Basic Macroeconomic Relationships

1/24/2012 5:40:00 PM

The Income- Consumption and Income- Saving Relationships: Saving= DI-C Disposable income determines the nations level of spending and consumption The 45 degree line is a reference point. At each point on the line, consumption would equal disposable income, or C= DI. The vertical distance between the line and any point on the horizontal axis measures either consumption or disposable income. As DI rises, saving increases; As DI falls, saving decreases y The Consumption Schedule o Schedule showing the amount that households will plan to consume at different levels of DI that might prevail at some time. o Spend a larger proportion of a small DI than of a large DI Saving Schedule o S= DI- C o There is a direct relationship between saving and DI but that saving is a smaller proportion of a small DI than of a large DI. o If households consume a smaller and smaller proportion of DI as DI increases, then they must be saving a larger and larger proportion. o Dissaving: consuming in excess of after- tax income o Dissaving will occur at low DIs Average and Marginal Propensities o APC  Fraction, or percentage, of total income that is consumed  APC= Consumption/Income o APS  Fraction of total income that is saved  APS= Saving/Income  APC+APS= 1 o MPC  The proportion, or fraction, of any change in income consumed  MPC= Change in consumption/Change in income  Slope of consumption schedule o MPS  The fraction of any change in income saved  MPS= Change in saving/Change in income

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MPC+MPS= 1 Slope of Saving schedule

Nonincome Determinants of Consumption and Saving o Wealth  Both real and financial assets  Increase spending and reduce saving  Shifts consumption schedule upward and the saving schedule downward o Expectations o Real Interest rates  When RIR fall, households borrow more, consume more, and save less.  Buy goods based on credit  Reduced interest payment makes them not want to save  Consumption slightly upward and saving slightly downward o Household debt  When consumers as a group increase their household debt , they can increase current consumption at each level of DI o Taxation  Change in taxes will result in C and S moving in the same direction The Interest- Rate- Investment Relationship y Expected rate of return o Business buy when they think they will make a profit o R= Profit/price The Real Interest Rate o i x amount borrowed = interest cost o if expected rate of return exceeds interest rate then the investment should be undertaken o invest up to the point of r = i Investment Demand Curve o Projects undertaken until i = r Shifts of the Investment Demand Curve o Acquisition, Maintenance, and Operating Costs  Effect expected rate of return on investment.  Costs rise= shift left  Costs fall= shift right

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o Business Taxes  Increase= shift left  Decrease= shift right o Technological Change  Stimulates investment  Shift curve to the right o Stock of Capital Goods on Hand  Economy is overstocked and when firms have too many finished goods, the R declines. Causes a shift left o Expectations o Durability  Optimism of the future vs. pessimism of the future o Irregularity of Innovation  When innovation occurs it triggers a wave of investment spending o Variability of Profits  Greater profits = invest o Variability of Expectations  Stock market tells the future of business conditions  Look at exchange rates, international peace, court decisions etc to see what the future will be like The Multiplier Effect Direct relationship between changes in spending and changes in real GDP Multiplier effect: a change in a component of total spending leads to a larger change in GDP Multiplier= Change in real GDP/ Initial change in spending Initial change is usually associated with investment spending but also with changes in consumption, net exports, and government purchases Initial change results from a change in the real interest rate and/or a shift of the investment demand curve Multiple increase or multiple decrease y Rational o Economy supports repetitive, continuous flows of expenditures o Any change in income will vary both consumption and saving in the same direction as, and by a fraction of, the change in income The Multiplier and Marginal Propensities o Multiplier = 1/ 1- MPC = 1/MPS

1/24/2012 5:40:00 PM

1/24/2012 5:40:00 PM