Macroeconomics: Unit 30

Macroeconomics                                                        Kostes

Chapter 30: Basic Macroeconomic Relationships

1)  Income and Consumption

2)  Interest Rates and Investment

3)   Changes in Spending and Output

4)   The “Multiplier Effect”

Income-Consumption/Income-Savings: this is one of the best­ established relationships in Macroeconomics. While many things determine a Nation's level of consumption, none are more important than disposable income.

Historical data: shows that Households spend most disposable income

Note: See Figure 30.1 on page 579 for historical consumption and disposable income from 1993 - 2015

- Example- in 1998 the nation's disposable income was $6498 Billion and consumption was $6157 Billion leaving approx. $341 Billion saved.

Note: Saving money does vary with the amount of disposable income.

1)   Households tend to increase their spending as disposable income increases. 

2)    Households spend a larger proportion of small disposable incomes then Households spend with large disposable incomes.

This is also referred to as the Consumption Schedule

The Saving Schedule - formula-wise, Savings equals Disposable Income minus Consumption (or S = DI - C), and Savings represents a smaller proportion of small DI than larger.

This makes sense; if households are spending a smaller proportion of DI as DI increases, than they must be saving a larger proportion

Dissaving -   households consuming more than after-tax income - which usually occurs at the low DI level. How can households really do this?

1)   By liquidating accumulated wealth (retirement funds, jewelry, heirlooms, etc.)

2)   Borrowing money (which can lead to growing debt)

Break-Even Income -this is the income level at which households plan to consume their entire incomes (what is another popular expression for this situation?)

Non-income Determinants of Consumption and Savings: there are determinants other than income that prompt households to spend and save

1)   Wealth - is defined as the dollar amount of all a household's assets minus their liabilities. Households build wealth by saving money out of their current incomes. To an economist (and to most of us), the point of wealth is to increase consumption possibilities now and in the future.

Wealth Effect - refers to some event that boosts the value of a household's wealth. When this happens, households tend to

.,. increase their spending and reduce their savings (which is the opposite of what we learned above). Example - the sudden stock market expansion in the late 1990's caused wealth to increase in households during more consumption and less savings

Reverse Wealth Effect - is the opposite: Example in 2008, real estate and stock values plunged downwards so badly they erased some $11.2 Trillion dollars of household wealth in the United States

2)   Borrowing - when a household borrows, it can increase its current consumption ability beyond its disposable income. By allowing households to do this and spend more than they normally could, they shift the consumption schedule upwards

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3)   Expectations - Household expectations can also affect consumption and savings levels. Events such as rising prices, recession, etc. can prompt households to alter their consumption and saving levels to deal with these events. They can move the consumption and savings schedules up and down as a result.

4)   Real Interest Rates - when rates fall, households tend to borrow more, consume more, and save less. However, this effect    on consumption and saving is very modest. They mainly shift consumption towards some products (those bought on credit) and away from others. Consumption schedules may rise slightly, and savings schedules may decline, again, slightly. Higher rates will, of course, do the opposite.

Note: Read the Yellow Insert on page 585 "The Great Recession and The Paradox of Thrift" for some perspective on how saving can help and hurt the economy at the same time.

Interest Rate - Investment Relationship: Recall that investment consists of spendi11g on new plants, capital equipment, machinery, and inventories (etc.). This, of course, is a cost/benefit trade off - the benefit is the rate of return businesses will hope to realize, and the cost is the interest rate paid on borrowed loans.

1)  The Expected Rate of Return - Businesses will invest in any project where the profit (expected rate of return) is greater than the interest rate.

2)  The Real Interest Rate - any money borrowed includes the cost

of interest paid on that money. The real interest rate is the interest cost of the investment in real (adjusted for inflation) dollars as opposed to the nominal rate (consisting of current value dollars).

Therefore, the expected rate of return (profits) and interest rates are the two basic determinants of investment spending

The Guideline applies even if a company finances the investment internally out of funds saved from past profit rather than borrowing.

When a Company does this, the investment represents an opportunity cost because the company is now foregoing (giving up) interest it could have earned on the money it is using to invest

3)  Investment Demand Curve - applies to an entire business sector

(like Energy) and not an individual company. Here macroeconomists can look at the total investment in that sector/industry and compute the different rates of return/profit potential for all the investment opportunities within the entire sector

Shifts of the Investment Demand Curve - Any factor that leads businesses, collectively in a sector or industry to expect greater rates of return on their investments will increase investment demand.

A good example of this is the current "Shale Boom" in the Energy sector. Shale deposits represent a huge and technologically reachable " new" source of oil and natural gas.

Advances in technology and multiple discoveries of gigantic deposits of oil and gas bearing shale are prompting intense demand for new investment opportunities by multiple energy companies throughout the industry.

The potential supplies of these fossil fuels are so huge and the new technology to mine them so reliable that the energy industry in America transformed from an energy importer to an energy exporter in the last few years - with all the positive implications that has for our economy.

In addition, the new technical advances in pollution control are supposedly able to remove most of the harmful effects on the water and land resources required to retrieve the oil and natural gas

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Non-interest rate determinants of Investment Demand:

1)  Acquisition, Maintenance and Operating Costs - when these costs rise, the expected rate of return from prospective investment projects will fall and investment demand will decrease. Lower costs will, of course, lead to investment demand increase

2)   Business Taxes - an increase in taxes lowers the expected profitability of investments, and decreases the demand; a reduction does the opposite

3)   Technological Change - progress, development of new products,

techniques and new technology all stimulate investment (look at the energy example previously). A more efficient or effective technology lowers production costs and/or improves product quality - both increase the expected rate of return and spur investment demand

4)   Stock of Capital Goods on Hand - when the economy is overstocked with production facilities and when firms have excessive inventories, the expected rate of return on new investment declines, and so investment demand decreases.

5)   Planned Inventory Changes - refers to changes in inventories of unsold goods. Some changes in inventory are planned and others are unplanned. The Investment Demand curve deals only with planned changes in inventories - therefore it is only affected by planned changes. Planned increases increase investment demand and vice versa

6)   Expectations - a firm's expectations of future sales, future

operating costs and future profitability all affect the demand for investment. Expectations are based on forecasts of future business conditions, and on such things as political climate, international relations, population growth and consumer tastes - all exceedingly difficult to predict. Any of these conditions could cause investment demand to rise or fall depending on their negative or positive impact on the economy.

The Instability of Investment - unlike consumption, investment is unstable - it rises and falls quite often and for a myriad of reasons. Investment is, in fact, the most volatile component of total spending, and this volatility is usually attributed to demand shocks. Examples:

1)   Variability of Expectations - business conditions can change quickly when some event suggests that a significant change will occur in business conditions. Changes in exchange rates, legislative actions, stock market prices, government policies, outlook for war or peace, etc.

2)   Durability- depending on their durability, capital goods can have indefinite life spans. Firms can scrap old or replace older equipment and buildings or they can repair them and use them for a few more years. Optimism or pessimism about the future will drive these decisions

3)   Irregularity of Innovation - while new products and processes

stimulate investment, these innovations occur quite irregularly and add to the volatility of investment

4)   Variability of Profits - high current profits generate optimism

.. about the future profitability of investments, whereas low profits generate pessimism and doubt about the wisdom of an investment. As we know, profits are highly variable which also contributes to the volatility

The Multiplier Effect - is the final relationship in the basic macroeconomic relationships we will discuss. The Multiplier Effect explores the relationship between changes in spending and changes in GDP - in fact, there is a direct relationship between these two aggregates - more spending results in a higher GDP: less spending results in lower GDP

                    The Multiplier determines how much larger that change will be. So, it is    

                    the ratio of change in GDP to the initial change in spending.

Rationale - the multiplier effect follows from two facts

1)   The economy supports repetitive, continuous flows of expenditures and income through which dollars spent by Smith are received as income by Chin, and then spent by Chin and received as income by Gonzales, and so on.

2)   Any change in income will change both consumption and saving in

the same direction as, and by a fraction of, the change in income.

The Multiplier Effect refers to the increase in final income arising from any new injection of spending. The size of the multiplier depends upon a household's marginal decisions to spend, which is called the marginal propensity to consume (mpc),