PART 3: MACROECONOMIC
MODELS AND FISCAL POLICY
CHAPTER 8
Basic
Macroeconomic
Relationships
Slides prepared by Bruno Fullone,
George Brown College
© 2010 McGraw-Hill Ryerson Limited
1
In This Chapter You Will Learn:
• Learning Objective 8.1: About the factors that
determine consumption expenditure and saving
• Learning Objective 8.2 How changes in real
interest rates affect investment
• Learning Objective 8.3 About factors other than
the real interest rate that can affect investment
• Learning Objective 8.4 Why changes in
investment increase or decrease real GDP by a
multiple amount
Chapter 8
2
8.1 The Income-Consumption &
Income-Saving Relationships
• The Consumption Schedule
o Reflects the direct consumption-disposable income
relationship
o higher income higher consumption
• The Saving Schedule
o Saving = Disposable Income – Consumption
o higher income higher saving
Illustrated…
LO8.1
3
LO8.1
4
Average and marginal propensities
APC + APS = 1
consumption
APC =
income
saving
APS =
income
change in consumption
MPC =
change in income
change in saving
MPS =
change in income
MPC + MPS = 1
LO7.1
5
Table 8-1
(1)
GDP
(=DI)
(2)
C
370
375
390
390
410
405
430
420
450
435
470
450
490
465
510
480
530
495
(3)
S
(1)-(2)
(4)
APC
(2)/(1)
(5)
APS
(3)/(1)
(6)
MPC
(2)/(1)
(7)
MPS
(3)/(1)
= 1.01 -5/370 = -.01
370 - 375 = 375/370
-5
15/20= .75 5/20 = .25
1.01
-.01
-5
.75
.25
1.00
.00
0
.75
.25
.99
.01
5
.75
.25
.98
.02
10
.75
.25
.97
.03
15
.75
.25
.96
.04
20
.75
.25
.95
.05
25
.75
.25
.94
.06
30
.75
.25
.93
.07
35
.75
.25
LO8.1
6
Graphically presented…
LO8.1
7
8.1 Global Perspective
Graphically presented…
LO8.1
9
Non-Income Determinants of
Consumption and Saving
• Wealth – dollar amount of all household debt minus its liabilities
• Wealth effect – downward shift of saving schedule and upward shift of
consumption schedule due to higher asset wealth
o Borrowing – when household borrow, it will increase consumption
o Expectations – expectations of future prices and income affect current
spending and saving
o Real interest rates – when real interest rates (those adjusted for
inflation) fall households tend to borrow more, consume more, and save less (and
vice versa)
LO8.1
10
More on Consumption and Saving
Schedules
• Switch to Real GDP – generally the macro models focus on real GDP
• Changes along Schedules – movements along curve caused by
changes in DI or real GDP
• Taxation – shift consumption and saving schedule in same direction; thus
increase in taxes will reduce both C and S (taxes paid at expense of consumption and
saving)
• Schedule Shifts – changes in wealth, borrowing, expectations, and real
interest rates will shift entire consumption schedule as well as saving schedule (in
opposite directions)
• Stability – both C and S are relatively stable
LO8.1
11
Schedule Shifts
Figure 8-4
Consumption
C
45
o
Saving
Disposable Income
S
390
Disposable Income
LO8.1
12
Schedule Shifts
Figure 8-4
Consumption
C1
C
An
increase in
consumption...
45
o
Disposable Income
Saving
S
390
Disposable Income
LO8.1
13
Schedule Shifts
Figure 8-4
Consumption
C1
C
An
increase in
consumption...
45
o
Disposable Income
Saving
S
Causes a
decrease
in saving
S1
Disposable Income
LO8.1
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Schedule Shifts
Figure 8-4
Consumption
C
C2
A
decrease in
consumption...
45
o
Saving
Disposable Income
S
Disposable Income
LO8.1
15
Schedule Shifts
Figure 8-4
schedules are
relatively stable
Consumption
C
C2
A
decrease in
consumption...
45
o
Disposable Income
Saving
S2
S
Causes an
increase
in saving
Disposable Income
LO8.1
16
8.2 The Interest Rate-Investment
• Expected Rate of Return, r
• The Real Interest Rate
o i = nominal rate – rate of inflation
o crucial in making investment decisions
• Investment Demand Curve
- illustrated
LO8.2
17
and interest rate, i (percent)
Expected rate of net profit,
r,
Figure 8-5
16
14
12
Investment
demand curve
10
8
6
4
2
ID
0
5
10 15 20 25 30 35 40
Investment (billions of dollars)
LO8.2
18
8.3 Shifts in the Invest Demand
Curve
• Acquisition, Maintenance & Operating Costs – i.e.
electricity costs go down, investment demand curve shifts right
• Business Taxes – after tax returns crucial to investment decisions, business
taxes go up, ID shifts left
• Technological Change – stimulate investments
• Stock of Capital Goods on Hand
• Planned Inventory – investment includes inventories; inv
increase/decrease depends on business conditions; investments include only planned
inv changes; unplanned inv changes only occur when the unexpected happens
• Expectations
LO8.3
19
and interest rate, i (percent)
Expected rate of net profit,
r,
Figure 8-6 Shifts in ID Curve
Increase in
investment demand
Decrease in
investment
demand
ID2
ID0
ID1
Investment (billions of dollars)
LO8.3
20
Fluctuations of Investment
•
•
•
•
Durability
Irregularity of Innovation
Variability of Profits
Variability of Expectations
LO8.3
21
Figure 8-7 The Volatility of Investment
LO8.3
22
8.4 The Multiplier Effect
Or rearranging the formula …
• The “Initial Change in Spending”
o associated with investment spending because of investment’s volatility
o associated with investment spending results from either a change in the real
interest rate or a shift of the ID curve
o may create a multiple increase in GDP and a decrease in spending may be
multiplied into a large decrease in GDP
LO8.4
23
The Multiplier Effect
Rationale:
• spending generates income
• change in income will cause both consumption &
saving to change
LO8.4
24
Table 8-3
(1)

income
Ig increases $5
(2)
C
(MPC=.75)
$5.00
$3.75
(3)
S
(MPS=.25)
$1.25
2nd round
3rd round
4th round
5th round
All other rounds
Total
LO8.4
25
Table 8-3
Ig increases $5
2nd round
(1)

income
(2)
C
(MPC=.75)
$5.00
$3.75
(3)
S
(MPS=.25)
$1.25
3.75
3rd round
4th round
5th round
All other rounds
Total
LO8.4
26
Table 8-3
Ig increases $5
2nd round
(1)

income
(2)
C
(MPC=.75)
(3)
S
(MPS=.25)
$5.00
$3.75
$1.25
3.75
2.81
0.94
3rd round
4th round
5th round
All other rounds
Total
LO8.4
27
Table 8-3
(1)

income
(2)
C
(MPC=.75)
$5.00
$3.75
$1.25
2nd round
3.75
2.81
0.94
3rd round
2.81
2.11
0.70
4th round
2.11
1.58
0.53
5th round
1.58
1.19
0.39
All other rounds
4.75
3.56
1.19
$20.00
$15.00
$5.00
Ig increases $5
Total
LO8.4
(3)
S
(MPS=.25)
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The Multiplier Process (MPC=.75)
All
I = $5 billion
other
LO8.4
29
The Multiplier and the Marginal
• Multiplier =
1_____ or ….
1 – MPC
• Multiplier =
___1____
MPS
LO 8.4
30
Figure 8-9
The MPC & the Multiplier
.9
10
.8
5
4
.75
.67
.5
3
3
• The larger the MPC (& the smaller the MPS), the
greater the size of the multiplier
LO8.4
31
The Multiplier Effect
How large is the actual multiplier effect?
• In reality, consumption of domestic output
increases in each round by a lesser amount than
implied by MPS alone
o imports & taxes
• actual multiplier: 1  (fraction of change in
income that is not spent on domestic output)
LO8.4
32
The Last Word: 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
Chapter 8 Summary
8.1 The Income-Consumption and IncomeSaving relationships
8.2 The Interest-Rate-Investment Relationship
8.3 Shifts in the Investment Demand
8.4 The Multiplier Effect
Chapter 8
34