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Basic Macroeconomic Relationships

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OverviewHere we study some basic economic relationships that we think hold in a general way in the economy. Here we study the income - consumption, income – saving, interest rate – investment relationships and we study the idea of the multiplier.Digress: Say I am interested in why people weigh what they do. What would you say is the relationship between a persons weight and how much they eat for lunch?Would you say the more eaten for lunch, the greater the weight? Sure you would. But, you also might say that this is true only if all other things in the persons life are the same. SO, lot of things influence weight and we look at each influence one at a time. This makes it easier to handle, but in the real world many things change at once.

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ConsumptionFrom the expenditure approach to GDP we saw the goods and services produced include consumption, investment, government spending and net exports.

Here we want to understand the pattern of household expenditure called consumption. Consumption depends on many things at the aggregate or national level. But a primary influence is some notion of income.

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Real world consumption

income

Consumption 45 degree

lineWhen you study the real world data about the level of income and consumption of households in the US you get a graph something like this.

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Real world consumptionIn the graph on the previous screen, note1) Each dot represents a year and we have matched the income and consumption in that year,2) The dots would not all be on a straight line,3) Higher income means higher consumption, and4) Most dots are below the 45 degree line. Note a 45 degree line means we are the same distance form each axis. Note we measure income horizontally and consumption vertically. But, if we take a horizontal income and go up to the 45 degree line that vertical distance is also the income amount. Then by looking at heights we could compare income and consumption. We will do this a lot.

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GDP, Income, and Disposable income

In this course we will build a simple model of the economy and a major idea in the model will be the GDP produced and the resultant income. Income in many ways will mean GDP. Disposable income equals personal income minus personal taxes.In a previous section we saw in the NIPA that GDP and disposable income were not the same. But, for our work here we can assume they are basically the same. I will just say in general income and the context will mean disposable or GDP in the context of the story. In other words I talk in general and on tests and assignments you may see a specific topic and just apply what I have here.

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ConsumptionC 450

C

income

In our theory we will have the graph here showing as income rises as consumption rises, given all else equal in the world.For the most part this graph is in line with

observation in the world. The consumption line or function is now interpreted as showing the consumption plans of the household sector at various levels of income. To see what consumption will be at any income level go to the income level and then up to the consumption line.

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ConsumptionThe graph is merely a reflection of information we could get in a table. Say we haveIncome Consumption370 375390 390410 405.In the graph on the previous screen we have income equal to consumption at income = 390. This is called the break-even income level. Notice to the left of this point the C line is higher than the 45 degree line meaning consumption is greater than income.

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SavingOur context of income here is disposable income and we think disposable income is either consumed or saved. (After the government takes taxes from you all you can do is consume or save. Note for each of us how we consume and how we save may be very different.)In this sense saving is just that part of income not consumed. So we can add to our table and graph by taking income minus consumption to get saving.

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SavingIncome Consumption Saving370 375 -5390 390 0410 405. 5Note that saving is negative when income is 370. What do we call this and how could this be?Negative saving is called dissaving (not datsaving!) and it could happen if our income is really low and we consume this period by using up assets we accumulated form the past, borrow, as well as use our current income.

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Average Propensities

The average propensity to consume (APC) can be calculated at each income level by taking the consumption at that level and dividing by the income. Note the APC falls as income rises. Think about it. With more and more income we consume more, but as a percentage of our income we cut back because we have all our main comforts taken care of and the rest is gravy.Since our income is either consumed or saved, if the APC is falling the APS is rising because the APC + APS = 1.Please write down and understand the APS.

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Marginal PropensitiesThe marginal propensity to consume (MPC) equals the change in consumption divided by the change in income between two points in time. It is felt that the MPC is constant over time. Let’s see this on the next screen in a numerical example. Before we get there note that since changes in income must either lead to a change in consumption or saving (after taxes are taken out), the MPC + MPS = 1.

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Marginal Propensities

Income C S MPC MPS APC APS370 375 -5 1.01 -.01390 390 0 .75 .25 1 0410 405. 5 .75 .25 .99 .01Note that MPC for income at 370 is not written in because we do not have information from before. How did I get the first .75? Answer - (390-375)/(390-370) = 15/20=.75With the MPC constant the APC must fall (since C does not equal zero when income is zero)

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C and S in graphsC

incomeS

income

45 degree line

45 degree line

s

CNotes about graphs1) When C crosses 45 degree line we have break-even income and S = 0,2) To the left of this income, C > income and we have dissaving,3) To the right of the income in 1), C < income and we have saving – hey, look at datsaving.

The slopes of C and S are the MPC and MPS, respectively.

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ConsumptionIn the national economy we think the level of consumption expenditure depends on1) output or income (which we just spent time looking at)2) the wealth of households3) expectations,4) real interest rates,5) Household debt,6) taxation.

Note. When item 1 here changes we move along the C and S lines, when items 2 through 6 change we shift C and S.

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Consumption - wealthIf the household sector becomes wealthier (like due to a stock market boom), then at a given level of income thehousehold sector will consume more and save less.

Presumably the reason the household saves is to build up wealth to use later. If they become wealthier, then there is less reason to save in the current period and thus more reason to consume.

The C line shifts up and the S line shifts down as the household becomes wealthier. This is called the wealth effect.

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Consumption - expectationsWhen households look to the future they have feelings, what are called expectations, about what will happen. If the outlook changes in a positive way expectations become more favorable and C shifts up and S shifts down.The reverse happens if the future outlook becomes negative or gloomy.

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Consumption – real interest rates

Higher rates of interest may make some folks consume less and save more because they see the higher rate paying back better in the future. Similarly a lower interest rate makes some give up saving because what they get in return is not enough to give up consumption today.Interest rate up, C line down and S line up.

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Consumption – household debt

Households can go into debt. To the extent that households can go into debt at a larger amount the consumption line can shift up.

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Consumption - taxation

Remember disposable income is personal income minus taxes and what we have left is either consumed of saved. Also note that what we have said on the last few slides if C goes up S goes down. Personal taxes are treated differently.If personal taxes go up, the household sector has less to both consume and save. So, if personal taxes rise, both C and S will fall.

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Consumption, Saving and taxes

When we consider the household sector and the income it earns in a period from production, then we see the income and be consumed, saved or taxed away. In symbols we = have Y = C + S + T. Disposable income is Y – T and thus Y – T = C + S. We have said 1) If Y changes (and T is fixed) C and S change in the same direction as the Y change,2) If Y is fixed (and T is fixed), when C changes (like due to more wealth) S changes in the opposite direction, and3) If T changes (and Y is fixed) both C and S change in the opposite direction of the change in T.

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consumption in the graph

income

CEarlier we showed C in a graph like this. Usually what we do is just pick astarting point, like point a. At this point we havea level of income and Cexplicitly in the graph. Implicitly the levels of

a

other influences are also at a certain level.

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consumption in the graph

income

C If income increases, we saw C will increase. We could have point b. We saw for every $ change in income, C changed by MPC. If from a to b income changed by 15 and MPC = .8, then Cchanged by ................?

a

In the graph when we consider a change in income all the other factors that influence C are assumed to not changeand we then move along the C line as I have drawn here.If the other factors change, and they can, the curve shifts.

b

C

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consumption in the graph

income

CIf the other factors changein such a way that C increases, the C line shiftsup. Similarly, it would shift down if the other factors changed in a certain way.

a

Note along C’, consumption is higher than along C at all levels of income.

b

CC’

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autonomous consumption

We have seen that consumption depends on income and other factors. The other factors are often called autonomous factors, or nonincome determinants. For us this means factors other than income.Note that the slope of the consumption function is the MPC. The slope tells us how much consumption rises for each change in income. So for every dollar change in income the slope tells us about the change in consumption.