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)
 Schedules
500

475

450
Consumption (Pula)

Consumption
425 Schedule
400

375

45°

Disposable Income (Pula)

50
25 Saving Schedule
Saving
(Pula)

Disposable Income (Pula)

 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) (4) (5) (6) (7)
Level of Average Average Marginal Marginal
Output (2) Propensity Propensity Propensity Propensity
And Consump- (3) to Consume to Save to Consume to Save
Income tion Saving (S) (APC) (APS) (MPC) (MPS)
(GDP=DI) (C) (1-2) (2)/(1) (3)/(1) Δ(2)/Δ(1) Δ(3)/Δ(1)

(1) P370 P375 P-5 1.01 -.01

.75 .25
(2) 390 390 0 1.00 .00
.75 .25
(3) 410 405 5 .99 .01
.75 .25
(4) 430 420 10 .98 .02
.75 .25
(5) 450 435 15 .97 .03
.75 .25
(6) 470 450 20 .96 .04
.75 .25
(7) 490 465 25 .95 .05
.75 .25
(8) 510 480 30 .94 .06
.75 .25
(9) 530 495 35 .93 .07
.75 .25
(10) 550 510 40 .93 .07
 Non-income determinants of
consumption & saving
• 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.
 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 apart from the
occur when any determinant
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
• Instability of Investment
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