This document discusses basic macroeconomic relationships including consumption, investment, and the multiplier effect. It contains the following key points: 1) Consumption is directly related to disposable income, with a marginal propensity to consume (MPC) of typically around 0.75. This means that an additional $1 of income leads to $0.75 of additional consumption. 2) Investment demand is negatively related to real interest rates, with the investment demand curve sloping downward. Factors like expectations, costs, and technological change can cause shifts in the investment demand curve. 3) The multiplier effect describes how an initial change in spending, such as an increase in investment, leads to a multiplied impact on overall

1. CHAPTER 30
Basic Macroeconomic Relationships

2. The Income-Consumption and Income-Saving Relationships
Nonincome Determinants of Consumption and Saving
The Interest-Rate–Investment Relationship
Shifts of the Investment Demand Curve
The Multiplier Effect
30-2
Chapter Contents

3. GDP and Components
• Total production (GDP) is same as national income (Y) and
aggregate expenditure (AE)
• AE has four components
• Consumption (C): 2/3 of GDP
• Investment (I): Irregular
• Government purchases (G)
• Net exports (NX): Mostly negative
• To understand business cycle, it is important to understand
how they are related.
13-3

4. Basic Macroeconomic Relationships
• Three basic macroeconomic relationships
• Consumption and Income
• Consumption and saving
• Interest rate and Investment
• Spending and Output
• Multiplier effect
13-4

5. Total Income, Disposable Income,
Consumption, and Saving
• Total Income (Y) earned by households equal to GDP
• Net taxes: Taxes minus transfer payments
• NT = Taxes – Transfer payments
• Disposable Income: Income after taxes and transfer payments
• DI = Y – NT
• Disposable Income can be freely spent (consumption) or saved
(saving) by households.
• DI = C + S
• When C < DI, S > 0 (Saving)
• When C > DI, S < 0 (Dis-saving)
LO30.1
30-5

6. Consumption Schedule
• Consumption schedule: A table or curve that shows the
various amount that households plans to spend at each of a
series of possible disposable income.
• Disposable income is the major determinant of consumption
• Direct relationship between disposable income and
consumption
• Higher the disposable income, higher the consumption.
• Consumption function: A diagram or mathematical equation
representation of consumption schedule
• Saving schedule and saving function 13-6

7. Consumption and Disposable Income, 1993–2015
Source: Bureau of Economic Analysis.
LO30.1
30-7

8. Consumption and Saving Schedules
(1)
Disposable
Income
(DI)
(2)
Consumption
(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),
(2)/(1)
(7)
Marginal
Propensity to
Save
(MPS),
(3)/(1)
(1) $370 $375 $−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 .75 .25
LO30.1
30-8

9. Consumption and Saving Functions
LO30.1
30-9
• 45 line indicates where C = DI.
• A vertical Distance between 45
line and consumption function is
saving:
• S = DI – C.
• Both consumption and saving
schedules are upward sloping,
indicating a direct relationship
between disposable income and
each of them.
• A slope of consumption
schedule is less than 1 (flatter
than 45 line).

10. Marginal Propensities
• Marginal propensity to consume (MPC): Proportion of a
change in disposable income consumed.
• Because households spends only fraction of disposable income
and save the rest, MPC is less than 1.
• Marginal propensity to save (MPS): Proportion of a change
in disposable income saved.
MPC + MPS = 1
LO30.1
30-10
MPS =
change in disposable income
change in saving
MPC =
change in consumption
change in disposable income
=
ΔC
ΔDI

11. Marginal Propensity to Consume
LO30.1
Consumption
C
MPC =
15
20
= .75
C ($15)
DI ($20)
0
Disposable income
30-11
MPC=0.75 means
• 75% of additional disposable
income will be spent.
• When household’s disposable
income increases by $1, the
household will spend 75¢ portion
of additional $1 income.
• It is also a slope of consumption
function.

12. Average Propensities
• Average propensity to consume (APC): Fraction of
disposable income consumed.
• Average propensity to save (APS): Fraction of disposable
income saved.
• National saving rate
APC = APS =
consumption
disposable income disposable income
saving
APC + APS = 1
LO30.1
30-12

13. Global Perspective 30.1
Source: Bureau of Economic Analysis.
LO30.1
AVERAGE PROPENSITIES TO CONSUME, SELECTED NATIONS, 2018
30-13

14. Consumption and GDP
• We focus on how real GDP (Total income) relates to
consumption
• Disposable income is total income after taxes and transfer
payments: Y = DI + NT
• For simplicity, we assume net tax constant (same next tax for
all levels of total income).
13-14

15. Consumption Schedule with GDP
13-15
Consumption Schedules (in Billions)
Total
Income
(Real GDP)
Net Taxes
(NT)
Disposable
Income
(DI)
Consumption
(C)
$375 $5 $370 $375
395 5 390 390
415 5 410 405
435 5 430 420
455 5 450 435
475 5 470 450
495 5 490 465
515 5 510 480
535 5 530 495
555 5 550 510
• How consumption relates to
real GDP?
• Real GDP = Y (Total Income)
• NT (Net taxes) is constant at
$5 regardless of income level
• DI = Y - NT

16. Consumption Function with GDP
• Slope of consumption
function is 0.75, same
as MPC.
• Changing to GDP does
not affect the slope of
consumption function.
• At point (a) where
consumption function
crosses 45° line,
GDP = C = $375,
NT = $5, and
S = -$5.
13-16
45°
C0
Real GDP (billions of dollars)
Consumption
(billionsofdollars)
325 350 375 400 425 450 475 500
475
450
425
400
375
350
325
a

17. Determinants of Consumption
• Amount of disposable income is the main determinant
• Other determinants
• Wealth: Wealth↑ → Consumption↑
• Expectations:
Income Expectation↑ → Consumption↑
• Real interest rates: Affect an amount of borrowings and savings,
which affect consumption
Real interest rates↑ → Borrowings↓ & Savings↑
→ Consumption↓
LO30.2
30-17

18. Changes in Consumption Schedule
• When the determinant of
consumption changes, the
consumption function shifts.
• Wealth ↑ →
Consumption function ↑ to (C1)
• Income Expectation ↑ →
Consumption function ↑ to (C1)
• Real interest rates ↑ →
Consumption function ↓ to (C2)
13-18
• As consumption function shifts up (down), saving function shifts down
(up).
Consumption(billionsofdollars)
0
Real GDP (billions of dollars)
C0
C2
C1
45°
Increase in
consumption
Decrease in
consumption

19. Interest-Rate–Investment Relationship
• Investment: Firms’ spending on new plants,
equipment, machinery, and tools
• It also includes planned inventory changes
• Firm’s investment depends on
• Expected rate of return on investment project:
Expected rate of return ↑ → investment ↑
• Real interest rate:
• Investment projects are financed by borrowing
• Real interest rate on borrowing is the opportunity cost of
investmentLO30.3
30-19

20. Investment Demand
• Investment demand: A relationship between the real
interest rate and Investment
• Real interest rate ↑ → investment ↓
• Investment demand curve is downward-sloping.
LO30.3
30-20

21. Investment Demand Curve
Real Interest
Rate (i) and
Expected Rate
of Return (r)
Cumulative Amount of
Investment Having this
Rate of Return or Higher,
Billions per Year
16% $ 0
14 5
12 10
10 15
8 20
6 25
4 30
2 35
0 40
LO30.3
Expectedrateofreturn,r
andrealinterestrate,i(percents)
16
14
12
10
8
6
4
2
0 5 10 15 20 25 30 35 40
Investment (billions of dollars)
Investment
demand
curve
ID
30-21

22. Shifts of Investment Demand
• Investment demand changes when changes in
• Business taxes↑ → investment ↓
• Acquisition, maintenance, and operating costs↑ → investment ↓
• Technological change↑ → investment ↑
• Stock of capital goods on hand ↑ → investment ↓
• Expectations
• Expected return↑ → investment ↑
• Expected risk↑ → investment ↓
• Expected sales↑ → Planned inventory changes ↑ → investment ↑
LO30.4
30-22

23. Shifts of the Investment Demand Curve
LO30.4
Expectedrateofreturn,r,and
realinterestrate,i(percents)
0
Investment (billions of dollars)
ID0 ID1ID2
Increase
in investment
demand
Decrease in
investment
demand
30-23
• When real interest rate changes, it
moves along the investment demand
curve (ID0)
• When investment increases due to
change in other determinants, the
investment demand curve shifts to
right (ID1).
• When investment decreases due to
change in other determinants, the
investment demand curve shifts to
left (ID2).

24. Global Perspective
• China invests far more than any
other country as percentage of
GDP. Since China’s GDP is ranked
second in the worlds, in absolute
quantity, China made largest
investment in the world.
• Investment will increase capital
resource along with new
technology. How will it affect
China’s economic growth?
• At the same time, in order to
invest, China must consume less
and save more than any other
countries. 13-24

25. Instability of Investment
• Investment demand is volatile due to
• Variability of expectations
• Variability of profits
• Both expectations and profits change along the business cycle
• Optimistic expectations and high profits during expansions, while
pessimistic expectations and low profits during recessions.
• Irregularity of innovation
• Durability: Investment can be postponed.
LO30.4
30-25

26. Investment and GDP in the U.S. 1976-2015
• Investment spending
changes erratically
• Investment spending
fluctuates much more
than GDP
• When Investment
spending is down (up),
GDP is also down (up).
• Investment spending
downturns correspond
to recessions.
13-26

27. The Multiplier Process
• When one of components of GDP changes, GDP also changes.
GDP ↑ = C + I + G + NX ↑
• Then, a change in GDP (national Income) causes a change in
consumption.
GDP ↑  DI ↑  C ↑
• A change in consumption further changes GDP.
• …
• Eventually, GDP will change more than an initial change in one
component which started the multiplier process.
13-27

28. Multiplier Process in Circular Flow
• The initial increase in
investment ($5.00) brought an
even bigger increase in real
GDP because it induced an
increase in consumption
expenditure.
• If MPC = 0.75, then
13-28
+$5
+$5 +$3.75 + $2.81 …
+$3.75 + $2.81 …+$5 +$3.75 + $2.81 …
I by $5.00  GDP by $5.00  Y by $5.00
 C by $3.75 (= 0.75 x $5.00)  GDP by $3.75
 Y by $3.75  C by $2.81 (= 0.75 x $3.75) …..

29. The Multiplier Process (MPC = 0.75)
LO30.5
30-29

30. The Multiplier Effect
• A change in spending changes real GDP more than the initial change in
spending.
• Initial change in investment by $5.00 results in $20 change in real GDP.
• Multiplier = 4 means any change in one of expenditure components
(C, I, G, NX) eventually changes GDP by fourfold.
Multiplier =
change in real GDP
initial change in spending
LO30.5
30-30
Multiplier =
$20
$5
= 4

31. The Multiplier Effect
• You can use the multiplier to find out how much real GDP will
change if one of expenditure components changes.
• If multiplier =4 and if investment decreases by $10, then real GDP
will decrease by $40.
Change in GDP = 4 x $10 = $40
Change in GDP = multiplier × initial change in spending
LO30.5
30-31

32. Multiplier and Marginal Propensities
• Multiplier and MPC directly related: Large MPC results in
larger increases in spending.
• If MPC = 0.75,
Multiplier =
1
1 − MPC
LO30.5
30-32
Multiplier =
1
1 − 0.75
=
1
0.25
= 4

33. The MPC and the Multiplier
LO30.5
30-33
Multiplier =
1
1- MPC

34. The Actual Multiplier Effect?
• In the U.S. APC is about 0.96 and MPC is estimated around
0.9.
• If MPC=0.9, then the multiplier = 10.
• However, actual multiplier in the U.S. is less than 10 because
• Consumers buy imported products
• Income taxes are not fixed, but marginal tax and progressive
• Inflation
• The multiplier is estimated between 2.5 and 0.
LO30.5
30-34

35. Investment and Business Cycle
• Even though Investment is a small portion of GDP, its
irregular changes have multiplier effect on GDP of economy.
• When entrepreneurs become pessimistic, they cut investment
spending
• Creates a ripple effect of people not spending, following the first
decision
• Ultimately the entire economy experiences an economic
downturn – recession
• Business cycles are result of irregular changes in Investment
and other components of GDP 13-35

36. Last Word: Toppling Dominoes
• Humorous example of the multiplier.
• One person in town decides not to buy a product.
• Creates a ripple effect of people not spending,
following the first decision.
• Ultimately, the entire town experiences an economic
downturn.
30-36