1. Copyright 2008 The McGraw-Hill Companies 8-1 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show 8 Basic Macroeconomic Relationships

2. Copyright 2008 The McGraw-Hill Companies 8-2 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show 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

3. Copyright 2008 The McGraw-Hill Companies 8-3 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show Basic Relationships Most important determinant of consumption and saving is disposable income Disposable Income= Consumption + Savings 45° Line C = DI on the Line S = DI(the 45 line) - C

4. Copyright 2008 The McGraw-Hill Companies 8-4 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show Income and Consumption Consumption (billions of dollars) Disposable Income (billions of dollars) Consumption and Disposable Income, 1983-2005 45° Reference Line C=DI 83 86 85 84 88 89 91 90 87 92 93 94 95 01 97 96 99 98 00 02 05 03 04 Consumption In 1992 Saving In 1992 45° C

5. Copyright 2008 The McGraw-Hill Companies 8-5 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show The Consumption Schedule Direct consumption-disposable income relationship –In the Aggregate Households increase their spending as their disposable income rises Spend a larger proportion of a small disposable income than large disposable income The Saving Schedule –The smaller the DI the smaller savings, and in reverse –Dissaving-consuming in excess of DI

6. Copyright 2008 The McGraw-Hill Companies 8-6 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show Consumption and Saving Break-Even Income -where households plans to spend their entire income Average Propensity to Consume (APC) –Proportion or fraction of total income consumed Average Propensity to Save (APS)- Proportion or fraction of total income saved O 8.1 APS = Saving Income APC = Consumption Income

7. Copyright 2008 The McGraw-Hill Companies 8-7 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show Consumption and Saving Marginal Propensity to Consume (MPC) Proportion of change in income spent Marginal Propensity to Save (MPS) Proportion of change in income saved MPC + MPS = 1 MPC = Change in Consumption Change in Income MPS = Change in Saving Change in Income

8. Copyright 2008 The McGraw-Hill Companies 8-8 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show 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 $375 390 405 420 435 450 465 480 495 510 $-5 0 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

9. Copyright 2008 The McGraw-Hill Companies 8-9 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show 500 475 450 425 400 375 45° Consumption and Saving 50 25 0 370390 410 430 450 470 490 510 530 550 Consumption and Saving Schedules 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)

10. Copyright 2008 The McGraw-Hill Companies 8-10 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show GLOBAL PERSPECTIVE Consumption and Saving Source: Statistical Abstract of the United States, 2006 Average Propensities to Consume Select Nations GDPs United States Canada United Kingdom Japan Germany Netherlands Italy France.80.85.90.95 1.00.963.958.953.942.896.893.840.833 Average Propensities to Consume

11. Copyright 2008 The McGraw-Hill Companies 8-11 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show Consumption and Saving Nonincome Determinants of Consumption and Saving Income is the main determinant for shifts Change in autonomous consumption –Wealth Effect The value of existing wealth they have already accumulated (real assets and financial assets) –Expectations Changes in future prices or income effect spending –Real Interest Rates Low interest rates induce purchasing on credit –Household Debt When consumers increase their H/D they increase consumption at each level of DI

12. Copyright 2008 The McGraw-Hill Companies 8-12 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show Other Important Considerations Changes Along Schedules –Changes along the C line is change in the amount consumed and solely caused by change in income Switch to Real GDP –Economists relate changes in DI to changes in RGDP Schedule Shifts –If households decide to consume more or less they do at each level of RGDP Stability –C & S schedules are typically stable unless major increases or decreases in tax Taxation –Change in tax shifts C and S in the same direction

13. Copyright 2008 The McGraw-Hill Companies 8-13 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show 45° Consumption and Saving Consumption and Saving Schedules C0C0 S0S0 Disposable Income (billions of dollars) Consumption (billions of dollars) Saving (billions of dollars) C2C2 C1C1 S1S1 S2S2

14. Copyright 2008 The McGraw-Hill Companies 8-14 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show Interest Rate and Investment Expected Rate of Return (r) –I is guided by profit motive The Real Interest Rate (i) –i = N – inflation Meaning of r = i –If nominal is higher than i the investment may not be profitable depending on the expected rate of return

15. Copyright 2008 The McGraw-Hill Companies 8-15 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show Interest Rate and Investment 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% $ 0 5 10 15 20 25 30 35 40 r and i (percent) 16 14 12 10 8 6 4 2 0 5 10 15 20 25 30 35 40 Investment (billions of dollars) The Investment Demand Curve ID

16. Copyright 2008 The McGraw-Hill Companies 8-16 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show Interest Rate and Investment Shifts of the Investment Demand Curve other than interest rates –Acquisition, Maintenance, and Operating Costs Changes in costs (or operating/maintence) of capital goods of impacting rate of return –Business Taxes Impacts profitability –Technological Change Advancements that improve production processes –Stock of Capital Goods on Hand –Expectations Of future sales, operating costs and profitability of product capital helps produce

17. Copyright 2008 The McGraw-Hill Companies 8-17 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show Interest Rate and Investment r and i (percent) 0 Investment (billions of dollars) Shifts in the Investment Demand Curve ID 0 ID 1 ID 2 Increase in Investment Demand Decrease in Investment Demand

18. Copyright 2008 The McGraw-Hill Companies 8-18 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show Interest Rate and Investment Instability of Investment –Durability of Capital Goods Perceived discretionary and can be postponed –Irregularity of Innovation Rail, electricity, fiber optics, computers –Variability of Profits Expanding profits increase incentive to invest –Variability of Expectations Firms ability to project future success based on wide variables (legislation, exchange rates, international peace)

19. Copyright 2008 The McGraw-Hill Companies 8-19 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show GLOBAL PERSPECTIVE Interest Rate and Investment Source: World Bank Gross Investment Expenditures as a Percent of GDP, Select Nations South Korea Japan Mexico Canada France United States Germany United Kingdom Sweden 0 10 20 30 Percent of GDP, 2004

20. Copyright 2008 The McGraw-Hill Companies 8-20 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show Interest Rate and Investment 1971 1975 1979 1983 1987 1991 1995 1999 2003 GDP Gross Investment The Volatility of Investment Percentage Change Year

21. Copyright 2008 The McGraw-Hill Companies 8-21 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show The Multiplier Effect Multiplier = Change in Real GDP Initial Change in Spending The Multiplier and the Marginal Propensities Multiplier = 1 1 - MPC Multiplier = 1 MPS -or- One person’s spending becomes another’s income….. W 8.2

22. Copyright 2008 The McGraw-Hill Companies 8-22 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show The Multiplier Effect (1) Change in Income (2) Change in Consumption (MPC =.75) (3) Change in Saving (MPC =.25) 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 Tabular and Graphical Views Rounds of Spending 12345All $20.00 15.25 13.67 11.56 8.75 5.00 $5.00 $3.75 $2.81 $2.11 $1.58 $4.75 ΔI= $5 billion

23. Copyright 2008 The McGraw-Hill Companies 8-23 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show The Multiplier Effect The MPC and the Multiplier 10 5 4 3 2.5.67.75.8.9 MPCMultiplier

24. Copyright 2008 The McGraw-Hill Companies 8-24 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show Squaring the Economic Circle Humorist Art Buchwald and the Multiplier 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 Last Word

25. Copyright 2008 The McGraw-Hill Companies 8-25 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show Key Terms 45° (degree) line45° (degree) line consumption scheduleconsumption schedule saving schedule break-even incomebreak-even income average propensity to consume (APC)average propensity to consume (APC) average propensity to save (APS)average propensity to save (APS) marginal propensity to consume (MPC)marginal propensity to consume (MPC) marginal propensity to save (MPS)marginal propensity to save (MPS) wealth effect expected rate of returnexpected rate of return investment demand curveinvestment demand curve multiplier

26. Copyright 2008 The McGraw-Hill Companies 8-26 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show Next Chapter Preview… The Aggregate Expenditures Model