1. Basic Macroeconomic Relationships 27 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Now that we have studied business cycles, unemployment, and inflation we want to eventually build a model to help explain these phenomena. We begin that process in this chapter by examining the relationship between 3 different pairs of economic aggregates which include; Income and consumption and income and saving relationship Interest rate and investment relationship Changes in spending and changes in output relationship

3. Income Consumption and Saving The relationship between income and consumption is one of the best established relationships in macroeconomics. In examining that relationship, we are also exploring the income- saving relationship. Remember that DI = C + S from chapter 24 so rearranging the terms we get S = DI – C. LO1 27-3

4. Many factors determine a nation’s level of consumption and saving, but the most significant is disposable income. Figure 27.1 shows some historical data for the U.S. Each dot represents consumption and DI for 1 year since 1987. The green line (C) that is loosely fitted to these points shows that consumption is directly related to DI and moreover, households spend most of their income.

5. The 45° line is a reference line. Because it bisects the 90° angle formed by the 2 axes of the graph, each point on it is equidistant from both axes. At each point on the 45° line, consumption would equal DI, or C = DI. Therefore, the vertical distance between the 45° line and any point on the horizontal axis measures either consumption or DI.

6. If we let it measure DI, the vertical distance between it and the consumption line labeled C represents the amount of saving (S) in that year. Saving is the amount by which actual consumption in any year falls short of the 45° line, S = DI – C. Ex. 1998 DI = $6498.9 C = $6157.5 S = $341.4

7. Observe that the vertical distance between the 45° line and line C increases as we move rightward along the horizontal axis and decreases as we move leftward. Like consumption, saving varies directly with the level of DI.

8. Income, Consumption, and Saving LO1 27-8

9. Consumption Schedule To understand how the economy would behave under different possible scenarios, we need a schedule showing the various amounts that households would plan to consume at each of the various levels of DI that might prevail during some specific time, so now we look at Table 27.1.

10. We plot the data from col.1 and 2 to get the consumption schedule in figure 27.2. Notice the data verifies the direct relationship between consumption and DI. Households increase their spending as their DI rises and they spend a larger proportion of a small DI than of a large DI.

11. Saving Schedule Because saving equals DI less C, we need only subtract C from DI to find the amount saved at each DI. So col. 1 minus col. 2 equals col. 3. We see that savings is also directly related to DI but that saving is a smaller proportion of a small DI than of a large DI. If households consume a smaller and smaller proportion of DI as DI increases, then they must be saving a larger and larger proportion.

12. Remembering that at each point on the 45° line C = DI, we see that dissaving, consuming in excess of DI will occur at relatively low DI’s. Households can consume more than their current incomes by liquidating some of their wealth or by borrowing.

13. Graphically, dissaving is shown as the vertical distance of the consumption schedule above the 45° line or as the vertical distance of the saving schedule below the horizontal axis. In our example, the break- even income is $390 billion. This is the income level at which households plan to spend their entire DI.

14. Graphically, the consumption schedule cuts the 45° line, and the saving schedule cuts the horizontal axis at the break-even income level. At all levels of DI above $390 households will plan to save part of their DI’s.

15. Consumption and Saving Schedules Consumption and Saving Schedules (in Billions) and Propensities to Consume and Save (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$375$-51.01-.01.75.25 (2) 390 390 01.00.00.75.25 (3) 410 405 5.99.01.75.25 (4) 430 420 10.98.02.75.25 (5) 450 435 15.97.03.75.25 (6) 470 450 20.96.04.75.25 (7) 490 465 25.95.05.75.25 (8) 510 480 30.94.06.75.25 (9) 530 495 35.93.07.75.25 (10) 550 510 40.93.07.75.25 LO1 27-15

16. Consumption and Saving Schedules 500 475 450 425 400 375 45° 50 25 0 370390 410 430 450 470 490 510 530 550 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) LO1 27-16

17. APC & APS Columns 4 to 7 in Table 27.1 show additional characteristics of the consumption and saving schedules. LO1 27-17

18. The fraction or percentage of total income that is consumed is the average propensity to consume (APC). The fraction of total income that is saved is the average propensity to save (APS). APC = consumption ÷ Income APS = saving ÷ Income

19. Look at table 27.1 to see how the APC and APS are calculated for columns 4 and 5. The APC falls as DI increases, while the APS rises as DI goes up. Because DI is either consumed or saved, the fraction of any DI consumed plus the fraction saved must exhaust that income. Mathematically, APC + APS = 1 at any level of DI.

20. MPC & MPS The fact that households consume a certain proportion of a particular total income does not guarantee they will consume the same proportion of any change in incomes they might receive. The proportion, or fraction, of any change in income consumed is called the marginal propensity to consume (MPC). LO1 27-20

21. The word “marginal” means additional, extra, or change in. Similarly, the fraction of any change in income saved is the marginal propensity to save (MPS). MPC = Δ C ÷ Δ DI MPS = Δ S ÷ Δ DI

22. See columns 6 and 7 to see how the MPC and MPS are calculated. Notice the MPC and the MPS are constant and that the MPC + MPS = 1. Figure 27.3 shows the MPC is the numerical value of the slope of the consumption schedule, and the MPS is the numerical value of the slope of the saving schedule. The slope of any line is the ratio of the vertical change to the horizontal change, or rise over run.

23. Marginal Propensities Disposable income Consumption Saving S C MPC = MPS = 15 20 =.75  C ($15)  DI ($20)  S ($5) 5 20 =.25 LO1 27-23

24. Non-income Determinants Certain determinants other than income might prompt households to consume more or less at each level of DI and thereby change the location of the consumption and saving schedules. Here we are releasing our other things equal assumption, or ceteris paribus. LO2 27-24

25. 1.Wealth- A household’s wealth is the dollar amount of all the assets that it owns minus the dollar amounts of its liabilities that it owes. Households build wealth by saving money out of current income. The larger the stock of wealth a household can build up, the larger will be its present and future consumption possibilities.

26. When the value of your home increases or stock market prices rise, increasing your 401K retirement plan, households are now willing to spend more out of their current income. The result is an upward shift in the consumption schedule and a downward shift in the saving schedule. A drop in real estate values or stock prices would have the opposite effect on the consumption and saving schedules. This is referred to as the wealth effect.

27. 2.Borrowing- When a household borrows, it can increase current consumption beyond what would be possible if its spending were limited to its DI. By allowing households to spend more, borrowing shifts the current consumption schedule upward. But note there is no free lunch.

28. While borrowing in the present allows for higher consumption in the present, it necessitates lower consumption in the future when the debts that are incurred due to the borrowing must be repaid. Stated differently, increased borrowing increases debt, which in turn reduces household wealth since wealth = assets – liabilities.

29. 3.Expectations- Household expectations about future prices and income may affect current spending and saving. The expectation of higher prices tomorrow may cause more spending today while prices are still low so the consumption schedule shifts up and the saving schedule shifts down.

30. An expectation of a coming recession, which would lower incomes, might lead households to reduce consumption and save more today. Their increased current saving will help build wealth that will help them ride out the expected bad times ahead.

31. 4.Real Interest Rates- When real interest rates, those adjusted for inflation fall, households tend to borrow more, consume more, and save less. The lower interest rate causes consumers to purchase more cars and other items on credit. The consumption schedule will shift upward and the saving schedule shifts downward. Higher interest rates will do the opposite.

32. Other Important Considerations There are several additional points to make regarding the consumption and saving schedules. Switching to real GDP- When developing macro models, economists change their focus from the relationship between consumption and saving and DI, to the relationship between consumption and saving and real domestic output, or real GDP. This change in reflected figure 27.4 where the horizontal axis now reads real GDP. LO2 27-32

33. Shifts of C & S Schedules 45° C0C0 S0S0 Real GDP (billions of dollars) Consumption (billions of dollars) Saving (billions of dollars) C2C2 C1C1 S1S1 S2S2 0 0 - + LO2 27-33

34. Changes along the Schedule- The movement from one point to another along the consumption schedule is called a change in the amount consumed and is solely caused by a change in real GDP. On the other hand, an upward or downward shift in the entire schedule is caused by changes in any one or more of the non-income determinants of consumption just discussed. The same distinction applies to the saving schedule.

35. Simultaneous shifts- Changes in wealth, expectations, interest rates, and household debt will shift the consumption schedule in one direction and the saving schedule in the opposite direction.

36. Taxation- In contrast, a change in taxes shifts the consumption and saving schedule in the same direction. Higher taxes reduce both consumption and saving, shifting both schedules downward.

37. Stability- The consumption and saving schedules usually are relatively stable unless altered by major tax increases or decreases.

38. Interest-Rate-Investment Recall that investment consists of spending on new plants, capital equipment, machinery and additions to inventory. The marginal benefit from investment is the expected rate of return businesses hope to realize. The marginal cost of the investment is the interest rate that must be paid for borrowing the money. LO3 27-38

39. 1.Expected rate of return- Investment spending is guided by the profit motive. Suppose a business purchases a new sanding machine that costs $1000. The new machine will increase the firm’s output and sales revenue. Let’s say the net expected revenue, after operating costs and taxes are deducted, is $1100.

40. Subtracting the $1000 cost from the net revenue of $1100, we get an expected profit of $100. Dividing the $100 profit by the $1000 cost of the machine, gives us the expected rate of return (r) on the machine which is 10%. Note that this is an expected rate of return, not a guaranteed rate of return.

41. 2.The real interest rate- The interest rate is the financial cost of borrowing the $1000 to purchase the sanding machine. The interest cost of the investment is computed by multiplying the interest rate (i) by the $1000 borrowed to buy the machine. If the interest rate is 7%, then the interest cost is $70. This compares favorably with the net expected return of $100, which produced the 10% expected rate of return.

42. If the investment works out as expected, it will add $30 to the firm’s profit. The firm should invest to the point for which r=I, because then it will have undertaken all investments for which r>i. The real interest rate, rather than the nominal rate, is crucial in making investment decisions.

43. Real interest rate = nominal interest rate – inflation Ex. $1000 sanding machine w/ 10% expected rate of return Nominal interest rate = 15% Inflation rate = 10%

44. Investment Demand Curve We now move from a single firm’s investment decision to total demand for investment goods by the entire business sector. Every firm has estimated the expected rates of return from all the possible projects and has recorded the data. Figure 27.5 shows this information in table form and graphically.

45. We can cumulate these data by asking: How many projects have an expected rate of return of say 16% or more? The answer is zero. Next, how many projects have an expected rate of return of 14% or more? The answer if $5 billion, and so on.

46. By applying our marginal benefit marginal cost rule firm’s should continue to undertake investments until the r = i. we can add the real interest rate to the vertical axis in figure 27.5. As you can see there is an inverse relationship between the real interest rate and the quantity of investment demanded as shown on the horizontal axis. The level of investment then depends on the expected rate of return and the real interest rate.

47. Investment Demand Curve Expected rate of return, r and real interest rate, i (percents) 16 14 12 10 8 6 4 2 0 5 10 15 20 25 30 35 40 Investment (billions of dollars) ID (r) and (i) Investment (billions of dollars) 16%$ 0 14 5 12 10 15 8 20 6 25 4 30 2 35 0 40 Investment demand curve LO3 27-47

48. Shifts of Investment Demand Figure 27.5 shows the relationship between the interest rate and the amount of investment demanded, other things equal. When other things change, the investment demand curve shifts. In general, any factor that leads businesses collectively to expect greater rates of return will increase the investment demand curve. See figure 27.6 for an example. LO4 27-48

49. Shifts of Investment Demand 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 LO4 27-49

50. Shifts in Investment Demand 1.Acquisition, maintenance, and operating costs- The initial costs of capital goods, and the estimated costs of operating and maintaining those goods, affect the expected rate of return. If these costs rise, the expected rate of return will fall and the investment demand curve shifts left. Lower costs will have the opposite effect.

51. 2.Business taxes- Firm’s look at expected rates of return after taxes have been taken out. Lower taxes will increase the investment demand curve, whereas higher taxes will decrease the investment demand curve.

52. 3.Technological change- The development of new products, improvements in existing products, and the creation of new machinery and production processes will stimulate investment. A more efficient machine, for example, will lower production costs and increase the expected rate of return. The investment demand curve will shift to the right.

53. 4.Stock of capital goods on hand- When the economy is overstocked with production facilities and when firms have excessive inventories of finished goods, the expected rate of return on new investment declines. The resulting investment demand curve shifts leftward.

54. 5.Planned inventory changes- Our definition of investment includes changes in inventories of unsold goods. If firms are planning to increase their inventories, the investment demand curve shifts to the right. If firms are planning on decreasing their inventories, the investment demand curve shifts to the left. Firms make planned changes to their inventory levels mostly because they are expecting either faster or slower sales.

55. 6.Expectations- Expected rates of return depends on a firm’s expectations of future sales, future operating costs, and future profitability of the products that the capital helps produce. It essentially boils down to how optimistic or pessimistic businesses are about the future.

56. Instability of Investment In contrast to consumption, investment is unstable; it rises and falls quite often. Investment, in fact, is the most volatile component of total spending. Figure 27.7 shows just how volatile investment in the U.S. has been. Why so volatile? LO4 27-56

57. Instability of Investment Source: Bureau of Economic Analysis, http://www.bea.gov.http://www.bea.gov LO4 27-57

58. Why so Volatile?  Business expectations can change quickly. Changes in exchange rates, trade barriers, legislative actions, stock market prices, government economic policies, the outlook for war or peace, court decisions and future recessions here or abroad may cause substantial shifts in business expectations.

59.  Capital goods are durable and as such have an indefinite lifespan.  Major innovations such as railroads, electricity, airplanes, cars, computers, and the internet have all caused an upsurge in investment spending. But as time passes investment spending begins to recede. Add to this, the fact that investment spending occurs irregularly.

60.  Business profits are highly variable from year to year which only contributes to investments volatility.

61. The Multiplier Effect A final basic relationship that requires discussion is the relationship between changes in spending and changes in real GDP. More spending results in a higher GDP, and less spending results in a lower GDP. However, a change in a component of total spending leads to a larger change in GDP. LO5 27-61

62. The multiplier will determine how much larger that change will be. Multiplier = change in real GDP ÷ initial change in spending Change in GDP = multiplier × initial change in spending

63. 3 Things about the Multiplier  The initial change in spending is usually associated with investment spending, but change in consumption, government, or net export spending also lead to a multiplier effect.

64.  The initial change in spending associated with investment spending results from a change in the real interest rate and/or a shift of the investment demand curve.  The multiplier works in both directions.

65. Rationale The multiplier effect follows from 2 facts. First, the economy supports repetitive, continuous flows of spending and income through which dollars spent by Smith are received as income by Jones and then spent by Jones and received as income by Taylor, and so on.

66. Second, any change in income will change both consumption and saving in the same direction as, and by a fraction of, the change in income. It follows that an initial change in spending will set off a spending chain throughout the economy. Figure 27.8 illustrates how the process works.

67. The Multiplier Effect (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 3.75 2.81.94 Third round 2.81 2.11.70 Fourth round 2.11 1.58.53 Fifth round 1.58 1.19.39 All other rounds 4.75 3.56 1.19 Total $20.00$15.00$5.00 $3.75 $2.81 $2.11 $1.58 $4.75 Cumulative income, GDP (billions of dollars) 20.00 15.25 13.67 11.56 8.75 5.00 2354 All others 1 LO5 27-67

68. Multiplier and Marginal Propensities The fractions of an increase in income consumed (MPC) and saved (MPS) determine the cumulative respending effects of any initial change in spending and therefore determine the size of the multiplier. The MPC and the multiplier are directly related and the MPS and the multiplier are inversely related. Multiplier = 1 1- MPC Multiplier = 1 MPS LO5 27-68

69. Tax Multiplier There is also a tax multiplier which is always 1 less than the spending multiplier and negative. Notice from figure 27.9 that the larger the MPC and the smaller the MPS, the larger the multiplier. Conversely, the smaller the MPC and the larger the MPS, the smaller the multipler.

70. Multiplier and Marginal Propensities 10 5 4 3 2.5.67.75.8.9 MPCMultiplier LO5 27-70

71. The Actual Multiplier Effect? Economists disagree on the size of the actual multiplier in the United States. Estimates range from as high as 2.5 to as low as zero. LO5 27-71

72. Squaring the Economic Circle 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 27-72