Chapter 8

8BasicMacroeconomicRelationships

Copyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show1Chapter ObjectivesHow Changes in Income Affect Consumption (and Saving)About Factors Other Than Income That Can Affect ConsumptionHow Changes in Real Interest Rates Affect InvestmentAbout Factors Other Than the Real Interest Rate That Can Affect InvestmentWhy Changes in Investment Increase or Decrease Real GDP by a Multiple AmountCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show2Income-Consumption and Income-Savings RelationshipsRelationship b/w income and savingPersonal saving = DI-C (disposable income-consumption)Most significant factor in determining nations level of C and S is DI45 degree line is a reference line b/c it bisects the 90 degree angle formed by the 2 graph axesDot on line represents C and DI in for one yearCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show4Consumption and SavingMPC + MPS = 1MPC and MPS as SlopesNonincome Determinants of Consumption and SavingWealth EffectExpectationsReal Interest RatesHousehold Debt

W 8.1Copyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show15The Consumption ScheduleHypothetical consumption scheduleShows various amounts that households would plan to consume at each of the various levels of DI that might prevail at some specific timeIn aggregate:Households inc. spending as DI incSpend a larger proportion of a small DI than of a large DICopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show7The Saving ScheduleTo find amount saved, subtract C from DI (S=DI-C)Direct relationship b/w saving and DISaving is a smaller proportion of a smaller DI than of a large DIDissaving (consuming in excess of after-tax income) will occur at relatively low DisCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show8Break-Even IncomeBreak-even income: income level at which households plan to consume their entire incomesGraphically:Consumption schedule cuts the 45 degree lineSaving schedule cuts the horizontal axis (saving is zero)Copyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show9Average and Marginal PropensitiesAverage propensity to consume: fraction or % or total income that is consumedAPC=consumption/incomeAverage propensity to save-fraction of total income that is savedAPS=saving/incomeAPS+APC = 1Copyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show10Consumption and Saving(1)Level ofOutputAndIncome(GDP=DI)(2)Consump-tion(C)(3)Saving (S)(1-2)(4)AveragePropensityto Consume(APC)(2)/(1)(5)AveragePropensityto Save(APS)(3)/(1)(6)MarginalPropensityto Consume(MPC)(2)/(1)(7)MarginalPropensityto Save(MPS)(3)/(1)$370 390 410 430 450 470 490 510 530 550$375390405420435450465480495510$-505101520253035401.011.00.99.98.97.96.95.94.93.93-.01.00.01.02.03.04.05.06.07.07.75.75.75.75.75.75.75.75.75.25.25.25.25.25.25.25.25.25Copyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd ShowBasic RelationshipsIncome-ConsumptionIncome-Saving45 LineC = DI on the LineS = DI - C

Copyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show3Income and Consumption

Consumption (billions of dollars)Disposable Income (billions of dollars)Consumption and Disposable Income, 1983-200545 Reference LineC=DI8386858488899190879293949501979699980002050304ConsumptionIn 1992SavingIn 199245CCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd ShowConsumption and SavingThe Consumption ScheduleThe Saving ScheduleBreak-Even IncomeAverage Propensity to Consume (APC)Average Propensity to Save (APS)

O 8.1APS =SavingIncomeAPC =ConsumptionIncomeCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show3. Real Interest Rates when interest rates fall, people spend more save less and vice versa

4. Household debt increased borrowing shifts C curve upward and vice cersaCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show1745Consumption and SavingConsumption and Saving SchedulesC0S0Disposable Income (billions of dollars)Consumption (billions of dollars)Saving(billions of dollars)C2C1S1S2Copyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd ShowInterest Rate and InvestmentExpected Rate of Return (r)The Real Interest Rate (i) Meaning of r = iInvestment Demand Curve

O 8.2G 8.2

Copyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show20Interest Rate and InvestmentExpectedRate ofReturn (r)CumulativeAmount ofInvestmentHaving ThisRate ofReturn or Higher(i)16%14%12%10%8%6%4%2%0%$ 0510152025303540 r and i (percent)16141210864205 10 15 20 25 30 35 40 Investment (billions of dollars)The Investment Demand CurveIDCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd ShowInterest Rate and InvestmentShifts of the Investment Demand CurveAcquisition, Maintenance, and Operating CostsBusiness TaxesTechnological ChangeStock of Capital Goods on HandExpectationsCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show25Interest Rate and Investment

1971 1975 1979 1983 1987 1991 1995 1999 2003 GDPGross InvestmentThe Volatility of InvestmentPercentage ChangeYearCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show33The Multiplier EffectMultiplier =Change in Real GDPInitial Change in SpendingThe Multiplier and the Marginal PropensitiesMultiplier =11 - MPCMultiplier =1MPS-or-Graphically

W 8.2Copyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd ShowSquaring the Economic CircleHumorist Art Buchwald and the MultiplierOne Person Cant Buy a ProductOthers Subsequently Impacted and Cannot Buy Other ItemsMultiple Effects Impact PsycheUltimately Causes Multiple Step Impact Upon the Economy as a WholeLastWordCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show41Key Terms45 (degree) lineconsumption schedulesaving schedulebreak-even incomeaverage propensity to consume (APC)average propensity to save (APS)marginal propensity to consume (MPC)marginal propensity to save (MPS)wealth effectexpected rate of returninvestment demand curvemultiplierCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show42Interest Rate and Investment r and i (percent)0Investment (billions of dollars)Shifts in the InvestmentDemand CurveID0ID1ID2Increase in Investment DemandDecrease in Investment DemandCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show26Non-Interest Rate Determinants of Investment DemandInc in investment demand, shift right Dec in investment demand, shift leftDeterminants:1. acquisitions, maintenance, and operating costs higher operating costs shift curve left, vice versaCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show272. business taxes taxes inc, investment demand curve shifts left, reduction of bus. Taxes shifts right3. Technological change new technology, shift right

Copyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show284. stock of capital goods on hand excess productive capacity decreases demand, vice versa

5. expectations of future sales, political climate, pop growth, etcif expectations optimistic then investment demand increases and vice versaCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show29Interest Rate and InvestmentInstability of InvestmentDurabilityIrregularity of InnovationVariability of ProfitsVariability of ExpectationsCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show30Instability of InvestmentInvestment is the most volatile component of total spendingWhy?1. durability indefinite life of capital goods2. irregularity of innovation difficult to predict the arrival of new inventions3. variability of profits expectation of future profit is influenced by current profits4. Variability of expectations possible changes in business conditionsCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show31GLOBAL PERSPECTIVE

Interest Rate and InvestmentSource: World BankGross Investment Expenditures as aPercent of GDP, Select NationsSouth KoreaJapanMexicoCanadaFranceUnited StatesGermanyUnited KingdomSweden0 10 20 30Percent of GDP, 2004 Copyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show32The Multiplier EffectThis will be discussed again in Ch. 9Direct relationship b/w changes in spending and changes in real GDPThe multiplier effect a change in a component of total spending leads to a larger change in GDPSee formula on previous slideCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show35The Multiplierinitial change in spending usually deals with investment, but could also include G,C or NXChange in spending results from change in real interest rate or shifts in the investment demand curveMultiplier works in both directions (inc/dec)Copyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show36Rationale1. economy supports repetitive and continuous flows of income and expenditures2. any change in income will alter consumption and spending in the same direction as the change in income- any change in income will set off a spending chain throughout economyCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show37The Multiplier and Marginal PropensitiesMPC and multiplier are directly relatedMPS and multiplier are inversely relatedMultiplier = 1/1-MPC orMultiplier = 1/MPSCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd ShowThe Multiplier Effect(1)Change inIncome(2)Change inConsumption(MPC = .75)(3)Change inSaving(MPC = .25)Increase in Investment of $5Second RoundThird RoundFourth RoundFifth RoundAll other rounds Total$ 5.003.752.812.111.584.75$ 20.00$ 3.752.812.111.581.193.56$ 15.00$ 1.25.94.70.53.391.19$ 5.00Tabular and Graphical ViewsRounds of Spending12345All$20.0015.2513.6711.568.755.00$5.00$3.75$2.81$2.11$1.58$4.75I=$5 billionCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show39The Multiplier EffectThe MPC and the Multiplier105432.5.67.75.8.9MPCMultiplierCopyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show40Next Chapter PreviewChapter 9! The AggregateExpenditures Model

Copyright 2008 The McGraw-Hill Companies8-#8ChapterBasic RelationshipsIncome and ConsumptionConsumption and SavingConsumption and Saving SchedulesChanges in C & SInterest Rate and InvestmentInvestment Demand CurveShifts in the Investment Demand CurveVolatility of InvestmentMultiplier EffectLast WordKey TermsEnd Show43Chart12374.82597.32829.33016.73216.93475.83734.53986.44140.14385.44627.94902.45157.354605770.56119.16536.47025.67354.57645.37996.38512.59072.1

Consumption

Sheet1DIConsumption19832608.42374.8198429122597.319853109.32829.319863285.13016.719873458.33216.919883748.73475.819894021.73734.519904285.83986.419914464.34140.119924751.44385.419934911.94627.919945151.84902.419955408.25157.319965688.5546019975988.85770.519986395.96119.1199966956536.4200071947025.620017468.87354.520027830.17645.320038169.27996.320048664.28512.520059038.69072.1

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Consumption

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