Chapter 27 - Basic Macroeconomic Relationships
CHAPTER TWENTY-SEVEN
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 28.
This was Chapter 8 in the 17th edition.
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.
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
the marginal propensities.
11. Discuss why the actual multiplier may differ from the theoretical examples.
12. Define and identify terms and concepts at the end of the chapter.
LECTURE NOTES
I.
Introduction—What 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.
C. Learning objectives – In this chapter students will learn:
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Chapter 27 - Basic Macroeconomic Relationships
1. How changes in income affect consumption and saving.
2. About factors other than income that can affect consumption.
3. How changes in real interest rates affect investment.
4. About factors other than the real interest rate that can affect investment.
5. Why changes in investment increase or decrease real GDP by a multiple amount.
II.
The Income-Consumption and Income-Saving Relationships
Disposable income is the most important determinant of consumer
spending.
A.
B. What is not spent is called saving.
C. Figure 27.1 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 1983-2005.
2. If the actual graph of the relationship between consumption and income is below the 45degree line, then the difference must represent the amount of income that is saved.
3. In 1992 consumption was $4385 billion and disposable income was $4751 billion.
Hence, saving was $366 billion. Notice that in 2005, consumption ($9072.1 billion)
exceeded disposable income ($9038.6 billion) – personal saving was a negative $33.5
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:
1. A hypothetical consumption schedule
(Table 27.1 and Key Graph
27.2a) shows that households spend a larger proportion of a small income than of a
large income.
2. A hypothetical saving schedule (Table 27.1, column 3) is illustrated in Key Graph 27.2b.
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.
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Chapter 27 - Basic Macroeconomic Relationships
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 27.1.
2. Define average propensity to save (APS) as a the fraction or % of income saved (APS =
saving/income). See Column 5 in Table 27.1.
3. Global Perspective 27.1 shows the APCs for several nations in 2006. 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 27.1.
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 27.1.
6.
Note that APC + APS = 1 and MPC + MPS = 1.
7.
Note that Figure 27.3 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 27.2.
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 borrowing( DEBT): Lower levels of borrowing shift the consumption
schedule up and saving schedule down.
G. Other important considerations: See Figure 27.4.
1. Macroeconomic models focus on real domestic output (real GDP) more than on
disposable income. Figure 27.4 reflects this change in the labeling of the horizontal axis.
2. Changes along schedules: Movement from one point to another on a given schedule is
called a change in the amount consumed; a shift in the schedule is called a change in
consumption schedule, and is caused by nonincome determinants of consumption..
3. Schedule shifts: Consumption and saving schedules will always shift in opposite
directions unless a shift is caused by a tax change.
4. Taxation: Lower taxes will shift both schedules up since taxation affects both spending
and saving, and vice versa for higher taxes.
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Chapter 27 - Basic Macroeconomic Relationships
5. 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.
Expected rate of return is found by comparing the expected
economic profit (total revenue minus total cost) to cost of investment
to get expected rate of return. The text’s 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 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 amount of investment.
1. As long as expected return exceeds interest rate, the investment is expected to be
profitable (see Table 27.2 example).
2. Key Graph 27.5 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 27.5.
E. Shifts in investment demand (Figure 27.6) 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.
2. Changes in expected returns result because:
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.
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Chapter 27 - Basic Macroeconomic Relationships
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 27.7).
1. Capital goods are durable, so spending can be postponed or not. This is unpredictable.
2. Innovation occurs irregularly.
3. Profits vary considerably.
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, but changes in consumption (unrelated to income), net exports, and
government purchases also are subject to the multiplier effect.
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 income—a ripple effect—in
which income received by Grant comes from money spent by Battaglia. Battaglia’s
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 27.3, and Figure 27.8 that is derived from the Table.
The size of the MPC and the multiplier are directly related; the size
of the MPS and the
multiplier are inversely related. See Figure 27.9
for an illustration of this point. In equation
form Multiplier =
1 / MPS or 1 / (1-MPC).
C.
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Chapter 27 - Basic Macroeconomic Relationships
D. The significance of the multiplier is that a small change in investment plans or consumptionsaving 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)
27-5
(Key Question) Complete the accompanying table.
Level of Output
and income
(GDP = DI) Consumption
Saving
APC
APS
MPC
MPS
$240
$ _____
$-4
_____
_____
_____
_____
260
$ _____
0
_____
_____
_____
_____
280
$ _____
4
_____
_____
_____
_____
300
$ _____
8
_____
_____
_____
_____
320
$ _____
12
_____
_____
_____
_____
340
$ _____
16
_____
_____
_____
_____
360
$ _____
20
_____
_____
_____
_____
380
$ _____
24
_____
_____
_____
_____
400
$ _____
28
_____
_____
_____
_____
Data for completing the table (top to bottom). Consumption: $244; $260; $276; $292; $308; $324;
$340; $356; $372. APC: 1.02; 1.00; .99; .97; .96; .95; .94; .94; .93. APS: -.02; .00; .01; .03; .04;
.05; .06; .06; .07. MPC: .80 throughout. MPS: .20 throughout.
a. Show the consumption and saving schedules graphically.
b. Find the break-even level of income. Explain how is it possible for households to dissave at
very low income levels.
c. If the proportion of total income consumed (APC) decreases and the proportion saved (APS)
increases as income rises, explain both verbally and graphically how the MPC and MPS can
be constant at various levels of income.
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Chapter 27 - Basic Macroeconomic Relationships
(a) See the graphs.
(b) Break-even income = $260. Households dissave borrowing or using past savings.
(c) Technically, the APC diminishes and the APS increases because the consumption and saving
schedules have positive and negative vertical intercepts respectively. (Appendix to Chapter
1). MPC and MPS measure changes in consumption and saving as income changes; they are
the slopes of the consumption and saving schedules. For straight-line consumption and
saving schedules, these slopes do not change as the level of income changes; the slopes and
thus the MPC and MPS remain constant.
27-6
What are the basic determinants of investment? Explain the relationship between the real
interest rate and the level of investment. Why is investment spending unstable? How is it
possible for investment spending to increase even in a period in which the real interest rate rises?
The basic determinants of investment are the expected rate of return (net profit) that businesses
hope to realize from investment spending, and the real rate of interest.
When the real interest rate rises, investment decreases; and when the real interest rate drops,
investment increases—other things equal in both cases. The reason for this relationship is that it
makes sense to borrow money at, say, 10 percent, if the expected rate of net profit is higher than
10 percent, for then one makes a profit on the borrowed money. But if the expected rate of net
profit is less than 10 percent, borrowing the money would be expected to result in a negative rate
of return on the borrowed money. Even if the firm has money of its own to invest, the principle
still holds: The firm would not be maximizing profit if it used its own money to carry out an
investment returning, say, 9 percent when it could lend the money at an interest rate of 10
percent.
Investment is unstable because, unlike most consumption, it can be put off. In good times, with
demand strong and rising, businesses will bring in more machines and replace old ones. In times
of economic downturn, no new machines will be ordered. A firm can continue for years with,
say, a tenth of the investment it was carrying out in the boom. Very few families could cut their
consumption so drastically.
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Chapter 27 - Basic Macroeconomic Relationships
New business ideas and the innovations that spring from them do not come at a constant rate.
This is another reason for the irregularity of investment. Profits and the expectations of profits
also vary. Since profits, in the absence of easy access to borrowed money, are essential for
investment and since, moreover, the object of investment is to make a profit, investment, too,
must vary.
As long as expected rates of return rise faster than real interest rates, investment spending may
increase. This is most likely to occur during periods of economic expansion.
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(Key Question) Suppose a handbill publisher can buy a new duplicating machine for $500 and
the duplicator has a 1-year life. The machine is expected to contribute $550 to the year’s net
revenue. What is the expected rate of return? If the real interest rate at which funds can be
borrowed to purchase the machine is 8 percent, will the publisher choose to invest in the
machine? Explain.
The expected rate of return is 10% ($50 expected profit/$500 cost of machine). The $50
expected profit comes from the net revenue of $550 less the $500 cost of the machine.
If the real interest rate is 8%, the publisher will invest in the machine as the expected profit
(marginal benefit) from the investment exceeds the cost of borrowing the funds (marginal cost).
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(Key Question) Assume there are no investment projects in the economy which yield an
expected rate of return of 25 percent or more. But suppose there are $10 billion of investment
projects yielding expected rate of return of between 20 and 25 percent; another $10 billion
yielding between 15 and 20 percent; another $10 billion between 10 and 15 percent; and so forth.
Cumulate these data and present them graphically, putting the expected rate of net return on the
vertical axis and the amount of investment on the horizontal axis. What will be the equilibrium
level of aggregate investment if the real interest rate is (a) 15 percent, (b) 10 percent, and (c) 5
percent? Explain why this curve is the investment-demand curve.
See the graph below. Aggregate investment: (a) $20 billion; (b) $30 billion; (c) $40 billion.
This is the investment-demand curve because we have applied the rule of undertaking all
investment up to the point where the expected rate of return, r, equals the interest rate, i.
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(Key Question) What is the multiplier effect? What relationship does the MPC bear to the size
of the multiplier? The MPS? What will the multiplier be when the MPS is 0, .4, .6, and 1?
What will it be when the MPC is 1, .9, .67, .5, and 0? How much of a change in GDP will result
if firms increase their level of investment by $8 billion and the MPC is .80? If the MPC is .67?
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Chapter 27 - Basic Macroeconomic Relationships
The multiplier effect describes how an initial change in spending ripples through the economy to
generate a larger change in real GDP. It occurs because of the interconnectedness of the
economy, where a change in Lasslett’s spending will generate more income for Gavidia, who
will in turn spend more, generating additional income for Grimes.
The MPC is directly (positively) related to the size of the multiplier. The MPS is inversely
(negatively) related to the size of the multiplier.
The multiplier values for the MPS values: undefined, 2.5, 1.67, 1.
The multiplier values for the MPC values: undefined, 10, 3 (approx. actually 3.03), 2, 0.
If MPC is .80, change in GDP is $40 billion (5 x $8 = $40)
If MPC is .67, change in GDP is $24 billion (approximately) (3 x $8 = $24)
27-10 Why is the actual multiplier for the U.S. economy less than the multiplier in this chapter’s simple
examples?
The actual multiplier (estimated to be about 2) is smaller because it includes other leakages from
the spending and income cycle besides just saving. Imports and taxes reduce the flow of money
back into spending on domestically produced output, reducing the multiplier effect.
27-11 Advanced analysis: Linear equations (see appendix to Chapter 1) for the consumption and
saving schedules take the general form C = a + bY and S = - a + (1- b)Y, where C, S, and Y are
consumption, saving, and national income respectively. The constant a represents the vertical
intercept, and b represents the slope of the consumption schedule.
a. Use the following data to substitute specific numerical values into the consumption and
saving equations.
National Income (Y)
Consumption (C)
$ 0
100
200
300
400
$ 80
140
200
260
320
b. What is the economic meaning of b? Of (1 - b)?
c. Suppose the amount of saving that occurs at each level of national income falls by $20, but
that the values for b and (1 - b) remain unchanged. Restate the saving and consumption
equations for the new numerical values and cite a factor that might have caused the change.
(a) C = $80 + 0.6Y
S = -$80 + 0.4Y
(b) Since b is the slope of the consumption function, it is the value of the MPC. (In this case the
slope is 6/10, which means for every $10 increase in income (movement to the right on the
horizontal axis of the graph), consumption will increase by $6 (movement upwards on the
vertical axis of the graph). (1 - b) would be 1 - .6 = .4, which is the MPS.
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Chapter 27 - Basic Macroeconomic Relationships
Since (1 - b) is the slope of the saving function, it is the value of the MPS. With the slope of
the MPC being 6/10, the MPS will be 4/10. This means for every $10 increase in income
(movement to the right on the horizontal axis of the graph), saving will increase by $4
(movement upward on the vertical axis of the graph).
(c) C  100  0.6Y
S  $100  0.4Y
A factor that might have caused the decrease in saving—the increased consumption—is the
belief that inflation will accelerate. Consumers wish to stock up before prices increase.
Other factors might include a sudden increase in wealth or decrease in indebtedness, or a
decrease in personal taxes.
27-12 (Advanced analysis) Suppose that the linear equation for consumption in a hypothetical economy
is C = $40 + .8Y. Also suppose that income (Y) is $400. Determine (a) the marginal propensity
to consume, (b) the marginal propensity to save, (c) the level of consumption, (d) the average
propensity to consume, (e) the level of saving, and (f) the average propensity to save.
(a) MPC is .8
(b) MPS is 1  8  .2
(c) C  $40  .8$400   $40  $320  $360
(d) APC  $360 / $400  .9
(e) S  Y  C  $400  $360  $40
(f) APS  $40 / $400  .1 or 1  APC
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