2. Basic Macroeconomic Relationships 9 C H A P T E R

3. The Income-Consumption and Income-Saving Relationships Disposable income is the most important determinant of consumer spending (consumption). What is not spent is called saving. Disposable Income (DI) = C + S S = saving Saving = DI – C

4. Note: (disposable income in Kuwait = personal income since there is no income tax) A 45-degree line: each point on the line is equidistant from the two axes. Therefore, represents all points where consumer spending is equal to disposable income. Or each point represent a situation where; C + S = DI Any vertical distance from the horizontal axis to the 45 0 line measures DI

5. 27- 4 Income and Consumption Consumption (billions of dollars) Disposable Income (billions of dollars) 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 Source: Bureau of Economic Analysis

6. Consumption Schedule Reflects the direct consumption- disposable income relationship Note: households tend to spend a larger proportion of a small DI than of a larger DI.

7. The saving schedule Reflects the direct relationship between S and DI Saving is a smaller proportion of small DI than of a large DI Dissaving: when households consume more than their DI. They do that by liquidating their wealth (assets) or by borrowing

8. Consumption and Saving Schedules

9. Consumption Saving o o 45 o C S Consumption schedule Saving schedule C S Disposable Income SAVING DISSAVING MPC = Slope of C MPS = Slope of S MPC + MPS = 1 CONSUMPTION AND SAVING

10. Break even income: The income level at which households plan to consume their entire income, (C=DI). At break even: Consumption schedule cuts the 45 0 line. -Saving schedule cuts the horizontal axis. -Saving = zero -APC = 1 -APS = zero

11. 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 MPC + MPS = 1 MPC and MPS measure slopes

12. Average and marginal propensities to consume and save Average propensity to consume (APC) is the fraction or % of income consumed APC = consumption/income Average propensity to save (APS) is the fraction or % of income saved APS = saving/income

13. Marginal propensity to consume (MPC) is the fraction or proportion of any change in income that is consumed MPC = change in consumption/change in income Marginal propensity to save (MPS) is the fraction or proportion of any change in income that is saved MPS = change in saving/change in income

14. Note: As DI increases; APS rises and APC falls. APC + APS = 1 MPC + MPS = 1 Because: ∆DI = ∆C + ∆S

15. Non-income determinants of consumption 1.Wealth: An increase in wealth shifts the consumption schedule up and saving schedule down. Wealth Effects: when assets boast, households feel wealthy, they save less and consumer more, and vice versa. 2.Expectations: Changes in expected future prices or wealth can affect consumption spending today.

16. 3.Real interest rates: Declining interest rates increase the incentive to borrow and consume, and reduce the incentive to save. Because many household expenditures are not interest sensitive – the light bill, groceries, etc. – the effect of interest rate changes on spending are modest. 4.Household debt: Lower debt levels shift consumption schedule up and saving schedule down. But if debt is too high, they will reduce their consumption to pay off some of their loans.

17. Terminology, shifts and stability 1.Terminology: Movement from one point to another on a given schedule is called a change in amount consumed; a shift in the schedule is called a change in consumption schedule. 2.Schedule shifts: Consumption and saving schedules will always shift in opposite directions unless a shift is caused by a tax change (move together). 3.Stability: Economists believe that consumption and saving schedules are generally stable unless deliberately shifted by government action.

18. Consumption Saving o o 45 o C0C0 S0S0 Disposable Income C1C1 S1S1 TERMINOLOGY, SHIFTS, & STABILITY Increases in Consumption Means… A Decrease In Saving

19. Consumption Saving o o 45 o C0C0 S0S0 Disposable Income C2C2 S2S2 TERMINOLOGY, SHIFTS, & STABILITY Decreases in Consumption Means… An Increase In Saving

20. 27- 19 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.80.85.90.95 1.00

21. The Interest Rate – Investment Relationship Investment consists of spending on new plants, capital equipment, machinery, inventories, construction, etc. The investment decision weighs marginal benefits (r) and marginal costs (i). 1. Expected Rate of Return, r: This is marginal benefit of investment. Expected Rate of Return = expected profit/cost of capital

22. If expected profit on a $1000 investment is $100. This is a 10% expected rate of return. Thus, this business would not want to pay more than a 10% interest rate on investment. Remember that the expected rate of return is not a guaranteed rate of return. Investment carries risk. 2. Real Interest Rate, i: This is the marginal cost of investment (nominal rate corrected for expected inflation) Real interest rate = nominal interest rate – expected inflation

23. The interest rate represents either the cost of borrowed funds or the opportunity cost of investing your own funds, which is income forgone. If real interest rate exceeds the expected rate of return, the investment should not be made, example: If expected rate of return r = 10% Nominal interest rate = 15% Inflation rate = 10% This investment is profitable since 10% > (i = 15%-10%) 5% Expected return > real interest rate

24. Interest rates Expected rate of return Cumulative investment 16%0 14%5 12%10 10%15 8%20 6%25 4%30 2%35 0%40 Investment demand curve

25. Investment demand schedule, or curve, shows an inverse relationship between the interest rate and amount of investment. As long as expected return exceeds interest rate, the investment is expected to be profitable if rate of interest is 12%, businesses will undertake all investment opportunities that yield 12% or more. If rate of interest is less, more investment will be undertaken If rate of interest is more, less investments will be undertaken

26. Investment (billions of dollars) Expected rate of return, r, and interest rate, i (percents) 16 14 12 10 8 6 4 2 0 INVESTMENT DEMAND CURVE 5 10 15 20 25 30 35 40 I D Interest Rate – Investment Relationship

27. Shifts of investment demand 1. Acquisition, Maintenance, and Operating Costs: Initial costs of capital, operating costs and maintenance affect the expected rate of return –When they fall, prospective investment projects increase (shift to the RHS) –When they increase, prospective investment projects decrease (shift to the LHS)

28. 2. Business Taxes When tax increases, expected (after tax) return decreases, shifts the investment curve to the LHS and vice versa. 3. Technological Change Technological progress (more efficient machines). Technological change often involves lower costs, which would increase expected returns and stimulates investment (shifts the investment curve to the RHS, and vice versa).

29. 4. Stock of capital goods on hand Relative to output and sales, if there is abundant idle capital on hand because of weak demand or recent investment (overstock), expected return on new machines declines (would be less profitable) and investment curve shifts to the LHS and vice versa. 5. Expectations about future economic and political conditions can change the view of expected returns. –Optimistic expectations about the return, shifts the investment curve to the RHS –Pessimistic expectations shifts the investment curve to the LHS

30. Instability of investment Investment schedule is unstable, it shifts upward or downward quite often. Investment is the most volatile component of total spending. Reasons for instability of investment 1. Durability of capital and variability of expectations Within limits, purchases of capital goods are discretionary and therefore, can be postponed. Optimism about future may prompt firms to replace older capital. Pessimism about the future lead to small investment as firms repair old capital.

31. 2. Irregularity of Innovation Technological progress is a major determinant of investment. But major innovations occur quite irregularly. When they happen, they induce vast investments. e.g., the new information technology 3. Variability of expectations Expectations are influenced by: -Current profit levels, -Changes in exchange rates, -Outlook for international peace, -Changes in government policies -Stock market prices…etc

32. 4. Variability of profits: Profits are highly variable. This contributes to the volatile incentive to invest. Also profits are a major source of investment finance (internal source), if they are variable, investment will be instable.

33. 27- 32 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 0 10 20 30

34. Volatility of Investment Source: Bureau of Economic Analysis 27-33

35. The Multiplier Effect Changes in spending ripple through the economy to generate even larger changes in real GDP. This is called the multiplier effect. Multiplier = change in real GDP / initial change in spending. Alternatively, it can be rearranged to read Change in real GDP = initial change in spending × multiplier.

36. Three points to remember about the multiplier: a.The initial change in spending is usually associated with investment because it is so volatile. b.The initial change refers to an upward shift or downward shift in the aggregate expenditures schedule due to a change in one of its components, like investment. c.The multiplier works in both directions (up or down).

37. Rationale: The multiplier is based on two facts 1. The economy has continuous flows of expenditures and income—a ripple effect—in which income received by Ali comes from money spent by Ahmad. Ahmad’s income, in turn, came from money spent by Said, and so forth. 2.Any change in income will cause both consumption and saving to vary in the same direction as the initial change in income, and by a fraction of that change. a.The fraction of the change in income that is spent is called the marginal propensity to consume (MPC). b.The fraction of the change in income that is saved is called the marginal propensity to save (MPS).

38. Change in GDP = Multiplier x initial change in spending THE MULTIPLIER EFFECT Multiplier = Change in Real GDP Initial Change in Spending For Example…

39. THE MULTIPLIER EFFECT Increase in Investment of $5 Second Round Third Round Fourth Round Fifth Round All Other Rounds Total (1) Change in Income (2) Change in Consumption (MPC =.75) (3) Change in Saving (MPS =.25) $ 5.00 3.75 2.81 2.11 1.58 4.75 $ 3.75 2.81 2.11 1.58 1.19 3.56 $ 1.25.94.70.53.39 1.19 $20.00 $15.00 $ 5.00

40. Change in GDP = Multiplier x initial change in spending Multiplier = or 1 MPS 1 1 - MPC THE MULTIPLIER EFFECT Inverse relationship between: Multiplier & MPS Multiplier Effect and the Marginal Propensities

41. THE MULTIPLIER EFFECT.9.8.75.67.5 10 5 4 3 2 MPCMultiplier MPC and the Multiplier

42. The size of the MPC and the multiplier are directly related. The significance of the multiplier is that a small change in investment plans or consumption-saving plans can trigger a much larger change in the equilibrium level of GDP. The simple multiplier given above can be generalized to include other “leakages” from the spending flow besides savings. For example, the actual multiplier is derived by including taxes and imports as well as savings in the equation. In other words, the denominator is the fraction of a change in income not spent on domestic output.