5 © 2016 McGraw ‐ Hill Education Limited 10.5 The Multiplier Effect 10-25

The LAST WORD Squaring the Economic Circle © 2016 McGraw ‐ Hill Education Limited Humorous small town example of the multiplier One person in town decides not to buy a product Creates a ripple effect of people not spending, following the first decision Ultimately the entire town experiences an economic downturn

LO10.1 Describe how changes in income affect consumption (and saving). LO10.2 List and explain factors other than income that can affect consumption. LO10.3 Explain how changes in real interest rates affect investment. LO10.4 Identify and explain factors other than the real interest rate that can affect investment. LO10.5 Illustrate how changes in investment (or one of the components of total spending) increase or decrease real GDP by a multiple amount. Chapter Summary © 2016 McGraw ‐ Hill Education Limited 10-27