Basic Macroeconomic Relationships

CHAPTER OVERVIEW

• Identify the consumption & savings functions: what influences them?

• What are the non income determinants of consumption & savings?

• What influences shifts and movement along a function?

• What is the relationship between interest rate & investment?

• What causes shifts in the Investment Demand Curve?

• What is the multiplier and what effect does it have?

INCOME-CONSUMPTION AND INCOME-SAVINGS RELATIONSHIPS

• By studying the Income & Consumption relationship we are also studying the income & saving relationship

• Savings means “not spending” to an economist

• Savings = DI (disposable income) – C (consumption)

• Although many factors contribute to a nation’s level of consumption or savings, DI is the most significant!!!!!!

• 45°line for reference

• C = DI on the Line

INCOME AND CONSUMPTION

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

0 2000 4000 6000 8000 10000

Co

nsu

mp

tio

n (

bil

lio

ns

of

do

llar

s)

Disposable Income (billions of dollars)

45° Reference LineC=DI

83

8685

84

8889

9190

87

9293

9495

01

9796

9998

00

02

05

03

04

ConsumptionIn 1992

SavingIn 1992

45°

C

Source: Bureau of Economic Analysis

INCOME-CONSUMPTION AND INCOME-SAVINGS RELATIONSHIPS

• The Consumption Schedule

• Also called the Consumption Function (CF), reflects the direct consumption-disposable income relationship (this is based on historical data)

• The CF shows the trend that as households have more DI they have a tendency to spend more; however, households with smaller DI spend a larger portion then households who have a larger DI

INCOME-CONSUMPTION AND INCOME-SAVINGS RELATIONSHIPS

• The Saving Schedule

• Shows the amount of savings per DI levels

• Households with larger DI can save a greater portion of their DI

• What does “dissaving” refer to?

• What does the “break-even” income refer to?

CONSUMPTION AND SAVING

(1)Level ofOutput

AndIncome

(GDP=DI)

(2)Consump-

tion(C)

(3)Saving (S)

(1) – (2)

(4)Average

Propensityto Consume

(APC)(2)/(1)

(5)Average

Propensityto Save(APS)(3)/(1)

(6)Marginal

Propensityto Consume

(MPC)Δ(2)/Δ(1)

(7)Marginal

Propensityto Save(MPS)

Δ(3)/Δ(1)

(1) $370

(2) 390

(3) 410

(4) 430

(5) 450

(6) 470

(7) 490

(8) 510

(9) 530

(10) 550

$375

390

405

420

435

450

465

480

495

510

$-5

0

5

10

15

20

25

30

35

40

1.01

1.00

.99

.98

.97

.96

.95

.94

.93

.93

-.01

.00

.01

.02

.03

.04

.05

.06

.07

.07

.75

.75

.75

.75

.75

.75

.75

.75

.75

.25

.25

.25

.25

.25

.25

.25

.25

.25

CONSUMPTION AND SAVING

500

475

450

425

400

375

45°

50

25

0

370 390 410 430 450 470 490 510 530 550

370 390 410 430 450 470 490 510 530 550

C

S

ConsumptionSchedule

Saving Schedule

Saving $5 Billion

Dissaving $5 Billion

Dissaving$5 Billion

Saving $5 Billion

Disposable Income (billions of dollars)

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avin

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f d

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)

INCOME-CONSUMPTION AND INCOME-SAVINGS RELATIONSHIPS

• What does Average and Marginal Propensities refer to and why are they important?

• Average Propensity to Consume (APC)

• The % of total income consumed

• APC = C / I

• Average Propensity to Save (APS)

• The % of total income saved

• APS = S / I

• APS + APC = 1

INCOME-CONSUMPTION AND INCOME-SAVINGS RELATIONSHIPS

• Marginal Propensity to Consume

• MPC = the % of “additional” income consumed

• MPC = change in C / change in income

• Marginal Propensity to Save

• MPS = the % of “additional” income saved

• MPS = change in S / change in income

• MPC + MPS (will always) = 1

MPC and MPS measure slopes

INCOME-CONSUMPTION AND INCOME-SAVINGS RELATIONSHIPS

• Nonincome Determinants of C and S• Although DI is the most important factor for our

spending and saving, “nonincome determinants” also influence us.

• These are wealth, expectations, real interest rates, household debt and taxes.• Wealth: the value of real and financial assets• When events boost the “value” of existing

wealth, households increase their spending and reduce savings.

INCOME-CONSUMPTION AND INCOME-SAVINGS RELATIONSHIPS

• Nonincome Determinants of C and S (continued)

• Expectations: household views of their future income and the price level affect their spending and saving decisions

• Real interest rates: when real interest rates fall, households tend to borrow more, consume more and save less

• Household Debt: households increase consumption by acquiring more debt, up to a point.

• Taxation: an increase in taxes will cause a downward shift in both consumption and savings

INCOME-CONSUMPTION AND INCOME-SAVINGS RELATIONSHIPS

• Terminology, Shifts and Stability• Movement along a C or S schedule (function) means

a change in relation to DI

• Upward or downward shifts in C or S schedules is due to a change in one or more of the 5 non income determinants

• Changes in wealth, expectations, real interest rates and household debt will cause C and S schedules to shift in opposite directions!!!!

INCOME-CONSUMPTION AND INCOME-SAVINGS RELATIONSHIPS

• Terminology, Shifts and Stability• A change in taxes will cause C and S schedules to

shift in the same direction!!!

• Although changes in non income determinants can shift the C and S schedules, there is generally more stability in them because households make “long-term” decisions, and don’t usually react immediately to changes caused by the non income determinants