Basic Macroeconomic Relationships. Overview. Here we study some basic economic relationships that we think hold in a general way in the economy. Here we study the income - consumption, income – saving, interest rate – investment relationships and we study the idea of the multiplier.
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Here we study some basic economic relationships that we think hold in a general way in the economy. Here we study the income - consumption, income – saving, interest rate – investment relationships and we study the idea of the multiplier.
Digress: Say I am interested in why people weigh what they do. What would you say is the relationship between a persons weight and how much they eat for lunch?
Would you say the more eaten for lunch, the greater the weight? Sure you would. But, you also might say that this is true only if all other things in the persons life are the same. SO, lot of things influence weight and we look at each influence one at a time. This makes it easier to handle, but in the real world many things change at once.
From the expenditure approach to GDP we saw the goods and services produced include consumption, investment, government spending and net exports.
Here we want to understand the pattern of household expenditure called consumption. Consumption depends on many things at the aggregate or national level. But a primary influence is some notion of income.
45 degree line
When you study the real world data about the level of income and consumption of households in the US you get a graph something like this.
In the graph on the previous screen, note
1) Each dot represents a year and we have matched the income and consumption in that year,
2) The dots would not all be on a straight line,
3) Higher income means higher consumption, and
4) Most dots are below the 45 degree line. Note a 45 degree line means we are the same distance form each axis. Note we measure income horizontally and consumption vertically. But, if we take a horizontal income and go up to the 45 degree line that vertical distance is also the income amount. Then by looking at heights we could compare income and consumption. We will do this a lot.
In this course we will build a simple model of the economy and a major idea in the model will be the GDP produced and the resultant income. Income in many ways will mean GDP.
Disposable income equals personal income minus personal taxes.
In a previous section we saw in the NIPA that GDP and disposable income were not the same. But, for our work here we can assume they are basically the same. I will just say in general income and the context will mean disposable or GDP in the context of the story. In other words I talk in general and on tests and assignments you may see a specific and just apply what I have here.
In our theory we will have the graph here showing as income rises as consumption rises, given all else equal in the world.
For the most part this graph is in line with observation in the world. The consumption line or function is now interpreted as showing the consumption plans of the household sector at various levels of income. To see what consumption will be at any income level go to the income level and then up to the consumption line.
The graph is merely a reflection of information we could get in a table. Say we have
In the graph on the previous screen we have income equal to consumption at income = 390. This is called the break-even income level. Notice to the left of this point the C line is higher than the 45 degree line meaning consumption is greater than income.
Our context of income here is disposable income and we think disposable income is either consumed or saved. (After the government takes taxes from you all you can do is consume of save. Note for each of us how we consume and how we save may be very different.)
In this sense saving is just that part of income not consumed. So we can add to our table and graph by taking income minus consumption to get saving.
Income Consumption Saving
370 375 -5
390 390 0
410 405. 5
Note that saving is negative when income is 370. What do we call this and how could this be?
Negative saving is called dissaving (not datsaving!) and it could happen if our income is really low and we consume this period by using up assets we accumulated form the past, as well as our current income.
The average propensity to consume (APC) can be calculated at each income level by taking the consumption at that level and dividing by the income. A few years back some dude named Engel saw the APC fell as income rose. Think about it. With more and more income we consume more, but as a percentage of our income we cut back because we have all our main comforts taken care of and the rest is gravy.
Since our income is either consumed or saved, if the APC is falling the APS is rising because the APC + APS = 1.
Please write down and understand the APS.
The marginal propensity to consume (MPC) equals the change in consumption divided by the change in income between two points in time.
It is felt that the MPC is constant over time. The main reason here for us is that this would be consistent with what Mr. Engel saw. Let’s see this on the next screen in a numerical example.
Before we get there note that since changes in come must either lead to a change in consumption or saving, the MPC + MPS = 1.
Income C S MPC MPS APC APS
370 375 -5 1.01 -.01
390 390 0 .75 .25 1 0
410 405. 5 .75 .25 .99 .01
Note that MPC for income at 370 is note written in because we do not have information from before.
How did I get the first .75? A- (390-375)/(390-370) = 15/20=.75
With the MPC constant the APC must fall (since C does not equal zero when income is zero)
45 degree line
Notes about graphs
1) When C crosses 45 degree line we have break-even income and S = 0,
2) To the left of this income, C > income and we have dissaving,
3) To the right of the income in 1), C < income and we have saving – hey, look at datsaving.
45 degree line
The slopes of C and S are the MPC and MPS, respectively.
In the national economy we think the level of consumption expenditure depends on
1) output or income (which we just spent time looking at)
2) the wealth of households
4) real interest rates,
5) Household debt,
Note. When item 1 here changes we move along the C and S lines, when items 2 through 6 change we shift C and S.
If the household sector becomes wealthier (like due to a
stock market boom), then at a given level of income the
household sector will consume more and save less.
Presumably the reason the household saves is to build up
wealth to use later. If they become wealthier, then there
is less reason to save in the current period and thus more
reason to consume
The C line shifts up and the S line shifts down as the household becomes wealthier. This is called the wealth effect.
When households look to the future they have feelings, what are called expectations, about what will happen. If the outlook changes in a positive way expectations become more favorable and C shifts up and S shifts down.
The reverse happens if the future outlook becomes negative or gloomy.
Higher rates of interest may make some folks consume less and save more because they see the higher rate paying back better in the future. Similarly a lower interest rate makes some give up saving because what they get in return is not enough to give up consumption today.
Interest rate up, C line down and S line up.
Households can go into debt. To the extent that households can go into debt at a larger amount the consumption line can shift up.
Remember disposable income is personal income minus taxes and what we have left is either consumed of saved. Also note that what we have said on the last few slides if C goes up S goes down. Personal taxes are treated differently.
If personal taxes go up, the household sector has less to both consume and save. So, if personal taxes rise, both C and S will fall.
Earlier we showed C in a
graph like this. Usually
what we do is just pick a
starting point, like point
a. At this point we have
a level of income and C
explicitly in the graph.
Implicitly the levels of
other influences are also at a certain level.
If income increases, we saw C will increase. We could have point b. We saw for every $ change in income, C changed by MPC. If from a to b income changed by 15 and MPC = .8, then C
changed by ................?
In the graph when we consider a change in income all the
other factors that influence C are assumed to not change
and we then move along the C line as I have drawn here.
If the other factors change, and they can, the curve shifts.
If the other factors change
in such a way that C
increases, the C line shifts
up. Similarly, it would
shift down if the other
factors changed in a
Note along C’, consumption is higher than along C at all
levels of income.
We have seen that consumption depends on income and other factors. The other factors are often called autonomous factors, or nonincome determinants. For us this means factors other than income.
Note that the slope of the consumption function is the MPC. The slope tells us how much consumption rises for each change in income. So for every dollar change in income the slope tells us about the change in consumption.