Lecture 8 - BASIC MACROECONOMIC RELATIONSHIPS.pptx

LECTURE 8 BASIC MACRO ECONOMIC RELATIONSHIPS

1. LECTURE 8: Basic Macro – Economic Relationships COURSE: MACRO-ECONOMICS COURSE INSTRUCTOR: SINDHU DAWANI

2. Learning Outcomes 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. THE INCOME - CONSUMPTION AND INCOME - SAVINGS RELATIONSHIPS There are many factors that determine a nation’s level of consumption (C) and saving (S), but the most significant is Disposable Income (DI). In examining the relationship between income and consumption, we are also exploring the relationship between income and saving. Personal saving is the part of Disposable Income that is not consumed, S = DI - C

4. Consumption and Disposable Income, 1980-2006 Each dot in this figure shows consumption and disposable income in a specific year. Consumption (billions of dollars) Disposable Income (billions of dollars) 45 ° Reference Line C=DI 83 86 85 84 88 89 91 90 87 92 93 94 95 01 97 96 99 98 00 02 05 03 04 Consumption In 1992 Saving In 1992 45 ° C Source: Bureau of Economic Analysis

5. Deriving the Consumption and Savings Schedules The consumption schedule shows the various amounts households would plan to consume at each of the different levels of disposable income that might prevail at a given time. The saving schedule is derived by subtracting consumption from disposable income.

6. Consumption and Saving Schedule (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) Average Propensity to Save (APS) (3)/(1) (6) Marginal Propensity to Consume ( MPC) Δ (2)/ Δ (1) (7) Marginal Propensity to Save ( 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 .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 MPC + MPS = 1 MPC and MPS measure slopes

7. Consumption and Saving Schedules graphed Breakeven income equals $390 bn , where C=DI and S=0 At $410 bn , saving equals $5 bn , at $370 bn , dissaving equals $5 bn. 500 475 450 425 400 375 45 ° 50 25 390 410 430 450 470 490 510 530 550 390 410 430 450 470 490 510 530 550 C S Consumption Schedule Saving Schedule Saving $5 Billion Dissaving $5 Billion Dissaving $5 Billion Saving $5 Billion Disposable Income (billions of dollars) Consumption (billions of dollars) Saving (billions of dollars)

8. Average Propensities to Consume and Save Average propensity to consume (APC ) : the fraction, or percentage, of total income that is consumed. Average propensity to save (APS ): the fraction, or percentage, of total income that is saved. APS = Saving Income APC = Consumption Income

9. Marginal Propensities to Consume and Save Marginal propensity to consume (MPC ): the proportion, or fraction, of any change in income that is consumed. Marginal propensity to save (MPS ): the proportion, or fraction, of any change in income that is saved . MPC = Change in Consumption Change in Income MPS = Change in Saving Change in Income

10. MPC and MPS as slopes The MPC is the slope ( ∆C/∆DI) of the consumption schedule, and the MPS(∆S/ ∆DI) is the slope of the saving schedule.

11. Non-income determinants of consumption and saving Other Non-income determinants that affect the consumption and savings schedule include: Wealth Borrowing Expectations Real interest rates

12. Other Important Considerations There are several other important points regarding the consumption and saving schedules. These include: Changes along schedules Switch to real GDP Schedule shifts Stability Taxation

13. Shifts of the consumption and savings schedules

14. The Interest Rate – Investment relationship The two basic determinants of investment spending are expected returns (profit) and the interest rate. The investment decision is one that considers the marginal benefit from investment (the expected rate of return, r) and the marginal cost of investment (the real interest rate, i ). Firms should undertake all projects it thinks will be profitable up to the point at which r = i .

15. Rates of expected return and investment As the expected rate of return falls, the cumulative amount of investment having this rate of return or higher rises.

16. Investment Demand Curve Expected Rate of Return (r) Cumulative Amount of Investment Having This Rate of Return or Higher (I) 16% 14% 12% 10% 8% 6% 4% 2% 0% $ 0 5 10 15 20 25 30 35 40 r and i (percent) 16 14 12 10 8 6 4 2 5 10 15 20 25 30 35 40 Investment (billions of dollars) ID

17. Shifts of the Investment Demand curve Increases in Investment Demand are shown as rightward shifts of the ID curve; decreases in investment demand are shown as leftward shifts of the ID curve.

18. Non-Interest Rate Determinants of Investment Demand Several non-interest-rate determinants also affect investment demand, such as: Changes in acquisition , maintenance, and operating costs Changes in Business taxes Technological change Stock of capital goods on hand Planned inventory changes Expectations

19. Instability of investment Investment tends to be more unstable than consumption for the following reasons: Durability of capital goods Irregularity of innovation Variability of profits Variability of expectations

20. Volatility of Investment Source: Bureau of Economic Analysis

21. The Multiplier Effect More spending results in higher GDP Initial change in spending changes GDP by a multiple amount

22. The Multiplier Multiplier = Change in Real GDP Initial Change in Spending

23. Three points about the Multiplier “Initial changes in spending” are usually associated with changes in investment spending because of investment volatility, but changes in consumption (unrelated to changes in income), net exports, and government purchases also lead to the multiplier effect. In addition, the “initial change in spending” associated with investment spending results from a change in the real interest rate and/or a shift of the investment demand curve. Finally , the multiplier works in both directions. A decrease in spending may be multiplied into a larger decrease in GDP just as an increase in spending may be multiplied into a larger increase in GDP .

24. Rationale of the Multiplier effect Rationale Dollars spent are received as income and Income received is spent ( MPC). Initial changes in spending cause a spending chain And second, any change in income will vary both consumption and saving in the same direction as, and by a fraction of the change in income.

25. The Multiplier – a tabular illustration (1) Change in Income (2) Change in Consumption (MPC = .75) (3) Change in Saving (MPC = .25) 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

26. The Multiplier illustrated Rounds of Spending 1 2 3 4 5 All $20.00 15.25 13.67 11.56 8.75 5.00 $5.00 $3.75 $2.81 $2.11 $1.58 $4.75 Δ I= $5 billion

27. The Multiplier and the Marginal Propensities Multiplier = 1 1 - MPC Multiplier = 1 MPS -or-

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

29. How large is the actual Multiplier effect? In addition to savings, households also purchase additional goods from abroad and pay additional taxes which drains off some of the additional consumption spending. This diminishes the multiplier effect and the 1/MPS formula for the multiplier overstates the actual outcome. The Council of Economic Advisors estimated the actual multiplier for the U.S. to be about 2.

30. Key terms 45 °(degree) line consumption schedule saving schedule break-even income average propensity to consume (APC) average propensity to save (APS) marginal propensity to consume (MPC) marginal propensity to save (MPS) wealth effect expected rate of return investment demand curve multiplier

31. THANK YOU… NEXT CHAPTER PREVIEW: The Aggregate Expenditures Model