Chapter 27

1. Chapter 27 Basic Macroeconomic Relationships

2. 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 = PI 2. All savings are personal saving: No business savings 3. Depreciation = 0; Gross I = Net I 4. Net foreign factor income = 0; Citizens earn as much abroad as foreigners earn inside. 5. No Exports , No Imports : Closed economy.

3. Income- Consumption-Saving Links • 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.

4. Income- Consumption-Saving Links C 45o DI

5. Income- Consumption-Saving Links 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.

6. Income- Consumption-Saving Links

7. Income- Consumption-Saving Links 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)

8. Income- Consumption-Saving Links 500 475 450 425 400 375 45° 50 25 0 • 390 410 430 450 470 490 510 530 550 C Saving $5 billion Consumption schedule Consumption (billions of dollars) Dissaving $5 billion • 390 410 430 450 470 490 510 530 550 Dissaving $5 billion Saving schedule S Saving (billions of dollars) Saving $5 billion Disposable income (billions of dollars)

9. Income- Consumption-Saving Links 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) consumption saving APC = APS = income income APC + APS = 1

10. Income- Consumption-Saving Links 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 change in consumption change in saving MPC = MPS = change in income change in income MPC + MPS = 1

11. Income- Consumption-Saving Links • 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.

12. Consumption and Saving Schedules Marginal Propensities (Slopes) C 5 20 15 20 MPC = = .75 Consumption C ($15) DI ($20) S MPS = = .25 Saving S ($5) DI ($20) Disposable income

13. Consumption and Saving Schedules

14. Consumption and Saving Schedules Consumption Schedule C Income (Y) Break-Even Point (C=Y) C Saving Dissaving 45o DI

15. Consumption and Saving Schedules Consumption Schedule C Income (Y) Break-Even Point (C=Y) C Saving Dissaving 45o DI Autonomous C (a)

16. Consumption and Saving Schedules Saving Schedule S + S 0 DI - Break-Even point (S=0)

17. Consumption and Saving Schedules Saving Schedule S + S DI - Break-Even point (S=0) Autonomous C (-a)

18. 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.

19. 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”.

20. Non-income Determinants 2. Expectations: about future prices and income level. • Expectations affect spending (C) and saving. • Expectations of an increase in price level (or future income): increase C and reduce S today, C schedule shifts upward while S schedule shifts downward.

21. Non-income Determinants 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.

22. Non-income Determinants 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.

23. 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 shifts The 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.

24. Other Important Considerations • Taxation Taxationfactor will shift the consumption schedule and the saving schedule in same direction. • Stability The consumption schedule and the saving schedule stay unchanged (stable) relatively unless major tax increases.

25. Shifts of C & S Schedules 45° C1 C0 C2 Consumption (billions of dollars) 0 S2 S0 + S1 Saving (billions of dollars) 0 - Real GDP (billions of dollars)

26. 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)

27. Interest-Rate-Investment 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)

28. Interest-Rate-Investment • 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).

29. Interest-Rate-Investment 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).

30. Investment Demand Curve 16 14 12 10 8 6 4 2 0 Expected rate of return, r and real interest rate, i (percents) 5 10 15 20 25 30 35 40 Investment (billions of dollars) Investment demand curve ID

31. 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.

32. Shifts of Investment Demand • Acquisition, maintenance, and operating costs The initial and then the operating cost of capital affect the expected rate of return in I negatively (Shifting ID to the left) • Business taxes Increase in taxes will reduce expected profitability (Shifting ID to the left) • Technological change Stimulates investment and lower production costs (Shifting ID to the right)

33. 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 changes If a firm expects higher sales in the future, it would keep more inventory in stock now. Thus increasing ID (Shifting ID to the right) • Expectations Expected 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.

34. Shifts of Investment Demand Increase in investment demand Expected rate of return, r, and real interest rate, i (percents) Decrease in investment demand ID1 ID0 ID2 0 Investment (billions of dollars)

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

36. Instability of Investment Factors 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 innovation Innovations in sectors such as railroads, electricity occur quite irregularly, but if they occur it would lead to a sharp growth of investment spending

37. 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 expectations Any 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.

38. 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? change in real GDP Multiplier = initial change in spending Change in GDP = multiplier x initial change in spending

39. The Multiplier Effect 20.00 15.25 13.67 11.56 8.75 5.00 $4.75 $1.58 Cumulative income, GDP (billions of dollars) $2.11 $2.81 $3.75 $5.00 All others 1 2 3 4 5

40. 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 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 !! 1 1 Multiplier = Multiplier = 1- MPC MPS

41. Multiplier and Marginal Propensities MPC Multiplier .9 10 .8 5 .75 4 .67 3 .5 2

42. 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 taxes We 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.