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Chapter Objectives

- How Changes in Income Affect Consumption (and Saving)
- About Factors Other Than Income That Can Affect Consumption
- How Changes in Real Interest Rates Affect Investment
- About Factors Other Than the Real Interest Rate That Can Affect Investment
- Why Changes in Investment Increase or Decrease Real GDP by a Multiple Amount

Basic Relationships

- Income-Consumption
- Income-Saving
- 45° Line
- C = DI on the Line
- S = DI - C

Income-Consumption and Income-Savings Relationships

- Relationship b/w income and saving
- Personal saving = DI-C (disposable income-consumption)
- Most significant factor in determining nation’s level of C and S is DI
- 45 degree line is a reference line b/c it bisects the 90 degree angle formed by the 2 graph axes
- Dot on line represents C and DI in for one year

04

03

02

01

00

99

98

97

96

95

94

93

92

91

90

89

88

87

86

85

84

83

45°

Income and ConsumptionConsumption and Disposable Income, 1983-2005

45° Reference Line

C=DI

C

Saving

In 1992

Consumption (billions of dollars)

Consumption

In 1992

Disposable Income (billions of dollars)

Consumption

Saving

APC =

APS =

Income

Income

Consumption and Saving- The Consumption Schedule
- The Saving Schedule
- Break-Even Income
- Average Propensity to Consume (APC)
- Average Propensity to Save (APS)

The Consumption Schedule

- Hypothetical consumption schedule
- Shows various amounts that households would plan to consume at each of the various levels of DI that might prevail at some specific time
- In aggregate:
- Households inc. spending as DI inc
- Spend a larger proportion of a small DI than of a large DI

The Saving Schedule

- To find amount saved, subtract C from DI (S=DI-C)
- Direct relationship b/w saving and DI
- Saving is a smaller proportion of a smaller DI than of a large DI
- Dissaving (consuming in excess of after-tax income) will occur at relatively low Dis

Break-Even Income

- Break-even income: income level at which households plan to consume their entire incomes
- Graphically:
- Consumption schedule cuts the 45 degree line
- Saving schedule cuts the horizontal axis (saving is zero)

Average and Marginal Propensities

- Average propensity to consume: fraction or % or total income that is consumed
- APC=consumption/income
- Average propensity to save-fraction of total income that is saved
- APS=saving/income
- APS+APC = 1

MPC =

Change in Income

Change in Saving

MPS =

Change in Income

Consumption and Saving- Marginal Propensity to Consume (MPC) – fraction of any change in income consumed
- Marginal Propensity to Save (MPS) – fraction of any change in income saved
- MPC+MPS =1

Level of

Output

And

Income

(GDP=DI)

(4)

Average

Propensity

to Consume

(APC)

(2)/(1)

(5)

Average

Propensity

to Save

(APS)

(3)/(1)

(6)

Marginal

Propensity

to Consume

(MPC)

Δ(2)/Δ(1)

(7)

Marginal

Propensity

to Save

(MPS)

Δ(3)/Δ(1)

(2)

Consump-

tion

(C)

(3)

Saving (S)

(1-2)

Consumption and Saving- $370
- 390
- 410
- 430
- 450
- 470
- 490
- 510
- 530
- 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

475

450

425

400

375

45°

50

25

0

- 390 410 430 450 470 490 510 530 550

Consumption and Saving Schedules

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

Consumption and Saving

Average Propensities to Consume

Select Nations GDPs

Average Propensities to Consume

.80 .85 .90 .95 1.00

United States

Canada

United Kingdom

Japan

Germany

Netherlands

Italy

France

.963

.958

.953

.942

.896

.893

.840

.833

Source: Statistical Abstract of the United States, 2006

Consumption and Saving

- MPC + MPS = 1
- MPC and MPS as Slopes
- Nonincome Determinants of Consumption and Saving
- Wealth Effect
- Expectations
- Real Interest Rates
- Household Debt

Nonincome Determinants of Consumption and Savings

- Determinants other than income may determine how much households will spend or save
- 1. wealth – existing wealth that they have already accumulated; wealth effect shifts consumption schedule upward and saving schedule downward
- 2. Expectations – about future prices and saving; if prices are expected to rise, people will spend more, save less; if recession is expected, people will save more, spend less

3. Real Interest Rates – when interest rates fall, people spend more save less and vice versa

- 4. Household debt – increased borrowing shifts C curve upward and vice cersa

Consumption and Saving

- Other Important Considerations
- Changes Along Schedules – movement from one point to another along schedule
- Switch to Real GDP
- Schedule Shifts – caused by changes in wealth, expectations, interest rates, and debt and will shift both curves
- Stability – curves tend to be relatively stable
- Taxation – increase in taxes will shift both curves downward and vice versa

Consumption and Saving

Consumption and Saving Schedules

C1

C0

C2

Consumption (billions of dollars)

Disposable Income (billions of dollars)

S2

Saving

(billions of dollars)

S0

S1

G 8.2

Interest Rate and Investment- Expected Rate of Return (r)
- The Real Interest Rate (i)
- Meaning of r = i
- Investment Demand Curve

Interest-Rate-Investment Relationship

- Relationship b/w the real interest rate and investment
- Expected rate of return – represented by letter “r”

The Real Interest Rate

- Interest – the financial cost of borrowing money
- If the expected rate of return exceeds the interest rate, the investment should be undertaken
- If the interest rate exceeds the expected rate of return, the investment should not be undertaken
- Should invest up to point where r=I
- If inflation is occurring, must use REAL interest rate

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)

Interest Rate and InvestmentThe Investment Demand Curve

16%

14%

12%

10%

8%

6%

4%

2%

0%

$ 0

5

10

15

20

25

30

35

40

ID

Investment Demand Curve

- How many dollars’ worth of investment projects have an expected rate of return of a certain %? See ex. p. 154
- Can graph the amount of investment at each expected rate of return and real interest rate
- Investment demand curve shows the amount of investment at each real interest rate

Interest Rate and Investment

- Shifts of the Investment Demand Curve
- Acquisition, Maintenance, and Operating Costs
- Business Taxes
- Technological Change
- Stock of Capital Goods on Hand
- Expectations

Interest Rate and Investment

Shifts in the Investment

Demand Curve

Increase in

Investment Demand

r and i (percent)

Decrease in

Investment Demand

ID1

ID0

ID2

0

Investment (billions of dollars)

Non-Interest Rate Determinants of Investment Demand

- Inc in investment demand, shift right
- Dec in investment demand, shift left
- Determinants:
- 1. acquisitions, maintenance, and operating costs – higher operating costs shift curve left, vice versa

2. business taxes – taxes inc, investment demand curve shifts left, reduction of bus. Taxes shifts right

- 3. Technological change – new technology, shift right

4. stock of capital goods on hand – excess productive capacity decreases demand, vice versa

- 5. expectations – of future sales, political climate, pop growth, etc…if expectations optimistic then investment demand increases and vice versa

Interest Rate and Investment

- Instability of Investment
- Durability
- Irregularity of Innovation
- Variability of Profits
- Variability of Expectations

Instability of Investment

- Investment is the most volatile component of total spending
- Why?
- 1. durability – indefinite life of capital goods
- 2. irregularity of innovation – difficult to predict the arrival of new inventions
- 3. variability of profits – expectation of future profit is influenced by current profits
- 4. Variability of expectations – possible changes in business conditions

Interest Rate and Investment

Gross Investment Expenditures as a

Percent of GDP, Select Nations

Percent of GDP, 2004

0 10 20 30

South Korea

Japan

Mexico

Canada

France

United States

Germany

United Kingdom

Sweden

Source: World Bank

Interest Rate and Investment

The Volatility of Investment

Gross Investment

Percentage Change

GDP

1971 1975 1979 1983 1987 1991 1995 1999 2003

Year

Initial Change in Spending

1

1 - MPC

1

MPS

W 8.2

The Multiplier EffectMultiplier =

The Multiplier and the Marginal Propensities

Multiplier =

-or-

Multiplier =

Graphically…

The Multiplier Effect

- This will be discussed again in Ch. 9
- Direct relationship b/w changes in spending and changes in real GDP
- The multiplier effect – a change in a component of total spending leads to a larger change in GDP
- See formula on previous slide

The Multiplier

- “initial change in spending” usually deals with investment, but could also include G,C or NX
- Change in spending results from change in real interest rate or shifts in the investment demand curve
- Multiplier works in both directions (inc/dec)

Rationale

- 1. economy supports repetitive and continuous flows of income and expenditures
- 2. any change in income will alter consumption and spending in the same direction as the change in income
- - any change in income will set off a spending chain throughout economy

The Multiplier and Marginal Propensities

- MPC and multiplier are directly related
- MPS and multiplier are inversely related
- Multiplier = 1/1-MPC or
- Multiplier = 1/MPS

The Multiplier Effect

Tabular and Graphical Views

(2)

Change in

Consumption

(MPC = .75)

(3)

Change in

Saving

(MPC = .25)

(1)

Change in

Income

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

Squaring the Economic Circle

Last

Word

- Humorist Art Buchwald and the Multiplier
- One Person Can’t Buy a Product
- Others Subsequently Impacted and Cannot Buy Other Items
- Multiple Effects Impact Psyche
- Ultimately Causes Multiple Step Impact Upon the Economy as a Whole

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
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