Basic Macroeconomic Relationships Please listen to the audio as you work through the slides.

Learning objectives Students should be able to thoroughly and completely explain: 1.The relationships between Income, Consumptions, Saving, and GDP. 2.The relationships between Interest rates, Expected Rates of Return, and Investment spending. 3.The Multiplier, (including the 3 types discussed in the notes), and how the Multiplier works.

Topics Household sector: Income – consumption & saving relationship Business sector: Interest rate – Rate of return – investment Magnification of changes: The multiplier – very important concept!

U.S. Income Relationships 2007 Gross Domestic Product (GDP) Less: Consumption of Fixed Capital Equals: Net Domestic Product (NDP) Less: Statistical Discrepancy Plus: Net Foreign Factor Income Equals: National Income (NI) Less: Taxes on Production and Imports Less: Social Security Contributions Less: Corporate Income Taxes Less: Undistributed Corporate Profits Plus: Transfer Payments Equals: Personal Income (PI) Less: Personal Taxes Equals: Disposable Income (DI) $ 13, $ 12, $ 12, $ 11, $ 10,177

Income – Consumption Relationship and Income – Saving Relationship Definition of some terms: Disposable Income (DI) DI = C+S Personal Saving (S) – “not spending” Consumption (C) – Consumption spending The Consumption Schedule (consumption function) A schedule showing the various amounts that households would plan to consume at each of the various levels of DI that might prevail at some point in time The Saving Schedule (saving function) A schedule showing the various amounts that households would plan to save at each of the various levels of DI that might prevail as some point in time Break-even Income – the level of income at which households plan to consume their entire incomes C=DI

Graphic representation of the income, consumption, saving relationship 45-Degree Line – reference line Measuring Consumption and (DI) Disposable Income Consumption Disposable Income SAVING Consumption schedule 45 o o Reference line Any point on the 45 degree Reference line is equidistant From each axis (DI = C) Saving and consumption Both are directly related to Disposable income DISSAVING C

Consumption and Saving Terminology APC – average propensity to consume – fraction of income that is spent on consumption. Consumption / Income APS – average propensity to save – fraction of income that is saved. Saving / Income APS+APC=1 MPC – marginal propensity to consume – the fraction of any change in Income that will be consumed. Change in Consumption / Change in Income MPS – marginal propensity to save – the fraction of any change in Income that will be saved. change in Saving / change in Income MPS+MPC=1

Consumption and Saving ° 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)

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

Non Income Determinants of Consumption and Saving (curve shifters) Wealth – value of real (houses and land) and financial assets (cash, bank accounts, securities, pensions) Wealth Effects – causes consumption and saving to increase or decrease Expectations – about inflation, recession, etc Real Interest Rates (adjusted for inflation) Household Debt – more debt enables more consumption Taxation – Consumption & saving move in same direction – taxes affect both

Consumer Debt 1999 to 2010

Terminology Movement along a curve (change in amount consumed) vs. shift of a curve Schedule Shifters Wealth, expectations, interest rates, household debt Taxes – affect both C and S Stability – consumption & savings functions relatively stable TERMINOLOGY, SHIFTS, & STABILITY

Consumption and Saving 45° C0C0 S0S0 Disposable Income (billions of dollars) Consumption (billions of dollars) Saving (billions of dollars) C2C2 C1C1 S1S1 S2S2

The Interest Rate – Investment Relationship Listen to the audio for more info. Relationship between real interest rates, expected rate of return, and investment. Investment – expenditures on new plants, capital equipment, machinery, inventories, etc. Investment decision – a MB MC decision. 1.MB is the expected rate of return businesses hope to realize. 2.MC is the interest rate that must be paid for borrowed funds. Business will invest in all projects where expected rate of return exceed the interest rate. The two basic determinants of investment spending!

Expected Rate of Return, r Real Interest Rate: i is the nominal rate adjusted for inflation. Inverse relationship between Investment demand and the real interest rate. Interest Rate – Investment Relationship Graphically presented...

Investment Demand Curve 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% $ r and i (percent) Investment (billions of dollars) ID

r and i (percent) 0 Investment (billions of dollars) ID 0 ID 1 ID 2 Increase in Investment Demand Decrease in Investment Demand Investment Demand Curve

These affect Investment Demand by way of the Expected Rate of Return What would have to happen to each of these factors to cause a change in the Expected Rate of Return on a project? Acquisition, Maintenance, and Operating Costs Business Taxes Technological Change Stock of Capital Goods on Hand Planned inventory changes Expectations Non-Interest Rate Determinants of Investment Demand

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

Durability of capital goods Irregularity of Innovation Variability of Profits Variability of Expectations Causes of Instability of Investment

February 2009 – $800 Billion stimulus bill signed Why $800 Billion? Multipliers

The Multiplier Effect Multiplier = Change in Real GDP Initial Change in Spending More spending results in higher GDP Initial change in spending changes GDP by a multiplied amount

The Multiplier Effect Some causes of the initial change in spending – Changes in investment – Other changes – such as: changes in Consumption, Government, or Net Export spending. Rationale – Dollars spent are received as income – Income received is spent (MPC) – Initial changes in spending cause a spending chain

The Multipliers – make sure you know these 1.Spending Multiplier = 1/MPS – An autonomous change in spending results in a change in aggregate production in the same direction. 2.Tax Multiplier = (MPC/MPS) – If, for example, the MPC is 0.75 (and the MPS is 0.25), then an autonomous $1 trillion change in taxes results in an opposite change in aggregate production of $3 trillion 3.Balanced Budget Multiplier = 1 – The balanced-budget multiplier measures the combined impact on aggregate production of equal changes in government purchases and taxes. The simple balanced- budget multiplier has a value equal to one

Change in GDP = Multiplier x initial change in spending The Multiplier Spending Effect Multiplier = Change in Real GDP Initial Change in Spending For Example… The big picture: We know we need to increase or decrease our GDP, but we don’t know by how much we need to change spending to get the desired result. How do we figure that out?

The Multiplier Effect The following slide shows you how the Multiplier operates.

Business Sector (1) Change in Income (2) Change in Consumption (MPC =.75) (3) Change in Saving (MPS =.25) Increase in Investment of $5 Second Round Third Round Fourth Round Fifth Round All other rounds Total $ $ $ $ $ $ 5.00 Rounds of Spending 12345All $ $5.00 $3.75 $2.81 $2.11 $1.58 $4.75 ΔI= $5 billion The Multiplier Effect

Change in GDP = Multiplier x initial change in spending Multiplier = or 1 MPS MPC The Spending Multiplier Effect Inverse relationship between: Multiplier & MPS Multiplier Effect and the Marginal Propensities

The Multiplier Effect MPCMultiplier MPC and the Multiplier Rules of thumb

The Tax Multiplier (- MPC/MPS) You are the chief economic adviser to the president. You are instructed to devise a plan to reduce unemployment to an acceptable level without increasing the level of government spending. You decide to cut taxes and maintain the spending level. A tax cut increases disposable income which leads to increases in consumption. Would the decrease in taxes affect aggregate output in the same way as an increase in government spending?

The Tax Multiplier A tax decrease causes an income increase. Consumption increases Inventories decrease Output increases in response. Employment and income increase and lead to subsequent rounds of spending. GDP will increase by a multiple of the decrease in taxes. The multiplier for a change in taxes is not the same as the multiplier for an change in government spending.