Chapter 27

Basic
Macroeconomic
Relationships

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter 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
 Basic Relationships

• Income and consumption

• Income and saving
• Disposable income (DI)
• 45°line for reference
–C = DI on the Line
• S = DI - C

27-3
Income and Consumption
10000

9000

Consumption (billions of dollars)

05

8000
45° Reference Line 04
C=DI 03
02
7000 01
00

6000
99 C
Saving 97
98

5000
In 1992 95
96
94
93
92
4000 91
90
89
88
3000 87
86
85
84
2000 83 Consumption
In 1992
1000

0 45°

0 2000 4000 6000 8000 10000

Disposable Income (billions of dollars)

Source: Bureau of Economic Analysis 27-4
 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
27-5
 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
27-6
 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

27-7
Consumption and Saving
500

Consumption (billions of dollars)

C
475

450

425
Saving $5 Billion Consumption
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

25 $5 Billion
S
Saving $5 Billion
0

370 390 410 430 450 470 490 510 530 550
27-8
Average Propensity to Consume
Selected Nations, with respect to GDP, 2006

.80 .85 .90 .95 1.00

United States
Canada
United Kingdom
Japan
Germany
Netherlands
Italy
France
Source: Statistical Abstract of the United States, 2006
27-9
 Consumption and Saving

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

27-10
 Consumption and Saving

• Other important considerations

–Changes along schedules
–Switch to real GDP
–Schedule shifts
–Stability
–Taxation

27-11
Consumption and Saving
C1

Consumption (billions of dollars)

C0
C2

45°
(billions of dollars)

Disposable Income (billions of dollars)

S2
Saving

S0
S1

27-12
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

27-13
Investment Demand Curve

Cumulative
Amount of
Investment 16
Having This
Expected Rate of 14
Rate of Return or Higher
12

r and i (percent)
Return (r) (I)
10
16% $ 0
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)

27-14
 Investment Demand Curve

• Shifts of the curve

–Acquisition, maintenance, and
operating costs
–Business taxes
–Technological change
–Stock of capital goods on hand
–Planned inventory changes
–Expectations
27-15
Investment Demand Curve

Increase in
Investment Demand
r and i (percent)

Decrease in
ID2 ID0 ID1
Investment Demand
0

Investment (billions of dollars)

27-16
 Investment Demand

• Instability of investment
–Durability
–Irregularity of innovation
–Variability of profits
–Variability of expectations

27-17
Gross Investment Expenditure
Percent of GDP, Selected Nations, 2006
0 10 20 30
South Korea
Japan
Canada
Mexico
France
United States
Sweden
Germany
United Kingdom
Source: International Monetary Fund
27-18
Volatility of Investment

Source: Bureau of Economic Analysis

27-19
 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

27-20
 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 27-21
 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
27-22
The Multiplier Effect

1
Multiplier =
1 - MPC

-or-

1
Multiplier =
MPS

27-23
The Multiplier and the MPC

MPC Multiplier
.9 10

.8 5

.75 4

.67 3

.5 2

27-24
 Squaring the Economic Circle

• Humorist Art Buchwald and the

multiplier
• Suppose one person can’t buy a
product
• Others subsequently impacted and
cannot buy other items
• Multiple effects impact psyche
• Ultimately causes multiple step impact
upon the economy as a whole
27-25
 Key Terms
• 45°(degree) line • marginal propensity to
• consumption consume (MPC)
schedule • marginal propensity to
• saving schedule save (MPS)
• break-even income • wealth effect
• average propensity • expected rate of
to consume (APC) return
• average propensity • investment demand
to save (APS) curve
• multiplier

27-26
Next Chapter Preview…

The Aggregate
Expenditures Model

27-27