1. Chapter 10 Basic Macroeconomic Relationships McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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
10-2

3. Income and consumption Income and saving Disposable income (DI)
Basic Relationships
Income and consumption
Income and saving
Disposable income (DI)
45°line for reference
C = DI on the Line
S = DI - C
10-3

4. Income and Consumption83 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)
10-4
Source: Bureau of Economic Analysis

5. Consumption and Saving
The consumption schedule
The saving schedule
Break-even income
Average propensity to consume (APC)
Average propensity to save (APS)
APC =
Consumption
Income
APS =
Saving
Income
10-5

6. 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
10-6

7. 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 + MPS = 1
MPC and MPS measure slopes
10-7

8. Consumption and Saving
500
475
450
425
400
375
45° C
Saving $5 Billion
Consumption
Schedule
Consumption (billions of dollars)
Dissaving $5 Billion
Disposable Income (billions of dollars) 50 25
Dissaving
$5 Billion
Saving Schedule
(billions of dollars)
Saving S
Saving $5 Billion
10-8

9. Average Propensity to Consume
Selected Nations, with respect to GDP, 2006
United States
Canada
United Kingdom
Japan
Germany
Netherlands
Italy
France
Source: Statistical Abstract of the United States, 2006
10-9

10. Consumption and Saving
Nonincome determinants of consumption and saving
Wealth
Borrowing
Expectations
Real interest rates
10-10

11. Consumption and Saving
Other important considerations
Changes along schedules
Switch to real GDP
Schedule shifts
Stability
Taxation
10-11

12. Consumption and Saving
45° C0 C2
Consumption (billions of dollars)
Disposable Income (billions of dollars) S2
(billions of dollars)
Saving S0 S1
10-12

13. Interest Rate and Investment
Expected rate of return (r)
The real interest rate (i)
Nominal rate less rate of inflation
Meaning of r = i
Investment demand curve
10-13

14. 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
Investment (billions of dollars)
16%
14%
12%
10% 8% 6% 4% 2% 0%
$ 0 5 10 15 20 25 30 35 40 ID
10-14

15. 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
10-15

16. Investment Demand Curve
Increase in
Investment Demand
r and i (percent)
Decrease in
Investment Demand
ID0
ID1
ID2
Investment (billions of dollars)
10-16

17. Investment Demand Instability of investment Durability
Irregularity of innovation
Variability of profits
Variability of expectations
10-17

18. Gross Investment Expenditure
Percent of GDP, Selected Nations, 2006
South Korea
Japan
Canada
Mexico
France
United States
Sweden
Germany
United Kingdom
Source: International Monetary Fund
10-18

19. Volatility of Investment
Source: Bureau of Economic Analysis
10-19

20. The Multiplier Effect More spending results in higher GDP
Initial change in spending changes GDP by a multiple amount
Change in Real GDP
Initial Change in Spending
Multiplier =
10-20

21. The Multiplier Effect Causes of the initial change in spending
Changes in investment
Other changes
Rationale
Dollars spent are received as income
Income received is spent (MPC)
Initial changes in spending cause a spending chain
10-21

22. The Multiplier Effect $ 20.00 $ 15.00 $ 5.00 (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
10-22

23. The Multiplier Effect -or- Multiplier = Multiplier = 1 1 - MPC 1 MPS
10-23

24. The Multiplier and the MPC.9 10 .8 5
.75 4
.67 3 .5 2
10-24

25. 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
10-25

26. Key Terms marginal propensity to consume (MPC) 45°(degree) line
marginal propensity to save (MPS)
wealth effect
expected rate of return
investment demand curve
multiplier
45°(degree) line
consumption schedule
saving schedule
break-even income
average propensity to consume (APC)
average propensity to save (APS)
10-26

27. Next Chapter Preview…
The Aggregate
Expenditures Model
10-27