Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms 8 Basic Macroeconomic Relationships End Show 8-1 Copyright 2008 The McGraw-Hill Companies Chapter Objectives Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show 8-2 • How Changes in Income Affect Consumption (and Saving) • About Factors Other Than Income That Can Affect Consumption • How Changes in Real Interest Rates Affect Investment • About Factors Other Than the Real Interest Rate That Can Affect Investment • Why Changes in Investment Increase or Decrease Real GDP by a Multiple Amount Copyright 2008 The McGraw-Hill Companies Basic Relationships Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word • Income-Consumption • Income-Saving • 45° Line • C = DI on the Line • S = DI - C Key Terms End Show 8-3 Copyright 2008 The McGraw-Hill Companies Income and Consumption Consumption and Disposable Income, 1983-2005 Key Terms 10000 9000 Consumption (billions of dollars) Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word 8000 04 03 01 7000 02 00 C 99 6000 Saving In 1992 5000 4000 3000 83 2000 84 98 97 96 95 94 93 92 91 90 89 88 87 86 85 Consumption In 1992 1000 45° 0 0 End Show 05 45° Reference Line C=DI 2000 4000 6000 8000 Disposable Income (billions of dollars) 8-4 Copyright 2008 The McGraw-Hill Companies 10000 Consumption and Saving Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word • The Consumption Schedule • The Saving Schedule • Break-Even Income • Average Propensity to Consume (APC) • Average Propensity to Save (APS) Consumption APC = Income Key Terms End Show 8-5 Copyright 2008 The McGraw-Hill Companies APS = Saving Income O 8.1 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word 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 Key Terms End Show 8-6 Copyright 2008 The McGraw-Hill Companies Consumption and Saving Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms (1) Level of (2) Output ConsumpAnd tion Income (C) (GDP=DI) (1) $370 (4) (5) (6) (7) Average Average Marginal Marginal Propensity Propensity Propensity Propensity (3) to Consume to Save to Consume to Save Saving (S) (APC) (APS) (MPC) (MPS) (1-2) (2)/(1) (3)/(1) Δ(2)/Δ(1) Δ(3)/Δ(1) $375 $-5 1.01 -.01 (2) 390 390 0 1.00 .00 (3) 410 405 5 .99 .01 (4) 430 420 10 .98 .02 (5) 450 435 15 .97 .03 (6) 470 450 20 .96 .04 (7) 490 465 25 .95 .05 (8) 510 480 30 .94 .06 (9) 530 495 35 .93 .07 (10) 550 510 40 .93 .07 End Show 8-7 Copyright 2008 The McGraw-Hill Companies .75 .25 .75 .25 .75 .25 .75 .25 .75 .25 .75 .25 .75 .25 .75 .25 .75 .25 Consumption and Saving Key Terms End Show 8-8 500 C 475 450 425 Saving $5 Billion Consumption Schedule 400 375 Dissaving $5 Billion 45° Saving (billions of dollars) Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Consumption (billions of dollars) Consumption and Saving Schedules 370 390 410 430 450 470 490 510 530 550 Disposable Income (billions of dollars) 50 Dissaving Saving Schedule S 25 $5 Billion Saving $5 Billion 0 370 390 410 430 450 470 490 510 530 550 Copyright 2008 The McGraw-Hill Companies Consumption and Saving GLOBAL PERSPECTIVE Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Average Propensities to Consume Select Nations GDPs Average Propensities to Consume .80 .85 .90 .95 1.00 United States .963 Canada .958 United Kingdom .953 Japan .942 Germany .896 Netherlands .893 Italy Key Terms France .840 .833 End Show Source: Statistical Abstract of the United States, 2006 8-9 Copyright 2008 The McGraw-Hill Companies Consumption and Saving Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show 8-10 • MPC + MPS = 1 • MPC and MPS as Slopes • Nonincome Determinants of Consumption and Saving –Wealth Effect –Expectations –Real Interest Rates –Household Debt Copyright 2008 The McGraw-Hill Companies W 8.1 Consumption and Saving Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word • Other Important Considerations • Changes Along Schedules • Switch to Real GDP • Schedule Shifts • Stability Key Terms • Taxation End Show 8-11 Copyright 2008 The McGraw-Hill Companies G 8.1 Consumption and Saving Consumption and Saving Schedules Key Terms End Show 8-12 C0 C2 45° Saving (billions of dollars) Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Consumption (billions of dollars) C1 Disposable Income (billions of dollars) Copyright 2008 The McGraw-Hill Companies S2 S0 S1 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Interest Rate and Investment • Expected Rate of Return (r) • The Real Interest Rate (i) • Meaning of r = i • Investment Demand Curve O 8.2 G 8.2 Key Terms End Show 8-13 Copyright 2008 The McGraw-Hill Companies Interest Rate and Investment The Investment Demand Curve Cumulative Amount of Investment Having This Rate of Expected Return or Higher Rate of (i) Return (r) 16% 14% 12% 10% 8% 6% 4% 2% 0% $ 0 5 10 15 20 25 30 35 40 Key Terms 16 14 r and i (percent) Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word 12 10 8 6 4 ID 2 0 5 10 15 20 25 30 35 Investment (billions of dollars) End Show 8-14 Copyright 2008 The McGraw-Hill Companies 40 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show 8-15 Interest Rate and Investment • Shifts of the Investment Demand Curve –Acquisition, Maintenance, and Operating Costs –Business Taxes –Technological Change –Stock of Capital Goods on Hand –Expectations Copyright 2008 The McGraw-Hill Companies Interest Rate and Investment Key Terms Increase in Investment Demand r and i (percent) Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Shifts in the Investment Demand Curve Decrease in Investment Demand 0 Investment (billions of dollars) End Show 8-16 Copyright 2008 The McGraw-Hill Companies ID2 ID0 ID1 Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Interest Rate and Investment • Instability of Investment –Durability –Irregularity of Innovation –Variability of Profits –Variability of Expectations Key Terms End Show 8-17 Copyright 2008 The McGraw-Hill Companies Interest Rate and Investment GLOBAL PERSPECTIVE Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Gross Investment Expenditures as a Percent of GDP, Select Nations Percent of GDP, 2004 0 10 20 30 South Korea Japan Mexico Canada France United States Germany Key Terms United Kingdom End Show Sweden Source: World Bank 8-18 Copyright 2008 The McGraw-Hill Companies Interest Rate and Investment The Volatility of Investment 40 30 Percentage Change Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word 20 Gross Investment 10 0 GDP -10 -20 -30 1971 1975 Key Terms 1979 1983 1987 1991 Year End Show 8-19 Copyright 2008 The McGraw-Hill Companies 1995 1999 2003 The Multiplier Effect Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Multiplier = Change in Real GDP Initial Change in Spending The Multiplier and the Marginal Propensities Multiplier = 1 1 - MPC -orMultiplier = 1 MPS Key Terms Graphically… End Show 8-20 W 8.2 Copyright 2008 The McGraw-Hill Companies The Multiplier Effect Tabular and Graphical Views Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Increase in Investment of $5 Second Round Third Round Fourth Round Fifth Round All other rounds Total $ 20.00 $ 15.00 $ 5.00 $20.00 $4.75 15.25 13.67 11.56 8.75 5.00 $1.58 $2.11 $2.81 ΔI= $5 billion $3.75 Key Terms $5.00 End Show 1 8-21 (2) (3) Change in Change in (1) Saving Change in Consumption (MPC = .75) (MPC = .25) Income $ 5.00 $ 3.75 $ 1.25 3.75 2.81 .94 2.81 2.11 .70 2.11 1.58 .53 1.58 1.19 .39 4.75 3.56 1.19 Copyright 2008 The McGraw-Hill Companies 2 3 4 Rounds of Spending 5 All The Multiplier Effect The MPC and the Multiplier Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms MPC Multiplier .9 10 .8 5 .75 4 .67 .5 3 2 End Show 8-22 Copyright 2008 The McGraw-Hill Companies Squaring the Economic Circle Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms End Show 8-23 • Humorist Art Buchwald and the Multiplier • 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 Copyright 2008 The McGraw-Hill Companies Key Terms Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word Key Terms • 45° (degree) line • consumption schedule • saving schedule • break-even income • average propensity to consume (APC) • average propensity to save (APS) End Show 8-24 Copyright 2008 The McGraw-Hill Companies • marginal propensity to consume (MPC) • marginal propensity to save (MPS) • wealth effect • expected rate of return • investment demand curve • multiplier Next Chapter Preview… Basic Relationships Income and Consumption Consumption and Saving Consumption and Saving Schedules Changes in C & S Interest Rate and Investment Investment Demand Curve Shifts in the Investment Demand Curve Volatility of Investment Multiplier Effect Last Word The Aggregate Expenditures Model Key Terms End Show 8-25 Copyright 2008 The McGraw-Hill Companies