Basic Macroeconomic Relationships

Chapter 10 Basic Macroeconomic Relationships Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Income, Consumption, and Saving Consumption and saving Primarily determined by DI Direct relationship Consumption schedule Planned household spending (in our model) Saving schedule DI minus C Dissaving can occur LO1 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-2 Consumption and Disposable Income LO1 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-3

Consumption and Saving Schedules Consumption and Saving Schedules (in Billions) and Propensities to Consume and Save (1) Level of Output and Income GDP = DI (2) Consumption (C) (3) Saving (S), (1) - (2) (4) (5) (6) (7) Average Propensity to Consume Average Propensity to

Save Marginal Propensity to Consume Marginal Propensity to Save (APC), (2)/(1) (APS), (3)/(1) (MPC), (2)/(1)* (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 LO1 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-4 Consumption and Saving Schedules Contd LO1

Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-5 Average Propensities Average propensity to consume (APC) Fraction of total income consumed Average propensity to save (APS) Fraction of total income saved consumption APC = income APS = saving income APC + APS = 1 LO1 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-6 Global Perspective 1 LO1 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

10-7 Marginal Propensities Marginal propensity to consume (MPC) Proportion of a change in income consumed Marginal propensity to save (MPS) Proportion of a change in income saved MPC = change in consumption change in income MPS = change in saving change in income MPC + MPS = 1 LO1 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-8 Consumption Marginal Propensities Continued C 15

MPC = = .75 20 C ($15) Saving DI ($20) MPS = 5 = .25 20 S S ($5) DI ($20) LO1 Disposable income Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-9 Nonincome Determinants Amount of disposable income is the main determinant Other determinants

Wealth Borrowing Expectations Real interest rates LO2 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-10 Other Important Considerations Switching to real GDP Changes along schedules Simultaneous shifts Taxation Stability LO2 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-11 Shifts of Consumption and Saving Schedules C1 C0 Saving (billions of dollars)

Consumption (billions of dollars) C2 LO2 0 45 S2 S0 S1 + 0 Real GDP (billions of dollars) Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-12 Interest-Rate-Investment Relationship Expected rate of return The real interest rate Investment demand curve LO3

Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-13 Investment Demand Curve LO3 14 5 12 10 10 15 8 20 6 25 4

30 2 35 0 40 16 Expected rate of return, r and real interest rate, i (percents) (r) and (i) 16% Cumulative Amount at this ROR (billions of dollars) $0 14 Investment demand curve

12 10 8 6 4 2 0 ID 5 10 15 20 25 30 35 40 Investment (billions of dollars) Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-14

Shifts of Investment Demand Acquisition, maintenance, and operating costs Business taxes Technological change Stock of capital goods on hand Planned inventory changes Expectations LO4 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-15 Shifts of Investment Demand Curve Expected rate of return, r, and real interest rate, i (percents) Increase in investment demand Decrease in investment demand 0 LO4

ID2 ID0 ID1 Investment (billions of dollars) Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-16 Global Perspective 2 LO4 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-17 Instability of Investment Variability of expectations Durability Irregularity of innovation Variability of profits LO4 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-18 Volatility of Investment LO4

Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-19 The Multiplier Effect A change in spending changes real GDP more than the initial change in spending Multiplier = change in real GDP initial change in spending Change in GDP = multiplier initial change in spending LO5 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-20 The Multiplier Effect Continued (1) Change in Income (2) Change in Consumption (MPC = .75)

(3) Change in Saving (MPS = .25) $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 $20.00 $15.00 $5.00 Increase in investment of $5.00 Total Cumulative income, GDP

(billions of dollars) 20.00 $4.75 $2.11 $2.81 11.56 $3.75 8.75 5.00 LO5 $1.58 15.25 13.67 $5.00 1 2 3 4

5 All others Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-21 Multiplier and Marginal Propensities Multiplier and MPC directly related Large MPC results in larger increases in spending Multiplier and MPS inversely related Large MPS results in smaller increases in spending Multiplier = LO5 1 1- MPC Multiplier = 1 MPS Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-22 Multiplier and Marginal

Propensities Continued MPC Multiplier .9 10 .8 5 .75 4 .67 .5 LO5 3 2 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-23 The Actual Multiplier Effect? Actual multiplier is lower than the model assumes

Consumers buy imported products Households pay income taxes Inflation Multiplier may be 0 LO5 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-24 Squaring the Economic Circle Humorous small town 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 10-25 Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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