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“The most powerful force in the universe is compound interest.” Albert Einstein

“The most powerful force in the universe is compound interest.” Albert Einstein. Basic Macroeconomic Relationships. Chapter Objectives. How Changes in Income Affect Consumption (and Saving) Factors Other Than Income That Can Affect Consumption

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“The most powerful force in the universe is compound interest.” Albert Einstein

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  1. “The most powerful force in the universe is compound interest.”Albert Einstein Basic Macroeconomic Relationships

  2. Chapter Objectives • How Changes in Income Affect Consumption (and Saving) • Factors Other Than Income That Can Affect Consumption • How Changes in Real Interest Rates Affect Investment • Factors Other Than the Real Interest Rate That Can Affect Investment

  3. Basic Relationships Income and Consumption (C) • Direct relationship Income and Saving (S) • Direct relationship • DI = Disposable Income • After tax income, your take-home pay • C = DI on the 45°Line • S = DI – C (gap between lines)

  4. 550 510 470 430 390 45° Basic Relationships The 45° Line C = DI at each point on the 45° line. Consumption (billions of dollars) 390 430 470 510 550 Disposable Income (billions of dollars)

  5. 500 475 450 425 400 375 45° 50 25 0 Consumption and Saving Schedules C = DI C Saving Consumption Schedule Saving (billions of dollars) S Consumption (billions of dollars) Dissaving 390 430 470 510 550 Disposable Income (billions of dollars) Saving Schedule Saving (billions of dollars) S Dissaving Saving 390 430 470 510 550

  6. Consumption and SavingDepend on Income and... • Wealth Effect • Wealth = value of real assets (houses, land) and financial assets (cash, savings, stocks, bonds, pensions) that households own. • Wealth is accumulated by saving. • When wealth increases, households do not feel the need to save as much, so consumption increases. • When wealth decreases, households save more to build it back up, so consumption falls.

  7. Consumption and SavingDepend on Income and... • Wealth Effect • Expectations • Expectation of higher prices in the future will increase consumption today, so savings will fall. • Expectations of recession, and perhaps lower income, will decrease consumption today, and therefore increase saving.

  8. Consumption and SavingDepend on Income and... • Wealth Effect • Expectations • Real Interest Rates • When interest rates fall, households tend to borrow more (for cars, houses, etc), consume more, save less (and vice versa).

  9. Consumption and SavingDepend on Income and... • Wealth Effect • Expectations • Real Interest Rates • Household Debt • Increasing household debt allows increases in consumption (in the short-run), causing a decrease in savings (and vice versa).

  10. Interest Rate and Investment • Investment (creation of capital) is a marginal benefit-marginal cost decision for firms. • MB = expected rate of return (r) • Example: If new machine costs $1,000 and is expected to yield $1,100 of revenue, profit=$100. • Expected rate of return = $100/$1,000 = 10%

  11. Interest Rate and Investment • Investment (creation of capital) is a marginal benefit-marginal cost decision for firms. • MC = real interest rate paid on borrowed funds (i) • Example: If firm pays 7% to borrow $1,000, loan will cost $70. • SO, this firm will pay $70 to earn $100, so net profit = $30 (MB > MC) • Firm should undertake this project.

  12. Interest Rate and Investment • Firms should undertake investment projects that they expect to be profitable. • Should invest up to the point where expected rate of return = real interest rate, or r = i.

  13. Interest Rate and InvestmentThe Investment Demand Curve • The investment demand curve is constructed by sorting all potential investment projects in descending order of their expected rates of return. • Example; There are $5 billion of projects with expected rates of return between 14% and 16%, • Another $5 billion between 12% and 14%, etc. • The amount of money demanded for investment increases as the interest rate decreases. • Any project that is profitable when interest rates are 12% will also be profitable when the interest rate is 5%.

  14. Interest Rate and InvestmentThe Investment Demand Curve At 16% interest, ID =$ 0 16 12 8 4 0 At 12% interest, ID =$10 r and i (percent) ID 5 10 15 20 25 30 35 40 Investment (billions of dollars)

  15. Interest Rate and InvestmentShifts of the Investment Demand Curve • Any factor that leads firms collectively to expect rates of return to change will change investment demand: • Acquisition, Maintenance, and Operating Costs • Business Taxes • Technological Change • Stock of Capital Goods on Hand • Expectations

  16. Interest Rate and InvestmentShifts in the Investment Demand Curve Increase in Investment Demand r and i (percent) Decrease in Investment Demand ID1 ID0 ID2 Investment (billions of dollars)

  17. Key Terms • 45 degree line • break-even income • consumption schedule • disposable income • expected rate of return • investment demand • saving schedule • wealth effect

  18. Basic Macroeconomic Relationships Wrap Up Consumption and Saving Investment Business Decision Disposable Income Interest Rate WealthExpectations Real Interest Rates Household Debt Demand for Investment Graph of Consumption Shifts in the Demand Curve

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