Basic Macroeconomic
Relationships
Chapter 11
•Remember: GDP = C+I+G+ (X-M)
•PART 1: What explains the trends in consumption
(consumer spending) and saving reported in the news?
•PART 2: How do changes in interest rates affect
investment?
•PART 3: How can initial changes in spending ultimately
produce multiplied changes in GDP? (C,I, and G) the
multiplier effect
PART 1
Consumption (Consumer Spending)
CONSUMER SPENDING
• Already studied how consumer spending is
affected by wealth and interest rates (see
previous notes)
• Now let us look at two additional factors –
current disposable income and expected
future disposable income
Current Disposable Income and
Consumer Spending
• Disposable income – income you have left to
spend of save after all expenses have been paid;
• Consumption function – equation showing how
an individual household’s consumer spending
varies with the household’s current disposable
income; Reflects the direct consumptiondisposable income relationship
– http://www.reffonomics.com/textbook2/macroecono
mics2/keynesianthought/keynesiancross.swf
Consumption Schedule
• Aggregate consumption function – consumption in
the economy as a whole
– Your spending can be affected by what you think/know
your disposable income is going to do in the future (you
are starting a higher paying job in a month but you start
spending now…or you know your company is going to
begin layoffs and you stop spending now)
– Life-cycle hypothesis – consumers plan their spending over
a lifetime…so people will save some of their income during
peak earnings and live off the wealth they have
accumulated while working during their retirement
(wealth effect)
• Change s in wealth across the economy can change the aggregate
consumption function (home values increase, etc.)
Average Propensity (to consume and
to save)
• APC- the fraction, or percentage, of total income
that is consumed (propensity means
tendency/inclination to…)
– APC= consumption/income
• APS – the fraction, or percentage, or total income
that is saved
– APS=savings/income
• APC+APS=1 (think about this… for every $1 you
have, you are going to spend some and save
some)
Marginal Propensity (to consume and
to save)
• The fact that households consume a certain proportion of
a particular total income does not guarantee they will
consume the same proportion of any CHANGE (marginal)
in income they might receive
• The proportion, or fraction, of any change in income
consumed is the marginal propensity to consume (MPC)
– MPC=change in consumption/change in income
• The fraction of any change in income saved is the
marginal propensity to save (MPS)
– MPS=change in saving/change in income
• MPC+MPS=1
Part 2
Interest Rate-Investment
Relationship
Investment
• Consists of expenditures on new plants, capital
equipment, machinery, inventories, and so on.
• Investment demand curve
• Marginal-benefit-marginal-cost decision (my dad’s
story)
– Marginal benefit from investment is the expected rate of
return businesses hope to realize.
– Marginal cost is the interest rate that must be paid for
borrowed funds
• Investment decision guided by profit motive
(businesses buy capital only when they think such
purchases will be profitable)
– EXPECTED RATE OF RETURN (r) – what businesses expect
to get out of investment; not guaranteed
– nominal rate of return – inflation rate = real rate of return
What is actual investment spending?
• It is planned investment spending + unplanned
inventory investment
• Planned investment spending
– Investment spending that firms intend to undertake during
a given period
• Unplanned inventory investment
– Occurs when actual sales are more or less than businesses
expected, leading to unplanned changes in inventories
– Inventories – stocks of goods held to satisfy future sales
– Firms hold inventories so they can quickly satisfy buyers (a
consumer can purchase off the shelf instead of waiting for
it to be manufactured)
– Read example on page 278
Shifts in Investment Demand Curve
• Investment Demand Curve – other things equal…
relationship between the interest rate and the
amount of investment demanded; movement
along curve caused by change in real interest rate
(r) and expected rate of return (i)
• When OTHER THINGS CHANGE, the investment
curve shifts
– Any factor that leads businesses collectively to expect
greater rates of return on their investments increases
investment demand (shift to the right); vice versa
Factors that cause shifts
• Acquisition, Maintenance, and Operating
Costs
• Business Taxes
• Technological Change
• Stock of Capital Goods on Hand
• Expectations
Instability of Investment
• Unstable; rises and falls quite often
• Most volatile component of total spending
• Factors that affect variability of investment:
– Durability (capital durable; businesses can choose
to get rid of capital, fix capital to last few years,
etc.)
– Irregularity of Innovation (does not happen too
often; when it does, surge in investment but then
levels off)
– Variability of Profits (affects incentives to invest)
– Variability of Expectations
Leakages and Injections (must know)
• Injections – firms sell some of its output to other
businesses (investment)
– Investment (purchases of capital goods) is an injection
of spending into the income-expenditure stream
• Leakages – a withdrawal of spending from the
income-expenditures stream
– Saving is a leakage!!!!
– Saving is what causes consumption to be less than
total output (or Real GDP)
• If leakage exceeds injection of investment =
leads to GDP decreasing (in other
words…people save more than spend)
• If injection of investment exceeds leakage =
leads to GDP increasing
• CIRCULAR FLOW: households are savers
(leakages) and businesses are investors
(injections)…leakage is OUTFLOW and
injections are INFLOW
• Examples of leakages: savings, taxes
• Examples of injections: investment,
government spending, net exports
• At equilibrium when leakages = injections
PART 3
Multiplier Effect
(relationship between changes in
spending and changes in real GDP)
Multiplier Effect
• Definition: change in a component of total
spending leads to a larger change in GDP
– In other words, when there is a shift in the aggregate
demand curve, HOW MUCH will it shift????????
• Multiplier: determines how much larger that
change will be
• Multiplier = change in real GDP/initial change in
spending
– Change in GDP = multiplier x initial change in
spending
Two Facts of Multiplier
1) Economy supports repetitive, continuous
flows of expenditures and income (your
spending becomes someone’s income, then
they spend, which is someone’s income, etc.)
2) 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 the Marginal
Propensities
• Multiplier = 1/ (1-MPC)
• Multiplier = 1/MPS
• The higher the MPC (the lower MPS),
the larger the multiplier
• Spend more, save less = Multiplier will
be greater
• Save more, spend less = Multiplier will
be smaller
TAX MULTIPLIER
• Taxes are leakages
• Raise taxes, lower spending (vice versa)
• INVERSE RELATIONSHIP BETWEEN TAXES AND
SPENDING!!!!
• Tax Multiplier will be smaller than spending
multiplier because some dollars leak out into
savings
• Tax Multiplier = MPC/1-MPC
– Will always will 1 less than spending multiplier