Chapter 10 Macroeconomics

income-consumption and income-saving relationships, nonincome determinants of consumpotion and saving,

ch. 9 answers: REVIEW FROM CH. 9

• GDP gap using Okra’s law is 8%, because its (9-5)x2. 40 billion is forgone

• if CPI was 110 last yr, and is 121 this yr. what is years inflation rate? 121-110/110(100)= 10%. If CPI was 110 last yr and is 108 this yr, what is this yrs inflation rate? 108-110/110(100)= -1.8% (deflation since its negative)

• how long would it take for price level to double if inflation persisted at 2% per year, 5%, and 10%? Use rule of 70

• if nominal income rises by 5.3% and the price level rises by 3.8%, what percentage will real income increase? 1.5% because 5.3-3.8= 2.5. formula= Real income= Nominal income-inflation. If nominal income rises by 2.8% and real income rises by 1.1% what is inflation? 2.8-1.1= 1.7%

• suppose nominal rate of inflation is 4% and inflation premium is 2%, what is real interest rate? N=R+I → 4=R+2→ R=2%.

Changes in consumption

• economy faces shocks in demand because spending increases

Disposable income

The money available to a home after taxes are paid

• consumption and saving:

→ determined by DI

→ direct relationship (more money available, more money can be consumed)

• consumption schedule/function: planned household spending 

• saving schedule/function: personal saving= “not spending”

→ Dissaving can occur, we spend more than we have

→ saving= disposable income - consumption (DI-C)

COVID 19 pandemic

• between 2019 and 2020, consumption fell despite an increase in disposable income

→ covid stimulus payments increased disposable income

→ people saved rather than spend much of this $

inverse relationship lasted ONE YEAR ONLY

things went back to normal between 2020 and 2021

consumption and disposable income, 2002-2021 (graph in ppt 10)

• there is a 45* line, and at every point DI equals consumption (which implies that there are no savings)

• also proves that you have no loans to pay down the line

• green line= consumption. Shows the proportion of our income that we consume

• the difference between what you consume, and disposable income must be savings

• SPACE IN BETWEEN GREEN AND RED LINES= SAVINGS

average propensities

Average Propensity to Consume (APC): fraction of total income consumed

• APC= CONSUMPTION/INCOME

• according to our chart, APC decreases as income increases

Average Propensity to Save (APS): Fraction of total income saved

• APS= SAVINGS/INCOME

APS + APC= 1

Marginal Propensities

Marginal Propensity to Consume (MPC): PROPORTION of a change in income consumed

• MPC= change in consumption/change in income

Marginal Propensity to Save (MPS): PROPORTION of a change in income saved 

• MPS= change in savings/change in income

MPS + MPC= 1

MPC and MPS are slopes.

• DIRECT RELATIONSHIP BETWEEN DI AND C.

• consumption is green

• savings is red

Non-income determinants

• MUST BE A SHIFT IN SOMETHING OTHER THAN C & DI or S & DI

• amount of disposable income is the main determinant of consumption and savings

• wealth

• borrowing- concept of no free lunch (someone always bears the cost of something, nothing is free)

• expectations inflation/recession- we make sure that our interest rate considers inflation premium since we don’t want to lose money

• real interest rates- if we think our interest rate will increase, asking for $ will be cheaper because we know well pay with cheaper dollars

shifts of consumption and saving schedules

• if our wealth increases, we’ll increase our consumption

• increase in consumption shifts the curve upwards

• decrease in consumption, increase savings

BOTH LINES MOVE TO THE SAME SIDE (CONSUMPTION AND SAVINGS BOTH INCREASE/DECREASE) IS WITH TAXES. 

→ if taxes decrease, consumption and savings increase, for ex.

Paradox of Thrift

A recession can be made worse when households become thriftier 

2 ironies:

1. saving more is usually good BUT ends up being bad, in this case

2. fallacy of composition: households end up saving less because they spend less, businesses need to produce less, people get laid off, decreases the income, saving even less

interest rate investment relationship

expenditures on new plants, capital equipment, machinery, inventories, and so on…

investment decision: MB (r) vs MC (i). When MB is equal to or greater than MC, we invest.

excepted rate of return (MB)= profit=r (expected rate of return is “r”)

the real interest rate (MC) = the price = i (real interest rate is “i”)

investment demand curve

investment always has a risk

interest rate investment relationship

expected- not guaranteed- rate of return- profit- r

machine= 1,000 dollars, increases rate of production to 1100 dollars.

(1100-1000/1000)x100= 10%

real interest rate (the price)- i

loan= 1000i= 7% (pays 1070)

r>i = 10%>7% = invest

if interest rate is nominal 15 and there’s inflation 10%, re-evaluate

if real interest rate is higher, less projects will be profitable, and investment decreases

govt can alter interest rates to avoid recessions

why is it important that the economy doesn’t fall into a recession?

• because people will lose their jobs and people will be under their potential production

investment demand curve

the sum of all investment decisions (goods and services) for the business sector

• we add everything up

• at same r (rate of return), we add the amount of investment that will yield each particular rate of return, r, or higher. we take everything as long as r and i are equal.

• r= i, go in the vertical axis as price of borrowing. Investment of dollars is on the x-axis

• firms should undertake all the investment projects up to the point where r=i

• slope= inverse. the higher the interest rate, the more costly it will be to repay the loan

shifts of the investment demand curve

acquisition, maintenance, and operating costs (the higher the costs, the higher the maintenance)-

business taxes-

technological change +

stock of capital goods on hand, relative to output and sales -

planned inventory changes (pos. change in inventory is a pos. change in investment) +

• increase in inventory= increase in investment

expectations of future sales, operating costs (machinery and people) and profitability

• replace 10 workers with 1 machine, etc.

• end result depends on whats more important in terms of money, not values

ALL NOT MOVEMENTS ALONG THE LINE, THEY ARE SHIFTERS

instability of investment

unlike consumption, investment is highly unstable and the most volatile of total spending

• variability of expectations- exchange rates, trade barriers, legislative actions, stock market prices, gov. economic policies, outlook of war or peace, court decisions in key labor or antitrust cases.

• durability- optimism (pos. change) replacement of capital goods. we try to change things, so they last a long time

• irregularity of innovation

• variability of profits- incentive and ability to invest. 

The multiplier effect

A change in spending changes real GDP, more than the initial change in spending.

assumption room to expand positive change spending don’t lead to positive change Px

The multiplier determines how much larger that change will be.

Multiplier= change in real GDP/initial change in spending

• usually around 4 or 5

change in GDP= multiplier X initial change in spending

we assume that there is an increase in spending and we still work in a private economy.

multiplier is based on 2 facts:

1. the economy has continuous flows of expenditures and income- a ripple effect- in which income received by one comes from money spent by another, and so forth. You get money, you pay someone, etc. you spend until you run out of money.

2. any change in income will cause both consumption and saving to vary in the same direction as the initial change in income. If you add more money to the economy, you add consumption and saving. 

3 points about the multiplier:

1. initial change in spending is associated with investment spending. But changes in C, G, and X can also generate multiplier effects.

2. the initial change in spending is usually associated with investment spending results from a change in rate of interest (r) and or a shift in the investment curve. r must be equal to i (interest rate = expected rate of return).

3. the multiplier works in both directions. Negative= GDP decreases. or you can increase GDP by increasing consumption.

multiplier process (MPC ΔC/ΔDI = 0.75)

• whatever is invested goes to consumers, consumers take that (5 billion dollars, for example) and spend and save the money. spend 75% of each previous value in the change in income column.

• you multiply initial increase in investment by MPC, this demonstrates the change in income

• the money put into the economy gets continually spent and saved, until there is nothing left to spend/save.

• larger the MPC and MPS tells us how many rounds we can go through.

• China’s MPS is very high

multiplier and marginal propensities

multiplier and MPC are DIRECTLY RELATED: Large MPC → large increases in sending

• Multiplier= 1/1-MPC; (1-MPC= MPS)

multiplier and MPS are INVERSELY RELATED: Large MPS → smaller increases in spending

• Multiplier= 1/MPS

Ex=

→MPC= 0.9, multiplier= 10

→ MPC= 0.8, multiplier= 5

→ MPC= 0.75, multiplier= 4

→ MPC= 0.67, multiplier= 3

→ MPC= 0.5, multiplier= 2

The larger the MPC, the larger the multiplier

how large is the actual multiplier?

actual multiplier is lower than the model assumes

• consumers buy imported products; multiplier is smaller in an open economy and bigger in a closed economy.

• households pay income taxes

• inflation

• multiplier may be 0

last word: toppling dominoes

• example of the multiplier

• one person in town decides not to buy a product

• creates a ripple effect of people not spending, following the first decision

• ultimately, the entire town experiences an economic downturn