1. 8
Basic
Macroeconomic
Relationships

2. Chapter Objectives
How Changes in Income Affect Consumption (and Saving)
About Factors Other Than Income That Can Affect Consumption
How Changes in Real Interest Rates Affect Investment
About Factors Other Than the Real Interest Rate That Can Affect Investment
Why Changes in Investment Increase or Decrease Real GDP by a Multiple Amount

3. Income-Consumption and Income-Saving Relationships
When we examine relationship between income and consumption we are also in effect looking at income-saving relationship
S = DI - C

4. Income and Consumption
Consumption and Disposable Income, 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)

5. Direct relationship between saving and DI
Smaller proportion of DI spend on consumption as income increases-Proportion of saving is increasing
Dissaving occurs only at very low levels of income

6. 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

7. Consumption and Saving
Consumption and Saving Schedules
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

8. APC and APS Average Propensity to Consume: Fraction of income consumed
Average Propensity to Save : Fraction of income saved
APS + APC = 1
APC =
Consumption
Income
APS =
Saving
Income

9. MPC and MPS
Marginal Propensity to Consume: Proportion of any change in income consumed
Marginal Propensity to Save: Fraction of any change in income that is saved
MPC + MPS = 1
MPC =
Change in Consumption
Change in Income
MPS =
Change in Saving
Change in Income

10. 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

11. MPC and MPS as slopes MPC is the slope of consumption schedule
MPS is the slope of saving schedule
Diagram (example)

12. Nonincome Determinants of Consumption and Saving
Wealth : Real and financial assets that households own
-Saving is in order to accumulate wealth
-If value of wealth goes up households save less and consume more
-Wealth effect : Consumption schedule shifts up, Saving Schedule shifts down
2) Expectations:
-If future prices are expected to rise, spend more
-If recession expected in future

13. Nonincome Determinants of Consumption and Saving
3) Real Interest Rate : If real interest rate falls, households borrow more, consume more and save less -Less return on savings -Higher interest rates do the opposite -Very modest changes

14. Nonincome Determinants of Consumption and Saving
4) Household Debt : If household debt as percentage of DI increases, consumption increases

15. Other important considerations
Switch to real GDP: When developing models look at relationship between consumption and real GDP (or real output)
-Horizontal axis
Changes along schedules: Movement along schedule is change in amount consumed and is due to change in GDP

16. Schedule shifts: Changes in non-income determinants
Have opposite effects on consumption and savings

17. Consumption and Saving
Consumption and Saving Schedules C1
45° C0 C2
Consumption (billions of dollars)
Disposable Income (billions of dollars) S2
(billions of dollars)
Saving S0 S1

18. Taxation: Shifts both in same direction
-Taxes paid partly at expense of consumption and partly savings
Stability: Usually stable except for taxes
-Non income determinants usually move in opposite direction and cancel out effects

19. Interest Rate-Investment Relationship
Marginal benefit: Expected Rate of Return
Marginal Cost : Interest Rate paid on borrowed funds
Expected rate of Return
Cost of machine : 1000, Net profit : 1100
Expected rate of return=100/1000
Expected rate of return not guaranteed: risk

20. Real Interest Rate You borrowed the 1000 at rate of 6 %
Expected return was 10% so favourable
In general
-If expected return> rate of interest-Profitable
-If expected return<rate of interest-Unprofitable
-So invest till the point both are equal
Real interest rate rather than nominal is crucial for investment decision

21. Real Interest Rate
Suppose an investment is expected to yield 10% real rate of return and nominal rate is 15%. Is it profitable if there is no inflation?
Is it profitable if there is inflation of 10%

22. Investment Demand Curve
Move from single firms investment decision to total demand for investment goods by business sector
Cumulate data

23. Interest Rate and Investment
The 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

24. Shifts in the Investment
Interest Rate and Investment
Shifts in the Investment
Demand Curve
Increase in
Investment Demand
r and i (percent)
Decrease in
Investment Demand
ID2
ID0
ID1
Investment (billions of dollars)

25. Shifts of the Investment Demand Curve
Rightward shift : Businesses expect greater rates of return
Leftward Shift: Lower rate of return
SHIFT FACTORS:
Acquisition, Maintenance, and Operating Costs: If they rise, expected return falls (higher electricity cost)
Business Taxes: Expected returns after taxes

26. Shifts of the Investment Demand Curve
3)Technological Change: Development of new products and machinery stimulates investments 4)Stock of capital goods on hand: Excessive inventories and capital stock-Lower return on new investment 5)Expectations: If optimistic about business conditions, political climate-Higher return

27. Interest Rate and Investment
The Volatility of Investment
Gross Investment
Percentage Change
GDP
Year

28. Instability of Investment
Durability: Capital goods have indefinite life so there is choice between replacing old machinery or repairing
Irregularity of Innovation: Creates a surge and then recedes e.g. computers
Variability of Profits : Expanding profits give greater incentive and means to invest
Variability of Expectations: Stock market is speculative

29. The Multiplier Effect
Relationship between changes in spending and changes in GDP
Multiplier effect : A change in component of total spending leads to larger change in GDP
Multiplier : How large will the change in GDP be
Change in Real GDP
Initial Change in Spending
Multiplier =

30. The Multiplier Effect
Usually the change is due to change in investment due to its volatility but changes can also be due to consumption
Change in investment usually due to change in interest rate or shift of investment schedule
Like increase , decrease can also be multiplied

31. Rationale
Economy supports repetitive and continuous flows of expenditures and income
Any change in income will change both savings and consumption
Spending chain : Cumulates to multiple changes in GDP, magnified changes in output and income

32. The Multiplier Effect Tabular and Graphical Views (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

33. The Multiplier and the Marginal Propensities
MPC and multiplier are directly related
MPS and multiplier are conversely related 1
1 - MPC
Multiplier =
-or- 1
MPS
Multiplier =

34. A large MPC means rounds of consumption spending diminish slowly and add up to a large change in income
A small MPC means rounds diminish quickly leading to a smaller change in income and smaller multiplier

35. The Multiplier Effect The MPC and the Multiplier MPC Multiplier .9 10.8 5
.75 4
.67 3 .5 2