Macroeconomic Models and Fiscal Policy Study Notes

Part Four: Macroeconomic Models and Fiscal Policy

Chapter 10: 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 the other components of total spending can multiply real GDP.

Introduction

• This chapter examines the basic relationships between three economic aggregates:
  • Income and consumption (and income and saving)
  • The interest rate and investment
  • Changes in spending and changes in output.

The Income-Consumption and Income-Saving Relationships

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

• Direct Relationship: There exists a direct (positive) relationship between income and consumption, which is one of the most established principles in macroeconomics. Similarly, as disposable income rises, saving also tends to increase.
• Definition of Personal Saving: Economists define personal saving as “not spending” or as “that part of disposable (after-tax) income not consumed.” The equation for saving is: S = DI - C Where:
  • S = Saving
  • DI = Disposable Income
  • C = Consumption
• Historical Data Example: An analysis of the U.S. consumption and disposable income from 2002 to 2021 shows a general trend where consumption rises as disposable income increases, depicted graphically in Figure 10.1. Each dot represents a year, demonstrating that households typically consume a large portion of their disposable income.
• Graphical Representation: The 45° line serves as a reference indicating equilibrium, where consumption equals disposable income. The vertical distance between the consumption line and the 45° line indicates the amount of saving for that year.

Example Calculation

• In 2017, disposable income was $14,801 billion and consumption was $13,725 billion, leading to saving of:
  S = 14,801 - 13,725 = 1,076 ext{ billion}
• Trends and Anomalies: During the COVID-19 pandemic, disposable income increased due to government stimulus, but consumption decreased, leading to an unusual spike in the personal savings rate from 7.6% in late 2019 to 33.8% in spring 2020.

The Consumption Schedule

• Hypothetical Consumption Schedule: Using Table 10.1, we assess households' planned consumption at various disposable income levels, showing that consumption rises with disposable income while a smaller proportion of income is spent as income increases.

Table 10.1: Consumption and Saving Schedules

• As disposable income increases, the Average Propensity to Consume (APC) decreases while the Average Propensity to Save (APS) increases. This indicates households spend a higher fraction of lower incomes than higher incomes.

The Saving Schedule

• Definition and Graphical Representation: The saving schedule can be derived by simply subtracting consumption from disposable income at each income level. When income is low enough to lead to dissaving, it is captured graphically when consumption exceeds disposable income.

Break-Even Income and Dissaving

• Break-Even Income: The break-even point occurs when disposable income equals consumption. For instance, at $390 billion, saving is zero. At all higher incomes, households tend to save a portion of their incomes.

Average and Marginal Propensities

• Average Propensity to Consume (APC): APC reflects the fraction of total income consumed. The fraction saved is the Average Propensity to Save (APS). Together:
  APC + APS = 1
• Marginal Propensity to Consume (MPC): This measures the proportion of any change in income that is consumed, while the Marginal Propensity to Save (MPS) measures the proportion that is saved with
  MPC + MPS = 1
• Using our previous example where income increases from $470 billion to $490 billion (row 7), the calculations for MPC and MPS yield:
  MPC = rac{15}{20} = 0.75
  MPS = rac{5}{20} = 0.25

Nonincome Determinants of Consumption and Saving

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

• Key Factors:
  • Wealth: Total assets minus liabilities. Increased wealth typically leads to increased consumption.
  • Borrowing: Households can increase current consumption through borrowing, though with future repayment obligations.
  • Expectations: Future price and income expectations can influence current spending.
  • Interest Rates: Lower rates boost borrowing and consumption; higher rates discourage these.

Shifts in Consumption and Saving Schedules

• Real GDP: When creating macroeconomic models, the focus shifts from the relationship between consumption/saving and disposable income to real GDP.
• Schedule Movement: Changes in any of the determinants shift the consumption schedule (upward for positive changes and downward for adverse ones) and the saving schedule in the opposite direction.
• Taxation Impact: Changing tax levels shifts both consumption and saving schedules in the same direction—higher taxes lower both.

Stability of Schedules

• The consumption and saving schedules maintain relative stability unless influenced by major tax changes, with decisions often shaped by long-term goals like retirement or emergency savings.

The Interest-Rate–Investment Relationship

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

• Investment Definition: Investment spending occurs on new plants, capital equipment, and inventories. It is driven by the expected rate of return compared to the real interest rate.
• Investment Decision-Making:
  • Businesses invest in projects where the expected rate of return exceeds the interest rate.
  • If the expected rate of return exceeds the real interest rate, the investment should proceed.

Calculation Example Involving Investment

• Net Expected Revenue Calculation:
  Revenue - Cost = Net Expected Revenue
• For an example with a $1,000 investment, expected revenue of $1,100 leads to an expected return rate of:
  • r = rac{100}{1000} = 0.10 = 10 ext{ percent}
• Understanding Rates: The real interest rate (nominal rate minus inflation) must be considered.
• Investment Demand Curve: Represents total investment demand based on expected rates of return across the economy.

Figure 10.5: Investment Demand Curve

• Graph shows an inverse relationship: as the real interest rate increases, investment demand decreases.

Quick Quiz for Figure 10.5

• The investment demand curve reflects an inverse relationship between the real interest rate and investment.

Shifts of the Investment Demand Curve

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

• Factors influencing shifts include:
  • Acquisition and maintenance costs
  • Business taxes
  • Technological advancements
  • Existing capital goods stock
  • Planned inventory changes
  • Business expectations
• Investment Instability: Investment is the most volatile component, often fluctuating due to changes in expectations, the durability of goods, or variable profits.

The Multiplier Effect

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

• Multiplier Definition: The ratio of the change in GDP to the initial change in spending. Generally expressed as:
  ext{Multiplier} = rac{ ext{Change in GDP}}{ ext{Initial Change in Spending}}
• Investment increases trigger larger GDP increases, generating a chain effect in the economy.
• Example Calculation: If an initial $30 billion investment leads to a $90 billion GDP increase, the multiplier is:
  ext{Multiplier} = rac{90}{30} = 3
• Roles of MPC and MPS: Higher MPC increases the multiplier, while higher MPS decreases it.

Actual Multiplier Estimates

• Actual multipliers range from 0 to 2.5, generally lower than theoretical estimates due to taxes and imports affecting domestic consumption.

Summary Points

• Changes in income directly affect consumption and saving.
• Nonincome factors that impact consumption include wealth, borrowing, expectations, and interest rates.
• Changes in real interest rates determine investment decisions, guided by expected returns.
• Investment demand shifts based on acquisition costs, business taxes, technology advances, and business expectations.
• Multiplier principle: Changes in spending lead to larger changes in GDP. The multiplier's magnitude is affected by MPC and MPS values.