Basic Macroeconomic Relationships

CHAPTER NINE
BASIC MACROECONOMIC RELATIONSHIPS

CHAPTER OVERVIEW
The central purpose of this chapter is to introduce three basic macroeconomic relationships that will
help us organize our thinking about macroeconomic theories and controversies: First, the focus is on the
income-consumption and income-saving relationships. Second, the relationship between the interest rate
and investment is examined. Finally, the multiplier concept is developed, relating changes in spending to
changes in output. All of this is done outside the formal framework of the Aggregate Expenditures
model, which is developed in Chapter 10.

WHATS NEW
This chapter has undergone substantial revision, combining parts of both Chapters 9 and 10 from the
previous edition. The Keynesian Aggregate Expenditures (AE) model is no longer introduced in this
chapter, but the underlying relationships and important conclusions are still presented here, including the
basic consumption and saving functions. Those wanting to discuss those relationships without developing
the AE model can omit Chapter 10 and proceed directly from this chapter to the Aggregate
Demand/Aggregate Supply model in Chapter 11.

The multiplier effect is now included in this chapter but is developed without the benefit of the AE model
(although the basic equations, including the marginal propensities, are presented). In discussion of the
multiplier, the terms simple multiplier and complex multiplier have been dropped. The text now
identifies the multiplier (as presented in examples) and the actual multiplier, although the latter is not
presented as a formal term for students to learn.

There are a number of other minor edits. The discussion of the wealth effect is modified, including a
Consider This box, and has an example of a reverse wealth effect. The real interest rate is now
identified as a determinant, albeit a minor one, of consumption spending. The discussion of the investment
schedule (relating investment and real GDP) now appears in Chapter 10.

There is a new Last Word on the multiplier (which appeared in the previous edition in Chapter 10).

End-of-chapter-questions are now a combination of questions from the last editions Chapter 9 and 10
questions, revised as needed to reflect content changes.

INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to

1. Describe the income-consumption and income-saving relationships.

2. Recognize, construct, and explain the consumption and saving schedules.
3. Identify the determinants of the location of the consumption and saving schedules.
4. Calculate and differentiate between the average and marginal propensities to consume (and save).
5. Describe the relationship between the interest rate, expected rate of return, and investment.
6. Identify the determinants of investment and construct an investment demand curve.
7. Identify the factors that may cause a shift in the investment-demand curve.
8. Describe the reasons for the instability in investment spending.

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9. Provide an intuitive explanation of the multiplier effect.

10. Calculate the multiplier and changes in real GDP given information about changes in spending and
marginal propensities.
11. Discuss why the actual multiplier may differ from the theoretical examples.

COMMENTS AND TEACHING SUGGESTIONS

1. Regardless of whether you develop the multiplier theoretically or more intuitively, if you require
students to calculate multiplier effects, expect to give them lots of practice. As part of that, you may
want to give them detective work If we know that real GDP changed by $100 billion and
spending changed by $25 billion, what can we conclude about the multiplier and MPC?
2. The multiplier concept can be demonstrated effectively by a role-playing exercise in which you have
students pretend that one row (group) of students are construction workers who benefit from a $1
million increase in investment spending. (Some instructors use an oversized paper $1-million bill.) If
their MPC is .9, then they will spend $900,000 of this at stores owned by a second row (group) of
students, who will in turn spend $810,000 or .9 x $900,000. At the end of the exercise, each row
can add up its new income and it will be well in excess of the initial $1 million. In fact, if played out
to its conclusion, the final change in GDP should approximate $10 million, given the MPS is .1 in
this example.
If you decide to use an oversized paper $1-million bill, then students will have to clip off one-tenth of
it at every stage to represent saving. By the end of the process, each row (group) of students has
seen its income increase by nine-tenths of what the previous group received. Adding up all of these
increases illustrates the idea that the original $1 million increase in spending has resulted in many
times that amount in terms of the students increased incomes. Obviously, you wont be able to
illustrate the final multiplier, but it should give them a good idea of how the final multiplier could be
equal to 10 in this example. In other words, if the process were carried to its conclusion, the original
$1 million of new investment would result in a $10 million increase in student incomes and $10
million of new saving.
If you dont want to use the prop, students are good at imagining that this could happen if youll
simply ask them to imagine that a new $1 million injection of investment spending (or government or
export sales) occurs, and then go through the chain of events described above.
3. Note that the multiplier effect can work in reverse as well as in the forward direction. The
closing of a military base or a factory shutting down has a multiplied negative impact on the local
community, reducing retail sales and placing a hardship on other businesses. Ask students to offer
examples of the multiplier effect that they have witnessed. They enjoy making up their own versions
of Buchwalds Last Word for this chapter.
4. Data to update Figure 9-1 may be found in the most recent issue of Survey of Current
Business or Economic Indicators. Web-based questions at the end of the chapter also point to
sources.
5. Investment expenditures are the most volatile segment of aggregate expenditures. Ask
students to research a particular industry to find out what factors are most likely to influence
investment decisions for that industry, or have students interview a local business manager or owner
about their decision to add capital equipment. Make a list of the factors that they consider when
making their decisions. Are they similar to the reasons given in the text? How were they different?

STUDENT STUMBLING BLOCKS

1. If your class is filled with struggling students consider using only one macro model. It is very
difficult for beginning students to switch from one set of assumptions to another. The concept of
equilibrium can be presented using Aggregate Expenditures or the AD-AS model presented in
Chapter 11. The model in this chapter uses income as the main determinant. AD-AS emphasizes

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the price level. An emphasis on only one model may help students understand the macro economy
better. This chapter may help you gauge whether or not to skip Chapter 10.
2. Students sometimes get so caught up in the theory that they forget the basic relationships. To help
them remember even simple things like MPC + MPS = 1, remind them that there are two things they
can do with their disposable income spend it or save it. Invariably someone will ask, What about
paying off credit cards (or other forms of debt)? Isnt that spending? You can either respond then
or attempt to preempt the question by explaining that repayment of debt is merely saving after the
fact. It is also an opportunity to review past material. If someone suggests that they can also pay
taxes, you can remind them that disposable income is after-tax income.
3. The discussion of the income and consumption relationship is a good opportunity to remind students
about the fallacy of composition. Unfortunately it is also a potential stumbling block. When you
discuss the marginal propensities, for example, it is on the one hand helpful to individualize the
experience If you received an extra dollar, how much of it would you spend? On the other hand,
how students answer such questions may cloud their ability to reason through what to expect in the
aggregate. You will need to remind students at times that theyre examining aggregate behavior and
that they cant necessarily generalize from their individual experience.

LECTURE NOTES
I. IntroductionWhat Are the Basic Macro Relationships?
A. Previously we identified macroeconomic issues of growth, business cycles, recession, and
inflation. Here we begin to develop tools to explain these events.
B. This chapter focuses on the three basic macroeconomic relationships.
1. Income and consumption, and income and saving.
2. The interest rate and investment.
3. Changes in spending and changes in output.
II. The Income-Consumption and Income-Saving Relationships
A. Disposable income is the most important determinant of consumer spending (see Figure 9-1
in text which presents historical evidence).
B. What is not spent is called saving.
C. Figure 9-1 represents graphically the recent historical relationship between disposable income
(DI), consumption (C), and saving (S) in the United States.
1. A 45-degree line represents all points where consumer spending is equal to disposable
income; other points represent actual C, DI relationships for each year from 1980-
2002.
2. If the actual graph of the relationship between consumption and income is below the 45-
degree line, then the difference must represent the amount of income that is saved.
3. In 1996 consumption was $5406 billion and disposable income was $5678 billion. Hence,
saving was $272 billion.
4. Some conclusions can be drawn.
a. Households consume a large portion of their disposable income.
b. Both consumption and saving are directly related to the level of income.
D. The consumption schedule.

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1. A hypothetical consumption schedule (Table 9-1 and Key Graph 9-2a) shows that
households spend a larger proportion of a small income than of a large income.
2. A hypothetical saving schedule (Table 1, column 3) is illustrated in Key Graph 9-2b.
3. Note that dissaving occurs at low levels of disposable income, where consumption
exceeds income and households must borrow or use up some of their wealth.
E. Average and marginal propensities to consume and save.
1. Define average propensity to consume (APC) as the fraction or % of income consumed
(APC = consumption/income). See Column 4 in Table 9-1.
2. Define average propensity to save (APS) as the fraction or % of income saved (APS =
saving/income). See Column 5 in Table 9-1.
3. Global Perspective 9-1 shows the APCs for several nations in 2000. Note the high APCs
for the U.S., Canada, and the United Kingdom.
4. Marginal propensity to consume (MPC) is the fraction or proportion of any change in
income that is consumed. (MPC = change in consumption/change in income.) See Column
6 in Table 9-1.
5. Marginal propensity to save (MPS) is the fraction or proportion of any change in income
that is saved. (MPS = change in saving/change in income.) See Column 7 in Table 9-1.
6. Note that APC + APS = 1 and MPC + MPS = 1.
7. Note that Figure 9-3 illustrates that MPC is the slope of the consumption schedule, and
MPS is the slope of the saving schedule.
8. Test Yourself: Try the Self-Quiz below Key Graph 9-2.
F. Nonincome determinants of consumption and saving can cause people to spend or save more or
less at various income levels, although the level of income is the basic determinant.
1. Wealth: An increase in wealth shifts the consumption schedule up and saving schedule
down. In recent years major fluctuations in stock market values have increased the
importance of this wealth effect. A reverse wealth effect occurred in 2000 and 2001,
when stock prices fell dramatically. CONSIDER THIS What Wealth Effect.
2. Expectations: Changes in expected future prices or wealth can affect consumption
spending today.
3. Real interest rates: Declining interest rates increase the incentive to borrow and consume,
and reduce the incentive to save. Because many household expenditures are not interest
sensitive the light bill, groceries, etc. the effect of interest rate changes on spending are
modest.
4. Household debt: Lower debt levels shift consumption schedule up and saving schedule
down.
5. Taxation: Lower taxes will shift both schedules up since taxation affects both spending
and saving; vice versa for higher taxes.
G. Terminology, shifts, and stability. See Figure 9-4.
1. Terminology: Movement from one point to another on a given schedule is called a change
in amount consumed; a shift in the schedule is called a change in consumption schedule.
2. Schedule shifts: Consumption and saving schedules will always shift in opposite directions
unless a shift is caused by a tax change.

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3. Stability: Economists believe that consumption and saving schedules are generally stable
unless deliberately shifted by government action.
III. The Interest Rate Investment Relationship
A. Investment consists of spending on new plants, capital equipment, machinery, inventories,
construction, etc.
1. The investment decision weighs marginal benefits and marginal costs.
2. The expected rate of return is the marginal benefit and the interest rate the cost of
borrowing funds represents the marginal cost.
B. The expected rate of return is found by comparing the expected economic profit (total revenue
minus total cost) to cost of investment to get the expected rate of return. The texts example
gives $100 expected profit on a $1000 investment, for a 10% expected rate of return. Thus,
the business would not want to pay more than a 10% interest rate on investment. Remember
that the expected rate of return is not a guaranteed rate of return. Investment carries risk.
C. The real interest rate, i (nominal rate corrected for expected inflation), determines the cost of
investment.
1. The interest rate represents either the cost of borrowed funds or the opportunity cost of
investing your own funds, which is income forgone.
2. If real interest rate exceeds the expected rate of return, the investment should not be made.
D. Investment demand schedule, or curve, shows an inverse relationship between the interest rate
and amountof investment.
1. As long as expected return exceeds interest rate, the investment is expected to be profitable
(see Table 9-2 example).
2. Key Graph 9-5 shows the relationship when the investment rule is followed. Fewer
projects are expected to provide high return, so less will be invested if interest rates are
high.
3. Test yourself with Quick Quiz 9-5.
E. Shifts in investment demand occur when any determinant apart from the interest rate changes.
1. Greater expected returns create more investment demand; shift curve to right. The reverse
causes a leftward shift.
a. Acquisition, maintenance, and operating costs of capital goods may change. Higher
costs lower the expected return.
b. Business taxes may change. Increased taxes lower the expected return.
c. Technology may change. Technological change often involves lower costs, which
would increase expected returns.
d. Stock of capital goods on hand will affect new investment. If there is abundant idle
capital on hand because of weak demand or recent investment, new investments
would be less profitable.
e. Expectations about future economic and political conditions, both in the aggregate
and in certain specific markets, can change the view of expected profits.
F. Investment is a very unstable type of spending; I is more volatile than GDP (See Figure 9-7).
1. Capital goods are durable, so spending can be postponed or not. This is unpredictable.
2. Innovation occurs irregularly.
3. Profits vary considerably.

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4. Expectations can be easily changed.

IV. The Multiplier Effect
A. Changes in spending ripple through the economy to generate event larger changes in real GDP.
This is called the multiplier effect.
1. Multiplier = change in real GDP / initial change in spending. Alternatively, it can be
rearranged to read Change in real GDP = initial change in spending x multiplier.
2. Three points to remember about the multiplier:
a. The initial change in spending is usually associated with investment because it is so
volatile.
b. The initial change refers to an upshift or downshift in the aggregate expenditures
schedule due to a change in one of its components, like investment.
c. The multiplier works in both directions (up or down).
B. The multiplier is based on two facts.
1. The economy has continuous flows of expenditures and incomea ripple effectin which
income received by Grant comes from money spent by Battaglia. Battaglias income, in
turn, came from money spent by Mendoza, and so forth.
2. Any change in income will cause both consumption and saving to vary in the same
direction as the initial change in income, and by a fraction of that change.
a. The fraction of the change in income that is spent is called the marginal propensity to
consume (MPC).
b. The fraction of the change in income that is saved is called the marginal propensity to
save (MPS).
c. This is illustrated in Table 9-3, and Figure 9-8 that is derived from the Table.
C. The size of the MPC and the multiplier are directly related; the size of the MPS and the
multiplier are inversely related. See Figure 9-9 for an illustration of this point. In
equation form Multiplier = 1/MPS or 1/(1-MPC).
D. The significance of the multiplier is that a small change in investment plans or consumption-
saving plans can trigger a much larger change in the equilibrium level of GDP.
E. The simple multiplier given above can be generalized to include other leakages from the spending
flow besides savings. For example, the actual multiplier is derived by including taxes and imports as
well as savings in the equation. In other words, the denominator is the fraction of a change in income not
spent on domestic output. (Key Question 9)

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