Basic Macroeconomic relationships

Lecture ?

Basic Macro Relationships• Previously we identified macroeconomic

issues of growth, business cycles, recession, and inflation. Here we begin to develop tools to explain these events.

• We focus on the three basic macroeconomic relationships. – Income and consumption, and income and saving.– The interest rate and investment. – Changes in spending and changes in output.

Learning 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

Students should be able to• Describe the income-consumption and income-saving relationships.• Recognize, construct, and explain the consumption and saving schedules.• Identify the determinants of the location of the consumption and saving

schedules.• Calculate and differentiate between the average and marginal

propensities to consume (and save).• Describe the relationship between the interest rate, expected rate of

return, and investment.• Identify the determinants of investment and construct an investment

demand curve.• Identify the factors that may cause a shift in the investment-demand

curve.• Describe the reasons for the instability in investment spending.• Provide an intuitive explanation of the multiplier effect.• Calculate the multiplier and changes in real GDP given information about

changes in spending and the marginal propensities.• Discuss why the actual multiplier may differ from the theoretical

examples.

Basic relationships• Income-Consumption– Disposable income is the most important determinant

of consumer spending• Income-Saving– What is not spent is called saving

• 45° Line (Draw disposable income-consumption curve)

– A 45-degree line represents all points where consumer spending is equal to disposable income (C = DI on the Line

• If the actual graph of the relationship between consumption and income is below the 45-degree line, then the difference must represent the amount of income that is saved

• S = DI - C

Consumption and Saving• The Consumption Schedule– Shows the amounts that households plan to consume

at various levels of disposable income – Direct relationship, with households spending a larger

proportion of a small DI than of a large DI.• The Saving Schedule– Shows the amounts that households plan to save at

various levels of disposable income – Direct relationship, with households saving a smaller

proportion of a small DI than of a large DI.• Break-Even Income– The income level at which households plan to

consume their entire incomes• Illustrate with a schedule & a graph for each

schedule (pp148-149)

Consumption and Saving Schedules

500

475

450

425

400

375

45°

50

25

0

Saving Schedule

ConsumptionSchedule

Disposable Income (Pula)

Disposable Income (Pula)

Sav

ing

(Pu

la)

Co

nsu

mp

tio

n (

Pu

la)

Consumption & Saving• The vertical distance between consumption & the 45

degree line is saving• Households consume a large portion of their

disposable income.• Both consumption and saving are directly related to

the level of income• At all higher incomes, households plan to save part

of their incomes• NB “dissaving” occurs at low levels of DI, where

consumption exceeds income and households must borrow or use up some of their wealth.

Average & marginal propensities• Average Propensity to Consume (APC)– the fraction or % of total income that is consumed

(APC = consumption/income).• Average Propensity to Save (APS)– the fraction or % of total income that is saved

(APS = saving/income).• DI is either consumed or saved, APC and APS

must exhaust the total income; (APC + APS =1)

Average & marginal propensities• Marginal Propensity to Consume (MPC)– the fraction or proportion of any change in

income that is consumed. (MPC = change in consumption/change in income.)

– MPC is the slope of the consumption schedule• Marginal Propensity to Save (MPS)– the fraction or proportion of any change in

income that is saved. (MPS = change in saving/change in income.)

– MPS is the slope of the saving schedule• The sum of any change MPC & MPS for any

change in disposable income must always be 1. (MPC + MPS = 1)

Consumption and Saving(1)

Level ofOutput

AndIncome

(GDP=DI)

(1) P370

(2) 390

(3) 410

(4) 430

(5) 450

(6) 470

(7) 490

(8) 510

(9) 530

(10) 550

P375

390

405

420

435

450

465

480

495

510

P-5

0

5

10

15

20

25

30

35

40

1.01

1.00

.99

.98

.97

.96

.95

.94

.93

.93

-.01

.00

.01

.02

.03

.04

.05

.06

.07

.07

.75

.75

.75

.75

.75

.75

.75

.75

.75

.25

.25

.25

.25

.25

.25

.25

.25

.25

(2)Consump-

tion(C)

(3)Saving (S)

(1-2)

(4)Average

Propensityto Consume

(APC)(2)/(1)

(5)Average

Propensityto Save(APS)(3)/(1)

(6)Marginal

Propensityto Consume

(MPC)Δ(2)/Δ(1)

(7)Marginal

Propensityto Save(MPS)

Δ(3)/Δ(1)

• can cause people to spend or save more or less at various income levels, although the level of income is the basic determinant.

• Wealth: An increase in wealth shifts the consumption schedule up and saving schedule down. Wealth means the value of both real assets (e.g…..) & financial assets (e.g.,……). This is called the wealth effect. Relate it to the current financial crises & economic slowdown

• Expectations: Changes in expected future prices or wealth can affect consumption spending today. Talk about expectations of a recession of current consumption & saving.

Non-income determinants of consumption & saving

• Real interest rates: Declining interest rates increase the incentive to borrow and consume, and reduce the incentive to save. Why is this the case? Cost of borrowing lower, return to saving (interest payment) lower. Effect on household consumption muted. Why?

• Household debt: when consumers as a group increase their household debt, they can increase current consumption at each level of DI. Increased borrowing shifts consumption schedule up and saving schedule down.

Non-income determinants of consumption & saving

Other important considerations• Macroeconomic models focus on real GDP more

than on disposable income• Changes along schedules: Movement from one

point to another on a given schedule is called a change in the amount consumed

• Shift in the schedule is called a change in consumption schedule, and is caused by nonincome determinants of consumption

• Schedule shifts: Consumption and saving schedules will always shift in opposite directions unless a shift is caused by a tax change.

Other important considerations• Taxation: Lower taxes will shift both schedules up

since taxation affects both spending and saving, and vice versa for higher taxes

• Stability: Economists believe that consumption and saving schedules are generally stable unless deliberately shifted by government action

The Interest Rate – Investment Relationship

• Investment consists of spending on new plants, capital equipment, machinery, inventories, construction, etc– The investment decision weighs marginal benefits

and marginal costs– The expected rate of return is the marginal

benefit and the interest rate – the cost of borrowing funds – represents the marginal cost

The Interest Rate – Investment Relationship

• Expected rate of return (r) is found by comparing the expected economic profit (total revenue minus total cost) to cost of investment to get expected rate of return

• The real interest rate, i (nominal rate corrected for expected inflation), determines the cost of investment.– The interest rate represents either the cost of

borrowed funds or the opportunity cost of investing your own funds, which is income forgone

– If real interest rate exceeds the expected rate of return, the investment should not be made

The Interest Rate – Investment Relationship

• Investment demand schedule, or curve, shows an inverse relationship between the interest rate and amount of investment

• As long as expected rate of return (r) exceeds interest rate (i), the investment is expected to be profitable

• If r > i, investment should be undertaken. Why? Coz the firm expects the investment to be profitable.

• The firm should invest up to the point where r = i• The rule applies even in cases where the firm does

not borrow, but uses internal funds

Shifts in investment demand curve• occur when any determinant apart from the interest

rate changes. • Greater expected returns create more investment

demand; shift curve to right• Changes in expected returns result because:

– Acquisition, maintenance, and operating costs of capital goods may change. Higher costs lower the expected return

– Business taxes may change. Increased taxes lower the expected return– Technology may change. – Stock of capital goods on hand will affect new investment. If there is

abundant idle capital on hand because of weak demand or recent investment, new investments would be less profitable.

– Expectations about future economic and political conditions, both in the aggregate and in certain specific markets, can change the view of expected profits

Interest Rate and Investment• Instability of Investment– Capital goods are durable, so spending can be

postponed or not. This is unpredictable.– Innovation occurs irregularly – when they do they

cause major changes in investment spending– Profits vary considerably – variability of current

profits feed into expectations of future profits, which in turn affect incentives to invest.

– Expectations can be easily changed – firms’ expectations about future business conditions can change quickly when some event suggests significant possible changes if future business conditions.

The multiplier effect• Changes in spending ripple through the

economy to generate event larger changes in real GDP.

• Multiplier effect – a change in component of total spending leads to a larger change in GDP

• Multiplier determines how much larger that change will be:

• Multiplier = change in real GDP / initial change in spending. Alternatively, it can be rearranged to read Change in real GDP = initial change in spending x multiplier.

Numerical examples• Consumption in an economy rises by P40

million & real GDP rises by P120 million. Calculate the multiplier.

• Investment falls P20 million & real GDP falls by P60 million. Calculate the multiplier.

• Government spending falls by P30 million & real GDP falls by P90 million. Calculate the multiplier.

Three points to remember about the multiplier

• The initial change in spending is usually associated with investment because it is so volatile, but changes in consumption (unrelated to income), net exports, and government purchases also are subject to the multiplier effect

• The initial change refers to an upshift or downshift in the aggregate expenditures schedule due to a change in one of its components, like investment

• The multiplier works in both directions (up or down).

Rationale• The economy has continuous flows of expenditures

and income—a ripple effect—in which income received by A comes from money spent by B. B’s income, in turn, came from money spent by C, and so forth.

• Any change in income will cause both consumption and saving to vary in the same direction as the initial change in income, and by a fraction of that change– The fraction of the change in income that is spent is called

the marginal propensity to consume (MPC)– The fraction of the change in income that is saved is called

the marginal propensity to save (MPS)

The multiplier & marginal propensities• The size of the MPC and the multiplier are

directly related; the size of the MPS and the multiplier are inversely related.

• Multiplier = 1 / MPS or 1 / (1-MPC).• The significance of the multiplier is that a

small change in investment plans or consumption-saving plans can trigger a much larger change in the equilibrium level of GDP