Chapter 27 Basic Macroeconomic Relationships McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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

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

Income and Consumption 83 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) Source: Bureau of Economic Analysis

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

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

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

Consumption and Saving 500 475 450 425 400 375 45° C Saving $5 Billion Consumption Schedule Consumption (billions of dollars) Dissaving $5 Billion 390 410 430 450 470 490 510 530 550 Disposable Income (billions of dollars) 50 25 390 410 430 450 470 490 510 530 550 Dissaving $5 Billion Saving Schedule (billions of dollars) Saving S Saving $5 Billion

Average Propensity to Consume Selected Nations, with respect to GDP, 2006 .80 .85 .90 .95 1.00 United States Canada United Kingdom Japan Germany Netherlands Italy France Source: Statistical Abstract of the United States, 2006

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

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

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

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

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

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

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

Investment Demand Instability of investment Durability Irregularity of innovation Variability of profits Variability of expectations

Gross Investment Expenditure Percent of GDP, Selected Nations, 2006 0 10 20 30 South Korea Japan Canada Mexico France United States Sweden Germany United Kingdom Source: International Monetary Fund

Volatility of Investment Source: Bureau of Economic Analysis 27-19

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 =

The Multiplier Effect Causes of the initial change in spending Changes in investment Other changes – C, G, X Rationale Dollars spent are received as income Income received is spent (MPC) Initial changes in spending cause a spending chain

The Multiplier Effect $ 20.00 $ 15.00 $ 5.00 (2) Change in Consumption (MPC = .75) (3) Change in Saving (MPS = .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

The Multiplier Effect 1 1 - MPC Multiplier = -or- 1 MPS Multiplier =

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

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

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)

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