Chapter 28

Basic Macroeconomic Relationships

Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

28-2

LO1. Describe how changes in income affect consumption (and saving).LO2. List & explain factors other than income that can affect consumptionLO3. Explain how changes in real interest rate affect investmentLO4. Identify & explain factors other than RIR that can affect investmentLO5. Illustrate how changes in investment (or one of the other components of total spending) can increase or decrease real GDP by a multiple amount.

28-3

LO1. Describe how changes in income affect consumption (and saving).

28-4

• Consumption and saving• Primarily determined by DI (disposable income = Income – Tax)• Direct relationship• DI – Consumption = Saving

• Consumption schedule• Planned household spending (in our model)

• Saving schedule• DI minus C• Dissaving can occur, dissaving (terlebih belanja) using borrowing or by selling asset.

Income Consumption and Saving

LO1

28-5

Income Consumption and Saving

LO1

28-6

Consumption and Saving Schedules

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

LO1

28-7

Consumption and Saving Schedules

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)LO1

28-8

Average Propensities(Purata kecenderungan)

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

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

APC = APS =consumption

income incomesaving

APC + APS = 1LO1

28-9

Global Perspective

LO1

28-10

Marginal Propensities(Kadar perubahan kecenderungan untuk

berbelanja/menyimpan)

• 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 = MPS =change in consumption

change in income change in income

change in saving

MPC + MPS = 1LO1

28-11

Marginal Propensities

Disposable income

Con

sum

ptio

nSa

ving

S

CMPC =

MPS =

1520 = .75

C ($15)

DI ($20)

DI ($20)

S ($5)

520 = .25

LO1LO1

28-12

Nonincome Determinants

• Amount of disposable income is the main determinant

• Other determinants of consumption & savings• Wealth• Borrowing• Expectations• Real interest rates

LO2

28-13

Other Important Considerations

• Switching to real GDP• Changes along schedules• Simultaneous shifts• Taxation• Stability

LO2

28-14

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

-

+

LO2LO2

28-15

LO3. Explain how changes in real interest rate affect investmentLO4. Identify & explain factors other than RIR that can affect investment

28-16

• Investment consists of spending on new plants, capital equipment, machinery, inventories, construction, etc.

• The investment decision weighs marginal benefits and marginal costs.

• The expected rate of return is the marginal benefit.

• The interest rate (the cost of borrowing funds) represents the marginal cost.

Interest-Rate-Investment Relationship

LO3

28-17

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

LO3 Interest rate = financial price

28-18

Shifts of Investment Demand occurs when any investment determinants change.

LO4

28-19

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

LO4

28-20

Global Perspective

LO4

28-21

Instability of Investment

• Investment is a very unstable type of spending. • Ig is more volatile than GDP• REASONS

• Variability of expectations• Durability• Irregularity of innovation• Variability of profits

LO4

28-22

Instability of Investment

LO4

28-23

The Multiplier Effect

• Def: A change in spending changes real GDP more than the initial change in spending

• Layman: increase in final income arising from any new injection of spending.

Multiplier =change in real GDP

initial change in spending

Change in GDP = multiplier x initial change in spending

LO5

28-24

28-25

28-26

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

of d

olla

rs)

20.00

15.2513.67

11.56

8.75

5.00 2 3 54 All others1LO5

28-27

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 =1

1- MPCMultiplier =

1MPS

LO5

28-28

Multiplier and Marginal Propensities

10

5

4

3

2.5

.67

.75

.8

.9

MPC Multiplier

LO5

28-29

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

28-30

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