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Basic Macroeconomic Relationships. Topics Income – consumption & saving relationship Interest rate – rate of return – investment The multiplier – very important concept!. $ 13,841 1687 $ 12,154 29 96 $ 12,221 1009 979 467 344 2237 $ 11,659 1482 $ 10,177.

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slide2

Topics

Income – consumption & saving relationship

Interest rate – rate of return – investment

The multiplier – very important concept!

u s income relationships 2007

$ 13,841

1687

$ 12,154

29

96

$ 12,221

1009

979

467

344

2237

$ 11,659

1482

$ 10,177

U.S. Income Relationships 2007

Gross Domestic Product (GDP)

Less: Consumption of Fixed Capital

Equals: Net Domestic Product (NDP)

Less: Statistical Discrepancy

Plus: Net Foreign Factor Income

Equals: National Income (NI)

Less: Taxes on Production and Imports

Less: Social Security Contributions

Less: Corporate Income Taxes

Less: Undistributed Corporate Profits

Plus: Transfer Payments

Equals: Personal Income (PI)

Less: Personal Taxes

Equals: Disposable Income (DI)

slide4

Income – Consumption Relationship and

Income – Saving Relationship

  • Disposable Income (DI)
  • DI = C+S
  • Personal Saving (S) – “not spending”
  • Consumption (C) – Consumption spending
  • The Consumption Schedule (consumption function)
    • A schedule showing the various amounts that households would plan to consume at each of the various levels of DI that might prevail at some point in time
  • The Saving Schedule (saving function)
    • A schedule showing the various amounts that households would plan to save at each of the various levels of DI that might prevail as some point in time
  • Break-even Income– the level of income at which households plan to consume their entire incomes C=DI
slide5

o

o

45

45

  • Graphic representation of the relationship
    • 45-Degree Line – reference line
    • Measuring C and DI

Reference line

Any point on the 45 degree

Reference line is equidistant

From each axis (DI = C)

Saving and consumption

Both are directly related to

Disposable income

SAVING

C

Consumption

Consumption

schedule

DISSAVING

Disposable Income

slide6

Consumption and Saving Terminology

Lsnh9 start here on 3/29

APC – average propensity to consume – fraction of income that is consumed. Consumption / Income

Alief macro start here 3/30

APS – average propensity to save – fraction of income that is saved.

Saving / Income

APS+APC=1

MPC – marginal propensity to consume – the fraction of any change in

Income that will be consumed. Change in Consumption / Change in Income

MPS – marginal propensity to save – the fraction of any change in

Income that will be saved. change in Saving / change in Income

MPS+MPC=1

consumption and saving

500

475

450

425

400

375

45°

50

25

0

  • 390 410 430 450 470 490 510 530 550
Consumption and Saving

C

Saving $5 Billion

Consumption

Schedule

Consumption (billions of dollars)

Dissaving $5 Billion

  • 390 410 430 450 470 490 510 530 550

Disposable Income (billions of dollars)

Dissaving

$5 Billion

Saving Schedule

S

Saving

(billions of dollars)

Saving $5 Billion

average propensity to consume
Average Propensity to Consume

Selected Nations, with respect to GDP, 2006

.80 .85 .90 .95 1.00

United States

Canada

United Kingdom

Japan

Germany

Netherlands

Italy

France

Source: Statistical Abstract of the United States, 2006

slide9

Non Income Determinants of

Consumption and Saving

  • Wealth – value of real (houses and land) and financialassets (cash, bank accounts, securities, pensions)
    • Wealth Effects – causes consumption and saving to increase or decrease
  • Expectations – about inflation, recession, etc
  • Real Interest Rates (adjusted for inflation)
  • Household Debt – more debt enables more consumption
  • Taxation –
    • Consumption & saving move in same direction – taxes affect both
slide10

TERMINOLOGY, SHIFTS, & STABILITY

  • Terminology
    • Movement along a curve (change in amount consumed) vs. shift of a curve
  • Schedule Shifts
    • Wealth,
    • expectations,
    • interest rates,
    • household debt
  • Taxes – affect both C and S
  • Stability – consumption & savings functions relatively stable

Lsmh 10:30 start here 3/29

consumption and saving11

45°

Consumption and Saving

C1

C0

C2

Consumption (billions of dollars)

Disposable Income (billions of dollars)

S2

Saving

(billions of dollars)

S0

S1

slide12

The Interest Rate – Investment

Relationship

Relationship between real interest rates and investment.

Investment – expenditures on new plants, capital equipment, machinery, inventories, etc.

Investment decision – a MB MC decision.

MB is the expected rate of return businesses hope to realize.

MC is the interest rate that must be paid for borrowed funds.

Business will invest in all projects where expected rate of return exceed the interest rate.

The two basic determinants of investment spending!

slide13

Interest Rate – Investment

Relationship

Expected Rate of Return, r

Real Interest Rate:

i is the nominal rate adjusted for inflation.

Inverse relationship between Investment demand and the real interest rate.

Graphically presented...

investment demand curve

Cumulative

Amount of

Investment

Having This

Rate of

Return or Higher

(I)

16

14

12

10

8

6

4

2

0

Expected

Rate of

Return (r)

r and i (percent)

5 10 15 20 25 30 35 40

Investment (billions of dollars)

Investment Demand Curve

16%

14%

12%

10%

8%

6%

4%

2%

0%

$ 0

5

10

15

20

25

30

35

40

ID

slide15

Investment Demand Curve

Increase in

Investment Demand

r and i (percent)

Decrease in

Investment Demand

ID1

ID0

ID2

0

Investment (billions of dollars)

slide16

Non-Interest Rate Determinants of Investment Demand

  • The affect Investment Demand by way of the Expected Rate of Return
  • Acquisition, Maintenance, and Operating Costs
  • Business Taxes
  • Technological Change
  • Stock of Capital Goods on Hand
  • Planned inventory changes
  • Expectations
gross investment expenditure
Gross Investment Expenditure

Percent of GDP, Selected Nations, 2006

0 10 20 30

South Korea

Japan

Canada

Mexico

France

United States

Sweden

Germany

United Kingdom

Source: International Monetary Fund

slide18

Causes of Instability of Investment

  • Durability of capital goods
  • Irregularity of Innovation
  • Variability of Profits
  • Variability of Expectations
the multiplier effect

Change in Real GDP

Initial Change in Spending

The Multiplier Effect
  • More spending results in higher GDP
  • Initial change in spending changes GDP by a multiple amount

Multiplier =

the multiplier effect20
The Multiplier Effect
  • Causes of the initial change in spending
    • Changes in investment
    • Other changes – such as?
  • Rationale
    • Dollars spent are received as income
    • Income received is spent (MPC)
    • Initial changes in spending cause a spending chain
the multipliers
The Multipliers
  • Spending Multiplier = 1/MPS
    • An autonomous change in spending results in a change in aggregate production in the same direction.
  • Tax Multiplier = - (MPC/MPS)
    • If, for example, the MPC is 0.75 (and the MPS is 0.25), then an autonomous $1 trillion change in taxes results in an opposite change in aggregate production of $3 trillion
  • Balanced Budget Multiplier = 1
    • The balanced-budget multiplier measures the combined impact on aggregate production of equal changes in government purchases and taxes. The simple balanced-budget multiplier has a value equal to one

http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=tax+multiplier

slide22

Change in Real GDP

=

Multiplier

Initial Change in Spending

initial change

in spending

Change

in GDP

=

x

Multiplier

The Multiplier Spending Effect

For Example…

slide23

The Multiplier Effect

(3)

Change in

Saving

(MPC = .25)

(1)

Change in

Income

(2)

Change in

Consumption

(MPC = .75)

Increase in Investment of $5

Second Round

Third Round

Fourth Round

Fifth Round

All other rounds

Total

$ 5.00

3.75

2.81

2.11

1.58

4.75

$ 20.00

$ 3.75

2.81

2.11

1.58

1.19

3.56

$ 15.00

$ 1.25

.94

.70

.53

.39

1.19

$ 5.00

$20.00

$4.75

15.25

$1.58

13.67

$2.11

11.56

$2.81

8.75

ΔI=

$5 billion

$3.75

5.00

$5.00

1

2

3

4

5

All

Rounds of Spending

slide24

1

1

=

or

Multiplier

1 - MPC

MPS

x

=

initial change

in spending

Change in

GDP

Multiplier

The Spending Multiplier Effect

Multiplier Effect and the Marginal Propensities

Inverse relationship between:

Multiplier & MPS

slide25

.9

10

.8

5

.75

4

.67

3

.5

2

The Multiplier Effect

MPC and the Multiplier

MPC

Multiplier

the tax multiplier
The Tax Multiplier
  • (- MPC/MPS)
  • You are the chief economic adviser to the president. You are instructed to devise a plan to reduce unemployment to an acceptable level without increasing the level of government spending.
  • You decide to cut taxes and maintain the spending level.
  • A tax cut increases disposable income which leads to increases in consumption.
  • Would the decrease in taxes affect aggregate output in the same way as an increase in government spending?
the tax multiplier27
The Tax Multiplier
  • A tax decrease causes an income increase.
  • Consumption increases
  • Inventories decrease
  • Output increases in response.
  • Employment and income increase and lead to subsequent rounds of spending.
  • GDP will increase by a multiple of the decrease in taxes.
  • The multiplier for a change in taxes is not the same as the multiplier for an change in government spending.
the tax multiplier28
The Tax Multiplier
  • Why does the tax multiplier differ from the Government spending multiplier?
  • Compare how each works its way through the economy.
  • First an increase in G.
    • The increase in G leads to an immediate and direct impact on total spending.
    • Because G is a component of GDP, an increase in G leads to a dollar for dollar increase in GDP.
    • If G increases by $1, GDP initially increases by $1.
the tax multiplier29
The Tax Multiplier
  • The tax cut case
    • When taxes are cut there is no direct impact on spending.
    • Taxes first have an impact on a household’s disposable income which influences household consumption spending (an element of total spending)
    • The tax cut flows through households before affecting aggregate expenditure.
    • If the tax cut = $1, by how much would spending increase?
the tax multiplier30
The Tax Multiplier
  • If the MPC = .75, spending will increase by $0.75.
  • Because the initial increase in GDP is smaller for a tax cut than for an increase in Government spending, the final effect on the equilibrium level of GDP will be smaller.
  • The tax multiplier = - (MPC/MPS)
the balanced budget multiplier
The Balanced Budget Multiplier
  • Balanced Budget Multiplier = 1
slide32
45-degree line

consumption schedule

saving schedule

break-even income

average propensity to consume (APC)

average propensity to save (APS)

marginal propensity to consume (MPC)

marginal propensity to save (MPS)

wealth effect

expected rate of return

investment demand curve

multiplier

KEY TERMS