Macroeconomics Chapter 10

Chapter 10: Macroeconomics Basic Macroeconomic Relationships

Learning Objectives

• LO10.1: Describe how changes in income affect consumption and saving.

• LO10.2: List and explain factors other than income that can affect consumption.

• LO10.3: Explain how changes in real interest rates affect investment.

• LO10.4: Identify and explain factors other than the real interest rate that can affect investment.

• LO10.5: Illustrate how changes in investment and other components of total spending can multiply real GDP.

10.1 The Income-Consumption and Income-Saving Relationship

Key Concepts:

• Consumption (C) and Saving (S) primarily depend on Disposable Income (DI), which influences household spending behaviors.

• Formula: [ DI = Y - T ] (where Y is total income and T is total taxes). This formula highlights that disposable income is what households have available for spending and saving after taxes have been deducted.

• Direct Relationship: A clear positive relationship exists, meaning as DI increases, both consumption and saving are likely to increase as households feel more financially comfortable to spend and save.

• The relationship can be summarized as: [ C + S = DI ]. This equation underscores the balance between spending and saving in relation to disposable income.

• Consumption Schedule: This represents planned household spending based on expected income levels. It helps in visualizing consumer demand in the economy.

• Saving Schedule: This represents DI minus planned consumption; it can also demonstrate dissaving (negative saving) during periods when consumption exceeds income.

• Graphical Representation: Each point on the graph shows consumption against disposable income over time, and a rising line reveals the direct relationship between income levels and consumer spending behaviors.

10.1.1 Measurement of Consumption and Saving

Metrics used to analyze consumption and saving schedules include:

• Level of Output and Income: Often determined by GDP = DI, highlighting the total economic output in relation to income levels.

• Consumption (C): Total amount spent on goods and services.

• Saving (S): The portion of income not spent on consumption.

• Average Propensity to Consume (APC): [ APC = \frac{C}{DI} ], which indicates the fraction of total income consumed.

• Average Propensity to Save (APS): [ APS = \frac{S}{DI} ], which indicates the fraction of total income saved.

• Marginal Propensity to Consume (MPC): [ MPC = \frac{\Delta C}{\Delta DI} ] represents the change in consumption relative to the change in disposable income.

• Marginal Propensity to Save (MPS): [ MPS = \frac{\Delta S}{\Delta DI} ] indicates the proportion of additional income that is saved rather than consumed.

10.1.2 Average Propensities

• Average Propensity to Consume (APC): Highlights the fraction of total income consumed and is critical for understanding aggregate demand in the economy.

• Average Propensity to Save (APS): Captures the portion of income being saved, indicating future consumption potential.

• Formula relation: [ APC + APS = 1 ]. This demonstrates that all disposable income is either consumed or saved.

• Global Perspective: There can be significant differences in APC among countries. For example, Finland and Spain had APCs above 100%, indicative of dissaving, while Switzerland maintained lower APCs suggesting higher saving rates.

10.1.3 Marginal Propensities

• Marginal Propensity to Consume (MPC): Essential for understanding how income changes impact consumer behavior.

• Marginal Propensity to Save (MPS): Similarly important, showing how new income is allocated towards saving.

• Relation: [ MPC + MPS = 1 ]. This relationship is vital for determining economic stability and growth dynamics.

10.2 Non-Income Determinants of Consumption and Saving

Factors that influence consumption beyond mere income levels include:

• Wealth: The total value of assets owned minus liabilities. The wealth effect suggests that as individuals perceive higher asset values, their consumption is likely to increase, driving economic expansion.

• Borrowing: Allows individuals to spend beyond their current means, increasing current disposable income but also creating future liabilities impacting long-term financial health.

• Expectations: Consumers’ anticipated changes in prices, economic conditions, or personal financial situations can shift the consumption schedule dramatically, influencing spending behavior.

• Real Interest Rates: Lower interest rates tend to increase consumption while reducing savings, shifting demand curves upwards as borrowing costs decrease.

• Other Factors: Changes in taxation policies (T), consumer sentiment, and cultural attitudes towards long-term saving versus immediate consumption can stabilize or destabilize consumption and saving schedules.

10.3 The Interest Rate-Investment Relationship

• Investment Demand: Primarily driven by the expected rate of return on investments. Higher anticipated returns lead to greater investment demand, while lower returns decrease it.

• Real Interest Rate: It is the cost of borrowing money adjusted for inflation and significantly impacts investment decisions. It is calculated as:[ Real : Interest = Nominal : Rate - Inflation : Rate. ] A high real interest rate can deter investment as borrowing costs rise.

• Investment Demand Curve: Illustrates an inverse relationship between interest rates and the level of investment – as interest rates increase, investment typically declines.

10.4 Shifts in the Investment Demand Curve

Factors that can cause shifts in the investment demand curve include:

• Acquisition Costs: Rising costs of purchasing capital goods can lead to reduced investment demand.

• Business Taxes: Changes in taxation on profits can affect net returns on investment, thus influencing investment decisions made by firms.

• Technological Changes: Innovations can create new opportunities for investment or render existing investments obsolete, prompting shifts in demand.

• Expectation Changes: Alterations in business confidence regarding future economic conditions can cause significant shifts in investment levels.

• Inventory Adjustments: Businesses may alter their investment strategies based on current inventory levels and anticipated future sales.

10.5 The Multiplier Effect

• Definition: The multiplier demonstrates how initial changes in spending lead to more significant overall effects on real GDP due to subsequent rounds of spending and re-spending within the economy.

• Multiplier Formula: [ Multiplier = \frac{Change : in : GDP}{Initial : change : in : spending}. ] A increased investment results in higher consumption, leading to greater overall economic activity.

• Significance of Investment: Investment spending is particularly crucial due to its high volatility, capable of driving major fluctuations in overall economic health.

• Practical Example: If a business increases its investment by $5 million, it can create a chain reaction, where this initial change leads to multiple rounds of increased GDP through subsequent consumption-driven economic activity.

Conclusion

The chapter effectively summarizes the intricate connections between income, consumption, savings, and investment, illustrating how these factors collectively influence the economy via the multiplier effect. Understanding these dynamics is essential for analyzing economic policies and business strategies.