Chapter 8Chapter 8

Basic Macroeconomic Basic Macroeconomic RelationshipRelationship

The Income-Consumption RelationshipThe Income-Consumption Relationship

Consumption function:Consumption function:

The consumption function is the relationship between The consumption function is the relationship between consumer expenditure and disposable income.consumer expenditure and disposable income.

Of the many possible factors influencing the level of Of the many possible factors influencing the level of consumer expenditure, the level of real disposable income consumer expenditure, the level of real disposable income is most important.is most important.

Men are disposed , as a rule and on the average, to Men are disposed , as a rule and on the average, to increase their consumption as their income increases, but increase their consumption as their income increases, but not by as much as the increase in income.not by as much as the increase in income.

The Consumption and Saving functionsThe Consumption and Saving functionsDisposableDisposable

IncomeIncome

Y-tY-t

Consumer Consumer expenditureexpenditure

CC

Autonomous Autonomous

ExpenditureExpenditure

aa

Induced Induced expenditureexpenditure

b(y-t)b(y-t)

SavingSaving

ss

A 0A 0 55 55 00 -5-5

B 20B 20 2020 55 1515 00

C 40C 40 3535 55 3030 55

D 60D 60 5050 55 4545 1010

Change in Change in

DisposableDisposable

IncomeIncome

Change in Change in consumer consumer expenditureexpenditure

Change in Change in savingsaving

Marginal Marginal propensity propensity to consumeto consume

Marginal Marginal propensity propensity to saveto save

2020 1515 55 15/20=0.7515/20=0.75 5/20=0.255/20=0.25

Connection between consumption and Connection between consumption and savings functionsavings function

The consumption functionThe consumption function

The saving functionThe saving function

The propensity to consumeThe propensity to consume

The propensity to saveThe propensity to save

Non-income determinants of Non-income determinants of consumption and savingconsumption and saving

WealthWealth

ExpectationsExpectations

Real Interest ratesReal Interest rates

Household DebtHousehold Debt

Important considerationImportant consideration

Switch to real GDPSwitch to real GDP Changes along schedulesChanges along schedules Schedule shiftsSchedule shifts TaxationTaxation StabilityStability

The Interest-Rate-Investment The Interest-Rate-Investment RelationshipRelationship

Expected rate of returnExpected rate of return

The Real Interest rateThe Real Interest rate

The Investment demand curveThe Investment demand curve

Shifts of the Investment demand Shifts of the Investment demand CurveCurve

Acquisition, Maintenance and Acquisition, Maintenance and operating costsoperating costs

Business taxesBusiness taxes Technological changesTechnological changes Stock of capital goodsStock of capital goods ExpectationExpectation

Instability of InvestmentInstability of Investment

DurabilityDurability Irregularity of innovationIrregularity of innovation Variability of profitsVariability of profits Variability of expectationsVariability of expectations

The Multiplier EffectThe Multiplier Effect

A change in a component of total A change in a component of total spending leads to a larger change in spending leads to a larger change in GDP. The multiplier determines how GDP. The multiplier determines how much larger that change will bemuch larger that change will be

Multiplier = Multiplier = change in real GDPchange in real GDP

initial change in spendinginitial change in spending

The Multiplier and the Marginal The Multiplier and the Marginal PropensitiesPropensities

The MPC and the multiplier are directly relatedThe MPC and the multiplier are directly related The MPS and the multiplier are inversely relatedThe MPS and the multiplier are inversely related

Multiplier= Multiplier= 11

1-MPC1-MPC

Multiplier = Multiplier = 11

MPSMPS