# AP Macro 3-0 Basic Macro Relationships v3

```Basic Macroeconomics
Relationships
&amp; Information
Technology
Unit 3 Chapter 27
1
Recession, and Inflation?
Macroeconomic Relationships help us explain
these events.
1. Income, Consumption, and Saving
2. Interest Rates, Expected Rate of Return, and
Investment.
3. Changes in Spending, and Real GDP
LO1
27-2
1. Income, Consumption, and Saving
Remember…
Personal Income – Taxes = Disposable Income
How many things can you do with your DI?
•
•
•
•
•
•
LO1
DI = Consumption + Savings
Direct relationship
45○ line C = DI
Points below are C
Difference is Savings
HHs spend a larger
proportion of a small income
than of a large income.
27-4
Savings and Consumption Schedule
Consumption (billions of dollars)
Dissavings occur at low income levels.
What do people do if Consumption &gt; DI?
500
C
475
450
425
Saving \$5 billion
Consumption
schedule
400
375
Dissaving \$5 billion
45&deg;
370 390 410 430 450 470 490 510 530 550
LO1
27-6
Average Propensities
Average propensity to consume (APC)
• Fraction of total income
consumed
Average propensity to save (APS)
• Fraction of total income saved
consumption
APC =
income
APS =
saving
income
APC + APS = 1
LO1
(4)
(5)
Average
Propensity
to Consume
(APC),
Average
Propensity
to Save
(APS),
(2)/(1)
(3)/(1)
(1) \$370
1.01
-.01
(2)
390
1.00
.00
(3)
410
.99
.01
(4)
430
.98
.02
(5)
450
.97
.03
(6)
470
.96
.04
(7)
490
.95
.05
(8)
510
.94
.06
(9)
530
.93
.07
.93
.07
(1)
Level of
Output and
Income
GDP=DI
(10) 550
Example: DI = \$1B. and C = \$96M:
APC = .96
APS = .04
27-8
Global Perspective
LO1
27-10
Marginal propensity to consume (MPC)
• Proportion of a change in income
consumed
Marginal propensity to save (MPS)
• Proportion of a change in income saved
MPS =
change in saving
change in income
C (\$15)
DI (\$20)
change in consumption
change in income
C
15
MPC = 20 = .75
MPS =
5
= .25
20
Saving
MPC =
Consumption
Marginal Propensities
S
S (\$5)
DI (\$20)
Disposable income
So, MPC + MPS = 1
Ex: .75 + .25 = 1
LO1
27-11
2. Interest-Rate-Investment Relationship
First, what is the Expected Rate of Return?
Example:
• A new robot costs \$1,000. Expected net revenue =
•
\$1,100. Expected profit = \$100.
Expected Rate of Return (r) = Profit/Cost x 100
r = \$100/\$1,000 x 100
r = 10%
The real interest rate
If the interest rate (i) to borrow capital is 7%, r = 3%
-2%
What if i = 12%? r = _______
Businesses will invest in projects for which r &gt; i
LO3
27-13
(r)
and
(i)
16%
Investment
(billions
of dollars)
\$0
14
5
12
10
10
15
8
20
6
25
4
30
2
35
0
40
Expected rate of return, r
and real interest rate, i (percents)
Investment Demand Curve
16
14
A
Investment
demand
curve
12
10
8
6
4
2
0
ID
5
10
15
20
25
30
35
40
Investment (billions of dollars)
There is an inverse relationship between r and Quantity of Investments
Demanded.
Example: At point A, \$10B “quantity” of investments will be demanded
at a “price” of 12% i and a r of 12% or HIGHER.
In other words, at an interest rate of 12%, investment will be \$10
billion, because these are projects with expected rates of return
between 12% and 13.99%.
27-15
LO3
Investment Volatility Compared to GDP
Source: Bureau of Economic Analysis, http://www.bea.gov.
LO4
27-17
3. Spending Changes-RGDP
The Multiplier Effect
Consider this…If spending increases and GDP is at
its potential, what will happen?
Remember this?
If GDP has room to grow…
•
A change in spending changes real GDP more than the
initial change in spending (Multiplier Effect)
Multiplier =
change in real GDP
initial change in spending
Change in GDP = multiplier x initial change in spending
LO5
27-18
The Multiplier Effect
(1)
Change in
Income
(2)
Change in
Consumption
(MPC = .75)
(3)
Change in
Saving
(MPS = .25)
\$5.00
\$3.75
\$1.25
Second round
3.75
2.81
.94
Third round
2.81
2.11
.70
Fourth round
2.11
1.58
.53
Fifth round
1.58
1.19
.39
All other rounds
4.75
3.56
1.19
\$20.00
\$15.00
\$5.00
Increase in investment of \$5.00
Total
Cumulative income,
GDP (billions of
dollars)
20.00
\$4.75
15.25
13.67
Multiplier =
change in real GDP
initial change in spending
\$1.58
\$2.11
11.56
\$2.81
8.75
Multiplier =
\$3.75
\$20 B
=4
\$5 B
5.00
\$5.00
1
LO5
2
3
4
5
All others
What if MPC = .90?
27-20
Multiplier and Marginal Propensities
Multiplier and MPC are directly related
•
Large MPC results in larger increases in spending
Multiplier and MPS inversely related
•
Large MPS results in smaller increases in spending
Multiplier =
1
1 - MPC
=
1
1 - .90
1
=
.1
= 10
Remember, MPC + MPS = 1
MPS = 1-MPC
Multiplier =
LO5
1
MPS
=
1
.1
MPC
.9
Multiplier
10
.8
5
.75
1
= 10
=
1/10
.67
.5
4
3
2
27-22
Let’s Practice…
•
•
•
•
Consumers initiate a \$7B increase in spending.
Government initiates a \$3B expenditures.
If the MPC is currently .60, what is the overall
increase to RGDP?
Step 1: Calculate the multiplier.
Multiplier =
1
1 - MPC
=
1
MPS
=
1
.4
=
1
2/5
= 2.5
Step 1: Calculate Change in GDP.
Change in GDP = Multiplier x initial change in spending
= 2.5 x \$14B = \$35B
27-24
The Actual Multiplier Effect?
• Actual multiplier is lower than the model
•
•
•
•
LO5
assumes