Basic

Macroeconomic
Relationships
 Objectives
• Effect of changes in income on
consumption (and saving)
• Other factors that affect consumption
• Effect of changes in real interest rates
on investment
• Other factors that affect investment
• Changes in investment have a
multiplier effect on real GDP

27-2
 Consumption and Saving
(1) (4) (5) (6) (7)
Level of Average Average Marginal Marginal
Output (2) Propensity Propensity Propensity Propensity
And Consump- (3) to Consume to Save to Consume to Save
Income tion Saving (S) (APC) (APS) (MPC) (MPS)
(GDP=DI) (C) (1) – (2) (2)/(1) (3)/(1) Δ(2)/Δ(1) Δ(3)/Δ(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

MPC + MPS = 1 MPC and MPS measure slopes

27-3
Consumption and Saving
500

Consumption (billions of dollars)

C
475

450
Saving $5 Billion Consumption
425
Schedule
400

375

Dissaving $5 Billion

45°
370 390 410 430 450 470 490 510 530 550
(billions of dollars)

Disposable Income (billions of dollars)

50 Dissaving
Saving Schedule
Saving

S
25 $5 Billion
Saving $5 Billion
0

370 390 410 430 450 470 490 510 530 550
27-4
 Basic Relationships
• Income and consumption
• Income and saving
• Disposable income (DI)
• 45°line for reference
–C = DI on the Line
• S = DI - C

27-5
 Consumption and Saving
• The consumption schedule
• The saving schedule
• Break-even income
• Average propensity to consume
(APC)
• Average propensity to save (APS)
Consumption Saving
APC = APS =
Income Income
27-6
 Consumption and Saving
• Marginal propensity to
consume (MPC)
• Marginal propensity to save
(MPS)
Change in Consumption
MPC =
Change in Income

Change in Saving
MPS = Change in Income
27-7
 Consumption and Saving

• Nonincome determinants of
consumption and saving
– Wealth
– Borrowing
– Expectations
– Real interest rates

27-8
Interest Rate and Investment

• Expected rate of return (r)

• The real interest rate (i)
– Nominal rate less rate of inflation
• Meaning of r = i
• Investment demand curve

27-9
Investment Demand Curve

Cumulative
Amount of
Investment 16
Having This
Expected Rate of 14
Rate of Return or Higher
Return (r) (I)

r and i (percent)
12

16% $ 0 10
14% 5
8
12% 10
10% 15 6
8% 20
4
6% 25
4% 30 2 ID
2% 35
0
0% 40 5 10 15 20 25 30 35 40
Investment (billions of dollars)

27-10
 Investment Demand Curve
• Shifts of the curve
– Acquisition, maintenance, and
operating costs
– Business taxes
– Technological change
– Stock of capital goods on hand
– Expectations

27-11
 The Multiplier Effect

• More spending results in higher

GDP
• Initial change in spending changes
GDP by a multiple amount

Change in Real GDP

Multiplier =
Initial Change in Spending

27-12
 The Multiplier Effect
• Causes of the initial change in
spending
– Changes in investment
– Other changes
• Rationale
– Dollars spent are received as
income
– Income received is spent (MPC)
– Initial changes in spending cause
a spending chain 27-13
 The Multiplier Effect
(2) (3)
(1) Change in Change in
Change in Consumption Saving
Income (MPC = .75) (MPC = .25)
Increase in Investment of $5 $ 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
$20.00
$4.75
15.25
$1.58
13.67
$2.11
11.56
$2.81
8.75
ΔI=
$5 billion $3.75
5.00
$5.00

1 2 3 4 5 All
Rounds of Spending
27-14
The Multiplier Effect

1
Multiplier =
1 - MPC

-or-

1
Multiplier =
MPS

27-15