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Lecture 8 - BASIC MACROECONOMIC RELATIONSHIPS.pptx
- 1. LECTURE 8: Basic Macro – Economic Relationships COURSE: MACRO-ECONOMICS COURSE INSTRUCTOR: SINDHU DAWANI
- 2. Learning Outcomes 1. How changes in income affect consumption (and saving). 2. About factors other than income that can affect consumption. 3. How changes in real interest rates affect investment. 4. About factors other than the real interest rate that can affect investment. 5. 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 consumptio n and disposable income in a specific year. 0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000 0 2000 4000 6000 8000 10000 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) (1) $370 (2) 390 (3) 410 (4) 430 (5) 450 (6) 470 (7) 490 (8) 510 (9) 530 (10) 550 $375 390 405 420 435 450 465 480 495 510 $-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 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 0 370 390 410 430 450 470 490 510 530 550 370 390 410 430 450 470 490 510 530 550 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 0 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 1. Dollars spent are received as income and Income received is spent (MPC). Initial changes in spending cause a spending chain 2. 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 ΔI= $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
Editor's Notes
- In this chapter, we examine the basic relationships that exist between three different pairs of economic aggregates. First we look at the trends in consumption (consumer spending) and saving, then we explore how changes in interest rates affect investment. Lastly, we discuss how initial changes in spending ultimately produce multiplied changes in GDP. There are many factors that determine a nation’s levels 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, that is, S = DI – C.
- We begin with the plot of a 45o angle line on a graph which relates disposable income on the horizontal (x) axis and consumption on the vertical (y) axis. At each point on the 45o line, C = DI. The relationship between C, DI, and S can be observed when the line of actual consumption over time is plotted in comparison to the 45o line. Each dot in this figure shows consumption and disposable income in a specific year, from 1985 to 2007. The line C, which generalizes the relationship between consumption and disposable income, indicates a direct relationship and shows that households consume most of their after-tax incomes. The vertical distance between the 45o line (which we let measures disposable income) and the consumption line labeled C represents the amount of savings in that year.
- 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 some specific time. The saving schedule is derived by subtracting consumption from disposable income and represents the various amounts households would plan to save at each of the various levels of disposable income prevailing at the time. The table on the next slide illustrates both consumption and savings schedule.
- Columns 1 and 2 show a hypothetical consumption schedule while columns 1 and 3 provide the savings schedule. Households, in the aggregate, increase their spending as their disposable income rises. Furthermore, they typically spend a larger proportion of a small disposable income than of a large disposable income. In this example, the break-even income is $390 billion, at row (2). At this income level, all disposable income is used for consumption spending, savings equals zero, and C = DI. At all higher incomes, households plan to save part of their incomes. At all lower incomes, dissaving (consuming in excess of after-tax income) will occur.
- In graph (a), the consumption schedule (or “consumption function”) depicts the direct consumption-disposable income relationship and in graph (b), the savings schedule shows the income-saving relationship in Table 27.1 graphically. The saving schedule in (b) is found by subtracting the consumption schedule in (a) vertically from the 45° line. Consumption equals disposable income (and saving thus equals zero) at $390 billion for these hypothetical data−the equilibrium for both schedules occurs at the same level of disposable income and anchors the relationship between the consumption and saving schedules. At $410 billion, saving equals $5 billion; on the other hand, at $370 billion, dissaving, or debt, equals $5 billion.
- Columns 4 to 7 in Table 27.1 show additional characteristics of the consumption and saving schedules. Columns 4 and 5 show average propensity to consume (APC) and average propensity to save(APS) at each of the 10 levels of DI included in the illustrations. The APC is derived from the fraction, or percentage, of total income that is consumed, while the APS represents the fraction of total income that is saved. For example, at $470 billion, APC = 450/470 = about 96% and APS = 20/470 = about 4%. APC + APS = 1 at any level of disposable income.
- Columns 6 and 7 in Table 27.1 provide marginal propensities data as well. The term marginal equates to “change in”. The marginal propensity to consume (MPC) represents the proportion, or fraction, of any change in income consumed and the marginal propensity to save (MPS) represents the proportion, or fraction of any change in income that is saved. For example, at $470 billion row 6 and $490 billion row 7, disposable income rises $20 billion and households consume $15 billion of this additional amount, or 15/20 = ¾= .75 = MPC. Reciprocally, MPS = 5/20 = ¼ = .25. The sum of MPC and MPS for any change in disposable income must always be 1, that is, MPC + MPS = 1. Algebraically, an alternate way of finding MPS is to subtract MPC from 1 (MPS = 1 – MPC); likewise, MPC can be determined by subtracting MPS from 1 (MPC = 1 – MPS).
- An interesting facet of MPC and MPS is that MPC also represents the numerical value of the slope (∆C/∆DI) of the consumption schedule and MPS represents the numerical value of the slope (∆S/∆DI) of the saving schedule from which they are derived. The Greek letter delta (∆) means “the change in.” We can observe in the figure that consumption changes by $15 billion (the vertical change) for each $20 billion change in disposable income (the horizontal change). The slope of the consumption line is thus .75 (= $15/$20), which is the value of the MPC. Similarly, the slope of the savings line is .25 (= $5/$20) which is the value of the MPS.
- The relationship between disposable income, consumption, and saving is significant, but a few non income factors also influence spending and saving behavior as well. The first of these non income determinants involves changes in wealth and the wealth effect. Wealth refers to the dollar amount of all the assets that a household owns minus the dollar amount of its liabilities (all the debt that it owes). When events boost the value of existing wealth, households increase their spending and reduce their saving. This so-called wealth effect shifts the consumption schedule upward and the saving schedule downward. A second determinant is household borrowing that affects consumption. Borrowing in the present allows for higher consumption in the present and shifts the current consumption function upward. But in the future, consumption must be lowered as the debts that are incurred due to the borrowing must be repaid. Another factor of consumption and savings is changes in the expectations of household members about future prices and income that may also affect current spending and saving. For example, expectations for rising prices in the future may prompt households to spend more and save less today. In contrast, expectations for lower prices in the future may have a negative impact on spending and a positive impact on saving behavior among households today. A final determinant is changes in real interest rates, or interest rates adjusted for inflation, that also affect spending and saving behavior among household members. When real interest rates fall, households tend to borrow more, consume more, and save less, while increases in real interest rates bring about the opposite behavior among household members.
- there are several other important points regarding the consumption and saving schedules. These include switching to real GDP, changes along schedules, schedule shifts, taxation, and stability. When developing macroeconomic models, economists change their focus from consumption, savings, and disposable income to the relationship between consumption, savings, and real GDP. (On the next slide, we graphically reflect this modification.) The movement from one point to another on a consumption schedule is a change in the amount consumed and is solely caused by a change in real GDP. Conversely, a shift upward or downward of the entire schedule is a shift of the consumption schedule and is caused by changes in wealth, borrowing, expectations, and real interest rates. As the consumption schedule shifts in one direction, the saving schedule moves in the opposite direction. In contrast, a change in taxes shifts the consumption and savings schedules in the same direction. As taxes increase, both consumption and saving schedules shift down; conversely, households will partly consume and partly save any decrease in taxes. A final important consideration is that consumption and saving schedules are usually relatively stable unless altered by major tax changes.
- These two graphs illustrate shifts in the consumption and savings schedules. Normally, if households consume more at each level of real GDP, they are necessarily saving less. Graphically this means that an upward shift of the consumption schedule (C0 to C1) entails a downward shift of the saving schedule (S0 to S1). If households consume less at each level of real GDP, they are saving more. A downward shift of the consumption schedule (C0 to C2) is is reflected in an upward shift of the saving schedule (S0 to S2). This pattern breaks down, however, when taxes change; then the consumption and saving schedules move in the same direction—opposite to the direction of the tax change.
- We now turn our focus toward examining the relationship between interest rates and investment. 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 interest rate that must be paid for borrowed funds, i ). The expected rate of return represents an estimation of the net expected revenue of an investment opportunity and the real interest rate is crucial in making investment decisions in that it discounts current inflation. Firms should undertake all endeavors it thinks will be profitable up to the point at which marginal benefit equals marginal cost, or r = i.
- The table presented here shows expected rates of return and the cumulative, or total amount of investment occurring at each rate of return or higher.The relationship between the two variables is inverse. As the expected rate of return falls, the cumulative amount of investment for which r equals i rises.
- The data from the prior table, once plotted graphically, gives us the investment demand curve, ID. By applying the marginal-benefit– marginal-cost rule that investment projects should be undertaken up to the point where r = i, we see that we can add the real interest rate to the vertical axis in the figure. The curve not only shows rates of return; it shows the quantity of investment demanded at each “price” i (interest rate) of investment. Thus, the level of investment depends on the expected rate of return and the real interest rate.
- In general, any factor that leads businesses collectively to expect greater rates of return on their investments, increases investment demand and shifts the curve rightward (ID0 to ID1). Any factor that leads businesses collectively to expect lower rates of return on investment shifts the curve to the left (ID0 to ID2).
- 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, and expectations. The first of these factors involves changes in acquisition, maintenance, and operating costs of capital goods. When any of these costs fall, the expected rate of return from potential investment rises and the investment demand curve shifts rightward. The opposite occurs if these costs increase. A second determinant is changes in business taxes. After tax expected return for businesses will rise and the investment demand curve will shift to the right when business taxes fall. Technological progress brings about the development of new products, improvements in existing products, and the creation of new machinery and production processes—all of which stimulates investment demand. The stock of capital goods on hand, relative to output and sales, also affects investment demand of firms. When the economy is overstocked with production facilities and firms have excess inventories of finished goods, the expected rate of return on new investment declines, as does the demand for investment funds. When the economy is under-stocked with production facilities and inventories of finished goods are low, the opposite will occur. Planned inventory changes also impacts investment demand. If firms are planning to increase their inventories, the investment demand curve shifts to the right; a planned decrease in inventories shifts it to the left. Lastly, when executives have positive expectations and are more optimistic about future sales, costs, and profits, the investment demand curve will shift to the right; a pessimistic outlook will shift the curve to the left.
- Investment tends to be more unstable than consumption, and is the most volatile component of total spending. There are several factors that affect the variability of investment. The first factor is the durability of capital goods which have an indefinite useful life. Firms that choose to replace such goods will require higher levels of investment whereas firms that decide to repair existing capital goods instead will need smaller amounts of investment. A major determinant of investment is technological progress. Technological innovation tends to come about in waves, therefore investment tends to follow this trend as well. The variability of profits contributes to the volatile nature of the incentive to invest. Expanding profits give firms both greater incentives and greater means to invest, whereas declining profits have the reverse effects. The last factor involves variability of business expectations. Changes in exchange rates, court decisions in key labor or antitrust cases, changes in trade barriers, changes in governmental economic policies, stock market fluctuations, and a host of similar considerations often suggest significant possible changes in future business conditions.
- The figure here shows annual percentage change in real gross investment and real GDP from 1971 t0 2007. The swings in investment are much greater than those of GDP illustrating just how volatile investment spending in the United States has been. Changes in investment cause most of the fluctuations in output and employment that occur over the course of the business cycle.
- A final basic relationship that requires discussion is the relationship between changes in spending and changes in real GDP. A change in spending, say, investment, ultimately changes output and income by more than the initial change in investment spending. This surprising result is called the multiplier effect which is defined as a change in a component of total spending leading to a larger change in GDP.
- The multiplier is determined by dividing a given change in real GDP by the initial change in spending that preceded it (multiplier = change in real GDP/initial change in spending). This equation can be rearranged as: change in real GDP = the multiplier X the initial change in spending. If the economy experiences an increase of $30 billion in investment spending and this leads to an increase of $90 billion change in GDP, we know that our multiplier is $90 / $30 = 3
- There are the important points about the multiplier that are worth mentioning. “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.
- The multiplier effect emanates from two facts. First, the economy supports repetitive, continuous flows of spending and income through which dollars spent by A are received as income by B, and then spent by B and received as income by C, and so on. 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.
- It follows that an initial change in spending will set off a spending chain throughout the economy and that initial changes in spending produce magnified changes in output and income. Table 27.3 illustrates the rationale underlying the multiplier effect. An increase in investment of $5 billion following the rounds of multiplier effect, leads to a $20 billion change in income, $15 billion increase in consumption (C) spending, and $5 billion increase in saving (S).
- The following figure shows several rounds of the multiplier process of Table 27.3 graphically. With an MPC = .75, an initial change in investment spending of $5 billion creates an equal $5 billion of new income in round 1. Households spend $3.75 (=.75 X $5) billion of this new income, creating $3.75 of added income in round 2. Of this $3.75 of new income, households spend $2.81 (=.75 X $3.75) billion, and income rises by that amount in round 3. Such income increments over the entire process get successively smaller but eventually produce a total change of income and GDP of $20 billion. The multiplier therefore is 4 (=$20 billion/$5 billion).
- The MPC and the multiplier are directly related and the MPS and the multiplier are inversely related. The multiplier = 1/(1-MPC) but recall, too, that MPC + MPS = 1. Rearranging, MPS = 1 – MPC. So the multiplier can also be written as: multiplier = 1/MPS. So the smaller the fraction of any change in income saved, the greater the respending at each round and, therefore, the greater the multiplier. A large MPC (small MPS) means the succeeding rounds of consumption spending diminish slowly and thereby cumulate to a large change in income. Conversely, a small MPC (a large MPS) will have the opposite effect. The relationship between the MPC and thus the MPS) and the multiplier is summarized in Figure 27.9 .
- The relationship between the MPC (and thus the MPS) and the multiplier is summarized in the accompanying table. The larger the MPC (the smaller the MPS), the greater the size of the multiplier. To verify this, we can review two examples. Example 1: MPC = .75 and (1 - .75) = .25, therefore MPS = .25 and the multiplier is 4 (= 1/.25). Example 2: MPC = .9 and (1 - .9) = .1, therefore MPS = .1 and the multiplier is 10 (= 1/.1).
- Our simplified example overstates the impact of MPS in that, in addition to saving, households use some of the extra income in each round to purchase additional goods from abroad (imports) and pay additional taxes which, in turn, drains off some of the additional consumption spending and diminishes the multiplier effect. The Council of Economic Advisers estimated the actual multiplier effect for the U.S. to be about 2.