1. Bell Ringer
In your opinion how is consuming and saving affected by increases in income?
What if you lose your income?
What if you already have a lot of wealth?
What if your taxes go up?
What if you expect prices to go up on needed items—how would you change your habits today?

2. Basic Macroeconomic Relationships
Chapter 27

3. The Income-Consumption and Income-Saving Relationships
When examining the relationship between income and consumption you have to consider savings too
Savings (S) = disposable income (DI) not consumed [DI – money left after taxes]
S = DI - Consumption (C) ($ spent)
If [DI – C] is equaled to zero, it means nothing was saved—also called the break-even income
Are you at break-even at the end of
month?

4. The Income-Consumption and Income-Saving Relationships
DI – C = S
Dashed line represents every instance where C = DI (break-even)
Red line represents actual consumption at different levels of income—in other words, from this we can see the more we make the more we spend
Loss, or dissavings, occurs here
Savings occur
here C

5. The Income-Consumption and Income-Saving Relationships
Average Propensity to Consume (APC) is the percentage of total income that is consumed
APC = C / Income (I)
I make $45,000 per year (income)
I spend (consume) $35,000 per year
APC = 35000/45000
APC = 0.778

6. The Income-Consumption and Income-Saving Relationships
Average Propensity to Save (APS) is the percentage of total income saved
APS = S / I
I save $10,000 per year
I make $45,000 per year
APS = 10000/45000
APS = 0.222
APC + APS = 1
= 1

7. The Income-Consumption and Income-Saving Relationships
Delta (Δ) represents change
Marginal Propensity to Consume (MPC) shows how much additional income is consumed as your income goes up
MPC = Δ in consumption
Δ change in income

8. The Income-Consumption and Income-Saving Relationships
EX:
I1 = C1 = 450
I2 = 490 C2 = 465
Δ I = (490 – 470) = 20
Δ C = (465 – 450) = 15
MPC = 15/20 = .75
Now calculate Marginal Propensity to Save (MPS)
S1 = 20 S2 = 25
Δ S = (25 – 20) = 5
MPS = 5/20 = .25
MPC (.75) + MPS (.25) = 1

9. The Income-Consumption and Income-Saving Relationships
Income is not the only factor that goes into how people save and consume
Wealth--if you have preexisting assets (house, savings, cars, stocks, etc.) and the value of them goes up, you will consume more and save less
Expectations—if higher prices are expected in the future, people will consume more and save less now

10. The Income-Consumption and Income-Saving Relationships
Other factors
Real Interest Rates—When interest rates drop, people tend to borrow more, consume more, and save less
If interest rates go up?
Household Debt—When you first start going into debt consumption goes up, when debt gets too high, consumption has to go down to pay for previous consumption
Taxation—If taxes go up, consuming and saving goes down…if taxes go down, consuming and saving go up

11. The Income-Consumption and Income-Saving Relationships
This graph represents a change in the amount consumed
This graph represents a SHIFT in consumption
Same concept
for saving B A C1 C2

12. Interest-Rate—Investment Relationship
Investments are expenditures on things such as: new facilities (buildings), capital equipment, machinery, inventories, etc.
When businesses decided to make new investments it’s called the marginal-benefit-marginal-cost decision
The marginal-benefit is the expected return on investment
The marginal-cost is the interest rate that must be paid to borrow the needed funds
A business will always invest in new items if their return on investment exceeds the interest rate

13. Interest-Rate—Investment Relationship
First rule of for-profit business—if you aren’t doing it for money, then why are you doing it?
ALL businesses are looking out for the bottom line ($$$)
They will buy investments when they believe it will make a profit for the company
EX: Cabinetmaking shop wants to buy a new sander that costs $ They conclude that after they pay for the cost of the sander, it will have increased their profits by $100
Their expected rate of return (r), = what they expect to earn/what they paid for the investment
100/1000 = 10%
Understand expected is just that, it’s not a guarantee!

14. Interest-Rate—Investment Relationship
In order to fully understand the cost of spending money on investments, we have to take interest into account
If you borrow the money, there is an interest rate charged
If you pull the money from savings, you’re giving up interest that could have been earned
Either way, you are losing funds to make new purchases in the form of interest
Back to the sander—say your interest rate (i) to borrow was 7%
i = 0.07 x 1000 = 70
Your interest rate will cost you $70 for the sander
Remember you expect to make $100 which, including interest still has you at positive $30

15. Interest-Rate—Investment Relationship
Anytime your interest rate is lower than your expected return rate, the business should invest
If the interest rate is higher than the rate of return, the business should not invest
You should continue investing up to the point where r = i
Understand that you need to use real interest rates not nominal interest rates

16. Interest-Rate—Investment Relationship
An investment demand curve is just another demand curve
You start with an investment demand schedule
Real Interest Rate (i)
Amount Companies are willing to invest at (i)
16% 14 5 12 10 15 8 20 6 25 4 30 2 35 40

17. Interest-Rate—Investment Relationship
The higher the interest rate, the less willing companies overall are likely to invest in new items 16 14 12 10 8 6 4 2
Real Interest Rate ID
Investment (billions of dollars)

18. Interest-Rate—Investment Relationship
Just like any other demand curve, the investment demand curve can completely shift places due to certain issues
If the initial cost of an item goes up, if it is more expensive to maintain than before, or if it is more expensive to operate, investment will go down
Which way will the line shift?
If taxes go up?
If the economy overproduces?
New technology is introduced
Future sales are expected to be good?

19. Interest-Rate—Investment Relationship
Investments are the most volatile (unstable) parts of total spending
There are several reasons:
Durability—goods last longer than projected due to patch-ups, etc. or goods don’t last as long as expected and are replaced sooner than desired
Irregularity of Innovation—can’t guarantee someone will invent something like the car, electricity, or fiber optics everyday
Profits—can’t guess how many people will buy the product
Expectations—businesses make projections, but things change—stock market is best example

20. Sell more chairs (GDP goes up)
The Multiplier Effect
The Multiplier shows you how much a change in spending is going to affect the economy
The initial change in spending is usually associated with investment
The change comes from a change in the real interest rate or a shift of the investment demand curve
Multiplier = Change in RGDP
Initial change in spending
The multiplier shows you how much additional spending will take place in each round of spending
Round 1
Purchase a sander
Sell more chairs (GDP goes up)
Pay employees more
Round 2
They spend more money

21. The Multiplier Effect
Imagine the economy sees a $5B increase in investment spending
Assume MPC (Marginal Propensity to Consume) for this change is .75
This $5B increase initially raises consumption by $3.75B
.75 x 5B = 3.75B
That $3.75B flows to other households as income who will increase their consumption by $2.81B
.75 x 3.75B = 2.81B
This process continues until there is no additional income to spend
This process will eventually produce a change in GDP of $20B, therefore the multiplier is 4
(add up change in RGDP) 20B / (initial change in spending) 5B = 4

22. The Multiplier Effect Alternate ways to find the Multiplier:
The MPC and the Multiplier are directly related
Large MPC = Large Multiplier
Multiplier = 1/1-MPC
The Multiplier and the MPS are negatively related
Large MPS = Small Multiplier
Multiplier = 1/MPS