chapter 27 basic macroeconomic relationships. income- consumption-saving links let’s introduce...

Chapter 27

Basic Macroeconomic Relationships

Income- Consumption-Saving Links

Let’s introduce some assumptions:1. Two-sector economy: households and business:• Aggregate spending = C + I only• No G, No T: DI = PI2. All savings are personal saving: No business savings3. Depreciation = 0; Gross I = Net I4. Net foreign factor income = 0; Citizens earn as much

abroad as foreigners earn inside.5. No Exports , No Imports : Closed economy.


• Relationship between income & consumption (C).• Relationship between income & saving (S).

- What is saving ?• Relationship between consumption (C) & saving (S)

- Primarily determined by Disposable Income (DI)- S = DI – C

• It has been approved that C is positively related to DI.• The 45o line represents points where each point on this line would have C=DI.


C

45o

DI


Consumption & Saving Schedule

• Schedule shows the various amounts that households would plan to consume at each various level of DI.

• Schedule shows the various amounts that households would plan to save at each various level of DI.

• DI = C + S• How much goes to C and S out of DI?• We use consumption and saving schedule.

GDP=DIGDP=DI CC SS$370$370 $375$375 $ -5$ -5390390 390390 00410410 405405 55430430 420420 1010450450 435435 1515470470 450450 2020490490 465465 2525510510 480480 3030530530 495495 3535550550 510510 4040



Based on the table; • If C > DI, then there is a decline in savings (Dis-saving)• When can households’ C > households’ DI ? ( two reasons )• When DI = C, then S = 0.• This is “Break-even” income; where households plan to consume their

entire incomes (C=DI).• What if DI=0? Will C=0 too?• Autonomous consumption: level of C when DI =0. (Independent C)


370 390 410 430 450 470 490 510 530 550

C

S

Consumptionschedule

Saving schedule

Saving $5 billion

Dissaving $5 billion

Dissaving$5 billion Saving $5 billion

Con

sum

ptio

n (b

illio

ns o

f dol

lars

)Sa

ving

(bill

ions

of d

olla

rs)

Disposable income (billions of dollars)


Average & Marginal Propensities

• Average propensity to consume (APC)is a Fraction of total income consumed

• Average propensity to save (APS)is a Fraction of total income saved

Note: APC falls and APS rises as DI increases (Check the table)

APC = APS =consumption

income incomesaving

APC + APS = 1


Average & Marginal Propensities

• Marginal propensity to consume (MPC)is a proportion of a change in income consumed

• Marginal propensity to save (MPS)is a proportion of a change in income saved

MPC = MPS =change in consumption

change in income change in income

change in saving

MPC + MPS = 1

• MPC and MPS are slopes: The slope of the consumption schedule = MPC,

the slope of the saving schedule = MPS.

• Even when DI=0, C≠0.


Consumption and Saving Schedules

Disposable income

Con

sum

ptio

nSa

ving

S

CMPC =

MPS =

1520 = .75

C ($15)

DI ($20)

DI ($20)

S ($5)

520 = .25

Marginal Propensities (Slopes)


Consumption and Saving Schedules (in Billions) and Propensities to Consume and Save

(1)Level of Output

and IncomeGDP=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

Consumption Schedule

45o

C

Dissaving

Saving

Income (Y)

C

DI

Break-Even Point (C=Y)


Consumption Schedule

45o

C

Dissaving

Saving

Income (Y)C

DI

Break-Even Point (C=Y)

Autonomous C (a)



Saving Schedule

S

+

-

0 DI

S

Break-Even point (S=0)

Saving ScheduleS

+

-

DI

S

Break-Even point (S=0)

Autonomous C (-a)


Determinants of Consumption and Saving

• The most important factor is income (DI): an increase in DI will lead to an increase in C by (MPC.DI) and increase in S by (MPS.DI).

• This will be a move along the C schedule and S schedule.

• The same result applies when DI declines. • DI is the only factor that leads to a move along the

lines.

Non-income Determinants

Non-income factors will shift the C and S schedules

1. Wealth: an increase in wealth will increase C and reduces S (shift the C schedule upward, S schedule downward).

• This is the case since people save to accumulate wealth. • As wealth increases, no need to save as much as before.• This is called “wealth effect”.


2. Expectations: about future prices and income level.

• Expectations affect spending (C) and saving.• Expectations of an increase in price levelincrease in price level (or future

income): increase C and reduce S today, C schedule shifts upward while S schedule shifts downward.


3. Borrowing: - household borrowing increases consumption, and will shift both C schedule upward:- since borrowing money allows C to shift upward, but if the debt is large, then C may shift downward.


4. Real Interest Rate: - lower real interest rates encourage households to borrow more, so consume more, & save less.- lower real interest rates allow C to shifts upward, but S shifts downward.

Other Important Considerations

• Switching to real GDP Change DI to Real GDP • Changes along schedules Differences between movements from point to point along

the curve versus upward/downward shift of the entire schedulable

• Simultaneous shiftsThe four non-economic factors will shift the consumption schedule in a one direction and the saving schedule to the other direction at the same time.

Other Important Considerations

• Taxation Taxation factor will shift the consumption schedule

and the saving schedule in same direction.

• StabilityThe consumption schedule and the saving schedule stay unchanged (stable) relatively unless major tax increases.

Shifts of C & S Schedules

C0

S0

Real GDP (billions of dollars)

Con

sum

ptio

n(b

illio

ns o

f dol

lars

)Sa

ving

(bill

ions

of d

olla

rs)

C2

C1

S1

S2

0

0

-

+

Interest-Rate-Investment

Recall the definition of I; spending on new plants, capital equipment, machinery & inventories.

Expected rate of return • is the marginal benefit from I.• Expected rate of return is calculated be (Profit

expected after adopting the new machine / Cost of that machine)


The Real Interest Rate • The Interest Rate (%) is the financial cost of

borrowing the money to purchase the machine.• The Interest cost is ( interest rate X amount borrowed

to purchase the machine)• if Expected Rate of Return > Interest Rate , then the

Investment should be undertaken (Profitable I ). • if Expected Rate of Return < Interest Rate , then the

Investment should not be undertaken(Unprofitable I)


• The Real Interest Rate rather than the Nominal Interest Rate is important in making investment decisions.

• The Real Interest Rate is ( Nominal Interest Rate - Inflation)

• if Expected Real Rate of Return > Real Interest Rate , then the Investment should be undertaken (Profitable I ).

• if Expected Real Rate of Return < Real Interest Rate , then the Investment should not be undertaken (Unprofitable I).


Investment Demand Curve• What determine the amount of funds that investors borrow? • Real interest rate (i): an increase in rr will increase the cost of

borrowing funds, thereby reducing the amount of I demanded.• A decline in (i) will reduce the cost of borrowing funds,

thereby increasing I demanded. • At each amount of I demanded, there is a certain expected rate

of return (r) equals or exceeds (i).

Investment Demand Curve

ID

(r) and (i)

Investment(billions

of dollars) 16% $ 0

14 5

12 10

10 15

8 20

6 25

4 30

2 35

0 40

Investmentdemandcurve

Investment Demand Curve

• Changes in the level of Real interest rate (i) will lead to a move in ID curve.

• This is the only factor leading to a move along the ID curve.

• All other factors will shift the ID curve.

Shifts of Investment Demand

• Acquisition, maintenance, and operating costsThe initial and then the operating cost of capital affect the expected rate of return in I negatively (Shifting ID to the left)

• Business taxesIncrease in taxes will reduce expected profitability (Shifting ID to the left)

• Technological changeStimulates investment and lower production costs (Shifting ID to the right)

Shifts of Investment Demand• Stock of capital goods on hand

as inventories rise, expected rate of return on investment increase (Shifting ID to the right)

• Planned inventory changesIf a firm expects higher sales in the future, it would keep more inventory in stock now. Thus increasing ID (Shifting ID to the right)

• ExpectationsExpected rate of return depends on firm’s expectations about its sales, future operation costs, future profitability, thus optimistic outlook about the future performance of the firm leads to higher I (Shifting ID to the right), versus the pessimistic outlook.

Shifts of Investment Demand E

xpec

ted

rate

of r

etur

n, r,

and

real

inte

rest

rate

, i (p

erce

nts)

0 Investment (billions of dollars)

ID0ID1ID2

Increasein investmentdemand

Decrease in investmentdemand

Instability of Investment

Source: Bureau of Economic Analysis, http://www.bea.gov.

http://www.bea.gov/

Instability of InvestmentFactors Explaining Variability in I• Durability

The quicker capital goods need to be replaced, the higher the level of I. The opposite in the case of keeping older capital goods after repairing them.

• Irregularity of innovationInnovations in sectors such as railroads, electricity occur quite irregularly, but if they occur it would lead to a sharp growth of investment spending

Instability of Investment• Variability of profits

Expanding profits give firms greater incentives and then greater means to invest, The opposite in the case of declining profits.

• Variability of expectationsAny change in expectations ( because of i.e economic outlook, trade policy, exchange rate policy, stock market, political reasons) would lead to a change in business expectations and then reach instability in investment spending.

The Multiplier Effect• More spending leads to more real GDP.• BUT!! a change in spending (i.e I) changes real GDP more than the initial change in spending (i.e I) • Thus, the Multiplier states that how much larger that change in Real GDP will be…

Example; if (I) in the economy rises by 30$ million and thus Real GDP increases by 90$ million, what is the Multiplier?

Multiplier =change in real GDP

initial change in spending

Change in GDP = multiplier x initial change in spending

The Multiplier Effect(1)

Change in Income

(2)Change in

Consumption (MPC = .75)

(3)Change in

Saving(MPS = .25)

Increase in investment of $5.00 $5.00 $3.75 $1.25

Second round 3.75 2.81 .94

Third round 2.81 2.11 .70

Fourth round 2.11 1.58 .53

Fifth round 1.58 1.19 .39

All other rounds 4.75 3.56 1.19

Total $20.00 $15.00 $5.00

$5.00

$3.75

$2.81

$2.11$1.58

$4.75

Cum

ulat

ive

inco

me,

GD

P (b

illio

ns o

f do

llars

)

20.00

15.2513.67

11.56

8.75

5.00

2 3 54 All others1

Multiplier and Marginal Propensities

• Multiplier and MPC directly relatedLarge MPC results in larger increases in spending

• Multiplier and MPS inversely relatedLarge MPS results in smaller increases in spending

Note: 1) The lower MPS , the larger is the fraction of

(1/MPS), thus the greater the multiplier and the greater the increase in income (Real GDP)

2) Think of MPC !!

Multiplier =1

1- MPCMultiplier =

1MPS

Multiplier and Marginal Propensities

10

5

4

3

2.5

.67

.75

.8

.9

MPC Multiplier

The Actual Multiplier Effect?In reality actual multiplier is lower than the model assumes

( only two sectors Households Sector & Business Sectors), this is because of ;

• Consumers buy imported products We should consider the external sector• Households pay income taxesWe should consider the Government sector• Inflation

Since we deal with Real GDP, this ignores people’s behaviors (to save or to consume) when price changes.

chapter 27 basic macroeconomic relationships. income- consumption-saving links let’s introduce...

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