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

2. 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

3. 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

4. Income and Consumption83 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

5. 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

6. 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

7. 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

8. Consumption and Saving
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

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

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

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

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

13. 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

14. 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

15. 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

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

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

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

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

20. 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 =

21. 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

22. 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

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

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

25. 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

26. 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)

27. Next Chapter Preview…
The Aggregate
Expenditures Model