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09 Basic Macroeconomic Relationships

The document discusses several macroeconomic relationships: 1) Household consumption and saving are determined by disposable income, with consumption rising as income rises and households saving the remainder. 2) Business investment depends on the expected rate of return compared to the real interest rate - businesses invest when expected returns exceed interest costs. 3) The multiplier effect means that an initial change in spending, such as an increase in investment, leads to a larger change in overall GDP as incomes rise and new consumption is triggered in a ripple effect through the economy. The size of the multiplier depends on the marginal propensity to consume.

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catherine tucay
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20 views3 pages

09 Basic Macroeconomic Relationships

The document discusses several macroeconomic relationships: 1) Household consumption and saving are determined by disposable income, with consumption rising as income rises and households saving the remainder. 2) Business investment depends on the expected rate of return compared to the real interest rate - businesses invest when expected returns exceed interest costs. 3) The multiplier effect means that an initial change in spending, such as an increase in investment, leads to a larger change in overall GDP as incomes rise and new consumption is triggered in a ripple effect through the economy. The size of the multiplier depends on the marginal propensity to consume.

Uploaded by

catherine tucay
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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ECON 2 PRINCIPLES OF ECONOMICS 2

BASIC MACROECONOMIC RELATIONSHIPS


Session 9

INCOME-CONSUMPTION AND INCOME-SAVING


RELATIONSHIPS change∈consumption
MPC=
change∈income
Disposable income is the most significant
Marginal Propensity to Save (MPS): the proportion of a
determinant of a nation’s level of consumption and saving.
change in saving to a change in income
Saving: the part of after-tax disposable income not
consumed
change∈saving
APS=
change∈income
Saving ( S )=Disposable Income ( DI ) −Consumption(C)
MPC + MPS = 1. The fraction of any change in income not
Consumption Schedule: a schedule showing the amounts consumed is saved. The fraction consumed plus the
households plan to spend for consumer goods at different fraction saved must exhaust the whole change in income.
levels of disposable income
Non-income Determinants of Consumption and
Saving Schedule: a schedule that shows the amounts Saving
households plan to save at different levels of disposable
income Certain factors other than income might prompt
households to consume more or less at each possible
In the aggregate, households increase their level of income and thereby change the locations of the
spending as their disposable income rises and spend a consumption and saving schedules.
larger proportion of a small disposable income than of a
large disposable income. 1. Wealth
Dissaving, consuming in excess of disposable 2. Borrowing
income, occurs at relatively low disposable incomes. 3. Expectations
Households can consume more than their current incomes 4. Real Interest Rates
by liquidating accumulated wealth or by borrowing.
At all higher incomes, households plan to save part Other Important Considerations
of their incomes.
1. Switching to real GDP
Average Propensities 2. Changes along schedules
3. Simultaneous shifts
Average Propensity to Consume (APC): the percentage of 4. Taxation
total income that is consumed 5. Stability

THE INTEREST-RATE – INVESTMENT RELATIONSHIP


consumption
APC=
disposable income Expected Rate of Return (r)

Average Propensity to Save (APS): the percentage of Investment consists of expenditures on new plants,
income that is saved capital equipment, machinery, inventories etc. The
investment decision weighs marginal benefits and
saving marginal costs.
APS= The marginal benefit from investment is the
disposable income
expected rate of return businesses hope to realize. The
APC + APS = 1 at any level of disposable income marginal cost is the interest rate that must be paid for
because income is either consumed or saved. borrowed funds. Businesses will invest in projects for
which the expected return exceeds the interest rate.
Marginal Propensities Expected rate of return is found by comparing the
expected economic profit (total revenue minus total cost)
Marginal Propensity to Consume (MPC): the proportion of to cost of investment.
a change in consumption to a change in income

INSTRUCTOR: NIÑA MAE BIANCA J. MARTIN LESSON 9


PAGE 1
ECON 2 PRINCIPLES OF ECONOMICS 2

total revenue−total cost results in higher GDP, while less spending results in lower
r= GDP.
cost of investment
Multiplier Effect: a change in a component of total
If r = 10%, the business would not want to pay more
spending leads to a larger change in GDP
than 10% interest rate on investment. The expected rate
of return is not a guaranteed rate of return. Investment change∈real GDP
Multiplier=
carries risk. initial change∈ spending
The Real Interest Rate (i) Change∈GDP=multiplier ×initial change∈spending
 Nominal rate collected for expected inflation
 Determines the cost of investment Points to remember about the multiplier:
 Rule: invest up to the point where i = r 1) The “initial change in spending” is usually
o i > r = do not invest associated with investment spending because it is
o i < r = invest so volatile, but changes in consumption (unrelated
to income), net exports, and government purchases
Investment Demand Curve also lead to the multiplier effect
 shows the total monetary amounts that will be 2) The “initial change in spending” associated with
invested by an economy at various possible interest investment spending results from a change in the
rates real interest rate and/or a shift of the investment
 graph indicating the demand for investment goods demand curve
by the entire business sector that have different 3) The multiplier works in both directions (up or down)
expected rates of return
The ripple effect: the economy has continuous flows of
Factors that will shift the Investment Demand Curve expenditures and income

1. Acquisition, maintenance, operating costs Example: Mr. Holmes buys lunch at Ms. Lynde’s
2. Business taxes hometown diner. Ms. Lynde takes the income earned
3. Technological change from her sales and buys a new dress at Ms. O’Hara’s
4. Stock of capital goods on hands clothing boutique. Ms. O’Hara takes the income earned
5. Planned inventory changes from her sales and buys a new car from Mr. Rochester.
6. Expectations And so it goes.

Instability of Investment Any change in income will cause both consumption


1) Durability and saving to vary in the same direction as the initial
 Capital goods have an indefinite useful life change in income, and by a fraction of that change.
 Spending can be postponed
2) Irregularity of Innovation The Multiplier and Marginal Propensities
 New products and processes stimulate
investment Marginal Propensity to Consume (MPC)
 Innovations occur irregularly, adding to the  The fraction of the change in income that is spent
volatility of investment  Size directly related to multiplier
3) Variability of Profits  A large MPC (small MPS) means the succeeding
 High current profits generate optimism about rounds of consumption spending diminish slowly &
the future profitability of new investments cumulate to a large change in income
 Low current profits or losses spawn doubt  A small MPC (large MPS) causes the increases in
4) Variability of Expectations consumption to decline quickly, so the cumulative
 Expectations can change quickly when some change in income is small
event suggests a significant possible change
in future business conditions 1
Multiplier=
1−MPC
THE MULTIPLIER EFFECT
Marginal Propensity to Save (MPS)
Changes in spending ripple through the economy to  The fraction of the change in income that
create even larger changes in real GDP. More spending is saved

INSTRUCTOR: NIÑA MAE BIANCA J. MARTIN LESSON 9


PAGE 2
ECON 2 PRINCIPLES OF ECONOMICS 2

 Size inversely related to multiplier

1
Multiplier=
MPS

INSTRUCTOR: NIÑA MAE BIANCA J. MARTIN LESSON 9


PAGE 3

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