BasicMacroeconomicRelationships

CHAPTEREIGHT BASICMACROECONOMICRELATIONSHIPS

LECTURENOTES
I. IntroductionWhatAretheBasicMacroRelationships? A. Previously we identified macroeconomic issues of growth, business cycles, recession, and inflation.Herewebegintodeveloptoolstoexplaintheseevents. B. Thischapterfocusesonthethreebasicmacroeconomicrelationships. 1. Incomeandconsumption,andincomeandsaving. 2. Theinterestrateandinvestment. 3. Changesinspendingandchangesinoutput. C. LearningobjectivesInthischapterstudentswilllearn: 1. Howchangesinincomeaffectconsumptionandsaving. 2. Aboutfactorsotherthanincomethatcanaffectconsumption. 3. Howchangesinrealinterestratesaffectinvestment. 4. Aboutfactorsotherthantherealinterestratethatcanaffectinvestment. 5. WhychangesininvestmentincreaseordecreaserealGDPbyamultipleamount. II. TheIncomeConsumptionandIncomeSavingRelationships A. Disposableincomeisthemostimportantdeterminantofconsumerspending. B. Whatisnotspentiscalledsaving. C. Figure8.1representsgraphicallytherecenthistoricalrelationshipbetweendisposableincome (DI),consumption(C),andsaving(S)intheUnitedStates. 1. A45degreelinerepresentsallpointswhereconsumerspendingisequaltodisposable incomeotherpointsrepresentactualC,DIrelationshipsforeachyearfrom19832005. 2. Iftheactualgraphoftherelationshipbetweenconsumptionandincomeis belowthe45 degreeline,thenthedifferencemustrepresenttheamountofincomethatissaved. 3. In1992consumptionwas$4385billionanddisposableincomewas$4751billion.Hence, saving was $366 billion. Notice that in 2005, consumption ($9072.1 billion) exceeded disposableincome($9038.6billion)personalsavingwasanegative$33.5billion! 4. Someconclusionscanbedrawn: a. Householdsconsumealargeportionoftheirdisposableincome. b. Bothconsumptionandsavingaredirectlyrelatedtothelevelofincome. D. Theconsumptionschedule: 1. A hypothetical consumption schedule (Table 8.1 and Key Graph 8.2a) shows that householdsspendalargerproportionofasmallincomethanofalargeincome.

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2. Ahypotheticalsavingschedule(Table 8.1,column3)isillustratedinKeyGraph 8.2b. 3. Note that dissaving occurs at low levels of disposable income, where consumption exceedsincomeandhouseholdsmustborroworuseupsomeoftheirwealth. E. Averageandmarginalpropensitiestoconsumeandsave: 1. Define average propensity to consume (APC) as the fraction or % of income consumed (APC=consumption/income).SeeColumn4inTable 8.1. 2. Defineaveragepropensitytosave(APS)asathefractionor%ofincomesaved(APS= saving/income).SeeColumn5inTable 8.1. 3. GlobalPerspective8.1showstheAPCsforseveralnationsin2006.NotethehighAPCs fortheU.S.,Canada,andtheUnitedKingdom. 4. Marginal propensity to consume (MPC) is the fraction or proportion of any change in incomethatisconsumed.(MPC=changeinconsumption/changeinincome.)SeeColumn 6inTable 8.1. 5. Marginalpropensitytosave(MPS)isthefractionorproportionofanychangeinincome thatissaved.(MPS=changeinsaving/changeinincome.)SeeColumn7inTable 8.1. 6. NotethatAPC+APS=1andMPC+MPS=1. 7. Note that Figure 8.3 illustrates that MPC is the slope of the consumption schedule, and MPSistheslopeofthesavingschedule. 8. TestYourself:TrytheSelfQuizbelowKeyGraph 8.2. F. Nonincomedeterminantsofconsumptionandsavingcancausepeopletospendorsavemoreor lessatvariousincomelevels,althoughthelevelofincomeisthebasicdeterminant. 1. Wealth: An increase in wealth shifts the consumption schedule up and saving schedule down. In recent years major fluctuations in stock market values have increased the importance of this wealth effect. A reverse wealth effect occurred in 2000 and 2001, whenstockpricesfelldramatically. ConsiderThisWhatWealthEffect? 2. Expectations: Changes in expected future prices or wealth can affect consumption spendingtoday. 3. Realinterestrates:Declininginterestratesincreasetheincentivetoborrowandconsume, and reduce the incentive to save. Because many household expenditures arenot interest sensitivethelightbill,groceries,etc.theeffectofinterestratechangesonspendingare modest. 4. Household debt: Lower debt levels shift consumption schedule up and saving schedule down.

G. Otherimportantconsiderations:SeeFigure 8.4. 1. Macroeconomicmodelsfocusonrealdomesticoutput(realGDP)morethanondisposable income.Figure8.4reflectsthischangeinthelabelingofthehorizontalaxis. 2. Changes along schedules: Movement from one point to another on a given schedule is called a change in the amount consumed a shift in the schedule is called a change in consumptionschedule,andiscausedby nonincomedeterminantsofconsumption..

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BasicMacroeconomicRelationships 3. Scheduleshifts:Consumptionandsavingscheduleswillalwaysshiftinoppositedirections unlessashiftiscausedbyataxchange. 4. Taxation: Lower taxes will shift both schedules up since taxationaffectsbothspending andsaving,andviceversaforhighertaxes. 5. Stability:Economistsbelievethatconsumptionandsavingschedulesaregenerallystable unlessdeliberatelyshiftedbygovernmentaction. III. TheInterestRateInvestmentRelationship A. Investment consists of spending on new plants, capital equipment, machinery, inventories, construction,etc. 1. Theinvestmentdecisionweighsmarginalbenefitsandmarginalcosts. 2. The expected rate of return is the marginal benefit and the interest rate the cost of borrowingfundsrepresentsthemarginalcost. B. Expected rate of return is found by comparing the expected economic profit (total revenue minustotalcost)tocostofinvestmenttogetexpectedrateofreturn.Thetextsexamplegives $100 expected profit on a $1000 investment, for a 10% expected rate of return. Thus, the businesswouldnotwanttopaymorethan10%interestrateoninvestment.Rememberthatthe expectedrateofreturnisnotaguaranteedrateofreturn. Investmentcarriesrisk. C. Therealinterestrate,i(nominalratecorrectedforexpectedinflation),determinesthecostof investment. 1. The interest rate represents either the cost of borrowed funds or the opportunity cost of investingyourownfunds,whichisincomeforgone. 2. Ifrealinterestrateexceedstheexpectedrateofreturn,theinvestmentshouldnotbemade. D. Investmentdemandschedule,orcurve,showsaninverserelationshipbetweentheinterestrate andamount ofinvestment. 1. Aslongasexpectedreturnexceedsinterestrate,theinvestmentisexpectedtobeprofitable (seeTable 8.2example). 2. Key Graph 8.5 shows the relationship when the investment rule is followed. Fewer projects are expected to provide high return, so less will be invested if interest rates are high. 3.TestyourselfwithQuickQuiz8.5. E.Shiftsininvestment demand(Figure8.6)occurwhenanydeterminant apart fromtheinterest ratechanges. 1.Greaterexpectedreturnscreatemoreinvestmentdemandshiftcurvetoright.Thereverse causesaleftwardshift. 2. Changesinexpectedreturnsresultbecause: a. Acquisition, maintenance, and operating costs of capital goods may change. Higher costslowertheexpectedreturn. b. Businesstaxesmaychange.Increasedtaxeslowertheexpectedreturn. c. Technology may change. Technological change often involves lower costs, which wouldincreaseexpectedreturns.

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d. Stock of capital goods on handwillaffect newinvestment.Ifthereis abundant idle capital on hand because of weak demand or recent investment, new investments wouldbelessprofitable. e. Expectations about future economic and political conditions, both in the aggregate andincertainspecificmarkets,canchangetheviewofexpectedprofits. F.InvestmentisaveryunstabletypeofspendingIismorevolatilethanGDP(SeeFigure 8.7). 1. Capitalgoodsaredurable,sospendingcanbepostponedornot.Thisisunpredictable. 2. Innovationoccursirregularly. 3. Profitsvaryconsiderably. 4. Expectationscanbeeasilychanged. IV. TheMultiplierEffect A. ChangesinspendingripplethroughtheeconomytogenerateeventlargerchangesinrealGDP. Thisiscalledthe multipliereffect. 1. Multiplier = change in real GDP / initial change in spending. Alternatively, it can be rearrangedtoread ChangeinrealGDP=initialchangeinspendingxmultiplier. 2. Threepointstorememberaboutthemultiplier: a. The initial change in spending is usually associated with investment because it is so volatile, but changes in consumption (unrelated to income), net exports, and governmentpurchasesalsoaresubjecttothemultipliereffect. b. The initial change refers to an upshift or downshift in the aggregate expenditures scheduleduetoachangeinoneofitscomponents,likeinvestment. c. Themultiplierworksinbothdirections(upordown). B. Themultiplierisbasedontwofacts. 1. Theeconomyhascontinuousflowsofexpendituresandincomearippleeffectinwhich income received by Grant comes frommoneyspent byBattaglia.Battaglias income,in turn,camefrommoneyspentbyMendoza,andsoforth. 2. Any change in income will cause both consumption and saving to vary in the same directionastheinitialchangeinincome,andbyafractionofthatchange. a. Thefractionofthechangeinincomethatisspentiscalledthemarginalpropensityto consume(MPC). b. Thefractionofthechangeinincomethatissavediscalledthemarginalpropensityto save(MPS). c. Thisisillustrated inTable 8.3,andFigure 8.8thatisderivedfromtheTable. C. ThesizeoftheMPCandthemultiplieraredirectlyrelatedthesizeoftheMPSandthe multiplierareinverselyrelated.SeeFigure 8.9foranillustrationofthispoint.Inequation formMultiplier=1/MPSor1/(1MPC). D. Thesignificanceofthemultiplieris that asmallchangeininvestment plansorconsumption savingplanscantriggeramuchlargerchangeintheequilibriumlevelofGDP. E. Thesimplemultipliergivenabovecanbegeneralizedtoincludeotherleakagesfromthe spendingflowbesidessavings.Forexample,theactualmultiplierisderivedbyincludingtaxes

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BasicMacroeconomicRelationships andimportsaswellassavingsintheequation.Inotherwords,thedenominatoristhefraction ofachangeinincomenotspentondomesticoutput.(KeyQuestion9) V. LASTWORD:SquaringtheEconomicCircle A. HumoristArtBuchwaldillustratestheconceptofthemultiplierwiththisfunnyessay. B. Hofberger, a Ford salesman in Tomcat, Va., called up Littleton of Littleton Menswear & Haberdashery,andtoldhimthatanew Ford hadbeensetasideforLittletonandhiswife. C. Littletonsaidhewassorry,buthecouldntbuyacarbecauseheandMrs.Littletonwere gettingadivorce. D. Soon afterward, Bedcheck the painter called Hofberger to ask when to begin painting the Hofbergers home. Hofberger said he couldnt, because Littleton was getting a divorce, not buyinganewcar,and,therefore,Hofbergercouldnotaffordtopainthishouse. E. WhenBedcheckwent homethat evening,hetoldhiswifetoreturntheirnewtelevisionsetto Gladstones TV store. When she returned it the next day, Gladstone immediately called his travelagentandcanceledhistrip.HesaidhecouldntgobecauseBedcheckreturnedtheTV setbecauseHofbergerdidntsellacartoLittletonbecauseLittletonsaredivorcing. F. Sandstorm, the travel agent, tore up Gladstones plane tickets, and immediately called his banker,Gripsholm,totellhimthathecouldntpaybackhisloanthatmonth. G. WhenRudemakercametothebanktoborrowmoneyforanewkitchenforhisrestaurant,the bankertoldhimthathehadnomoneytolendbecauseSandstormhadnotrepaidhisloanyet. H. Rudemakercalledhiscontractor,Eagleton,whohadto layoffeightmen. I. Meanwhile, Ford announced it would give a rebate on its new models. Hofberger called Littletontotellhimthat hecouldprobablyaffordacarevenwiththedivorce.Littletonsaid thatheandhiswifehadmadeupandwerenotdivorcing.However,hisbusinesswassolousy that he couldnt afford a car now. His regularcustomers,Bedcheck,Gladstone,Sandstorm, Gripsholm,Rudemaker,andEagletonhadnotbeeninforoveramonth!

ANSWERSTOENDOFCHAPTERQUESTIONS
81 Verybriefly summarizetherelationshipsshownby(a)theconsumptionschedule,(b)thesaving schedule,(c)theinvestmentdemandcurve,and(d)themultipliereffect.Whichofthese relationshipsaredirect(positive)relationshipsandwhichareinverse(negative)relationships? WhyareconsumptionandsavingintheUnitedStatesgreatertodaythantheywereadecadeago. (a) Theconsumptionscheduleorcurveshowshowmuchhouseholdsplantoconsumeatvarious levelsofdisposableincomeataspecificpointintime,assumingthereisnochangeinthe nonincomedeterminantsofconsumption,namely,wealth,thepricelevel,interestrates, expectations,indebtedness,andtaxes.Achangeindisposableincomecausesmovementalong agivenconsumptioncurve.Achangeinanonincomedeterminantcausestheentireschedule orcurvetoshift. (b) Thesavingscheduleorcurveshowshowmuchhouseholdsplantosaveatvariouslevelsof disposableincomeataspecificpointintime,assumingthereisnochangeinthenonincome determinantsofsaving,namely,wealth,thepricelevel,interestrates,expectations, indebtedness,andtaxes.Achangeindisposableincomecausesmovementalongagiven savingcurve.Achangeinanonincomedeterminantcausestheentirescheduleorcurveto shift.
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(c) Theinvestmentdemandcurveshowshowmuchwillbeinvestedatallpossibleinterestrates, giventheexpectedrateofnetprofitfromtheproposedinvestments,assumingthereisno changeinthenoninterestratedeterminantsofinvestment,namely,acquisition,maintenance, operatingcosts,businesstaxes,technologicalchange,thestockofcapitalgoodsonhand,and expectations.Achangeinanyofthesewillaffecttheexpectedrateofnetprofitandshiftthe curve.Achangeintheinterestratewillcausemovementalongagivencurve. (d) Themultipliereffectshowshowaninitialchangeinspendingcanflowthroughthesystemto generatealargerchangeinGDP. Consumptionandsavingaredirectly(positively)relatedtoincome.Investmentisinversely (negatively)relatedtotherealinterestrate.Themultiplierdirectlyrelateschangesinspendingto changesinGDP. Consumptionandsavingaregreatertodayprimarilybecauseincomeisgreater.Notethatthisdoes notnecessarilymeanthatpercapitaconsumptionandsavinghaverisenbothGDPandpopulation haverisenoverthepastdecade. 82 PreciselyhowdotheAPCandtheMPCdiffer?WhymustthesumoftheMPCandtheMPS equal1?Whatarethebasicdeterminantsoftheconsumptionandsavingschedules?Ofyour personallevelofconsumption? APCisanaveragewherebytotalspendingonconsumption(C)iscomparedtototalincome(Y): APC=C/Y.MPCreferstochangesinspendingandincomeatthemargin.Herewecompare a changeinconsumerspendingtoachangeinincome:MPC=changeinC/changeinY. Whenyourincomechangesthereareonlytwopossibleoptionsregardingwhattodowithit:You eitherspenditoryousaveit.MPCisthefractionofthechangeinincomespenttherefore,the fractionnotspentmustbesavedandthisistheMPS.Thechangeinthedollarsspentorsavedwill appearinthenumeratorandtogethertheymustaddtothetotalchangeinincome.Sincethe denominatoristhetotalchangeinincome,thesumoftheMPCandMPSisone. Thebasicdeterminantsoftheconsumptionandsavingschedulesarethelevelsofincomeand output.Oncetheschedulesareset,thedeterminantsofwheretheschedulesarelocatedwouldbe theamountofhousehold wealth(themorewealth,themoreisspentateachincomelevel) expectationsoffutureincome,therealinterestrate,pricesandproductavailabilitytherelativesize ofconsumerdebtandtheamountoftaxation. Chancesarethatmostofuswouldanswerthatourincomeisthebasicdeterminantofourlevelsof spendingandsaving,butafewmayhavelowincomes,butwithlargefamilywealththat determinesthelevelofspending.Likewise,otherfactorsmayenterintothepattern,aslistedinthe precedingparagraph.Answerswillvarydependingonthestudentssituation. 83 Explainhoweachofthefollowingwillaffecttheconsumptionandsavingschedules(astheyrelate toGDP)ortheinvestmentschedule: a. Alargeincreaseinthevalueofreal estate,includingprivatehouses. b. Adeclineintherealinterestrate. c. Asharp,sustaineddeclineinstockprices. d. Anincreaseintherateofpopulationgrowth. e. Thedevelopmentofacheapermethodofmanufacturingcomputerchips. f. AsizableincreaseintheretirementageforcollectingSocialSecuritybenefits. g. AnincreaseintheFederalpersonalincometax.

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BasicMacroeconomicRelationships (a) Ifthissimplymeanshouseholdshavebecomemorewealthy,thenconsumptionwillincreaseat eachincomelevel.Theconsumptionscheduleshouldshiftupwardandthesavingschedule shiftdownward.Theinvestmentschedulemayshiftrightwardifownersofexistinghomessell themandinvestinconstructionofnewhomesmorethanpreviously. (b) Thedeclineintherealinterestratewillincreaseinterestsensitiveconsumerspendingthe consumptionschedulewillshiftupandthesavingscheduledown.Investorswillincrease investmentastheymovedowntheinvestmentdemandcurvetheinvestmentschedulewillshift upward. (c) Asharpdeclineinstockpricescanbeexpectedtodecreaseconsumerspendingbecauseofthe decreaseinwealththeconsumptionscheduleshiftsdownandthesavingscheduleupwards. Becauseofthedepressedsharepricesandthenumberofspeculatorsforcedoutofthemarket, itwillbehardertofloatnewissuesonthestockmarket.Therefore,theinvestmentschedule willshiftdownward. (d) Theincreaseintherateofpopulationgrowthwill,overtime,increasetherateofincome growth.Initselfthiswillnotshiftanyoftheschedulesbutwillleadtomovementupwardto therightalongtheupwardslopinginvestmentschedule. (e)Thisinnovationwillinitselfshifttheinvestmentscheduleupward.Also,astheinnovation startstolowerthecostsofproducingeverythingusingthesechips,priceswilldecreaseleading toincreasedquantitiesdemanded.This,again,couldshifttheinvestmentscheduleupward. (f) Thepostponementofbenefitsmaycausehouseholdstosavemoreiftheyplannedtoretire beforetheyqualifyforbenefitsthesavingschedulewillshiftupward,theconsumption scheduledownward.Thisimpactisuncertain,however,ifpeoplecontinuetoworkandearn productiveincomes. (g) Becausethisreducesdisposableincome,consumptionwilldecline inproportiontothe marginalpropensitytoconsume.Consumptionwillbelessateachlevelofrealoutput,andso thecurveshiftsdown.Thesavingschedulewillalsofallbecausethedisposableincomehas decreasedateachlevelofoutput,solesswouldbesaved. 84 Explainwhyanupwardshiftintheconsumptionscheduletypicallyinvolvesanequaldownshiftin thesavingschedule.Whatistheexceptiontothisrelationship? If,bydefinition,allthatyoucandowithyourincomeisuseitforconsumptionorsaving,thenif youconsumemoreoutofanygivenincome,youwillnecessarilysaveless.Andifyouconsume less,youwillsavemore.Thisbeingso,whenyourconsumptionscheduleshiftsupward(meaning youareconsumingmoreoutofanygivenincome),yoursavingscheduleshiftsdownward(meaning youareconsuminglessoutofthesamegivenincome). Theexceptionisachangeinpersonaltaxes.Whenthesechange,yourdisposableincomechanges, and,therefore,yourconsumptionandsavingbothchangeinthesamedirectionandoppositetothe changeintaxes.IfyourMPC,say,is0.9,thenyourMPSis0.1.Now,ifyourtaxesincreaseby $100,yourconsumptionwilldecreaseby$90andyoursavingwilldecreaseby$10. 85 (KeyQuestion) Complete theaccompanyingtable.

LevelofOutput andincome (GDP=DI) Consumption

Saving

APC

APS

MPC

MPS

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$240 260 280 300 320 340 360 380 400

$_____ $_____ $_____ $_____ $_____ $_____ $_____ $_____ $_____

$4 0 4 8 12 16 20 24 28

_____ _____ _____ _____ _____ _____ _____ _____ _____

_____ _____ _____ _____ _____ _____ _____ _____ _____

_____ _____ _____ _____ _____ _____ _____ _____ _____

_____ _____ _____ _____ _____ _____ _____ _____ _____

Dataforcompletingthetable(toptobottom).Consumption:$244$260$276$292$308$324$340 $356$372.APC:1.021.00.99.97.96.95.94.94.93.APS: .02.00.01.03.04.05 .06.06.07.MPC:.80throughout.MPS:.20throughout. a. Showtheconsumptionandsavingschedulesgraphically. b. Findthebreakevenlevelofincome. Explainhowisitpossibleforhouseholdstodissaveat verylowincomelevels. c. Iftheproportionoftotalincomeconsumed(APC)decreasesandtheproportionsaved(APS) increasesasincomerises,explainbothverballyandgraphicallyhowtheMPCandMPScan beconstantatvariouslevelsofincome. (a) Seethegraphs.

(b) Breakevenincome=$260.Householdsdissaveborrowingorusing pastsavings. (c) Technically,theAPCdiminishes andtheAPSincreases becausetheconsumptionandsaving scheduleshavepositiveandnegativeverticalinterceptsrespectively.(AppendixtoChapter1).

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BasicMacroeconomicRelationships MPCandMPSmeasurechangesinconsumptionandsavingasincomechangestheyarethe slopes of the consumption and saving schedules. For straightline consumption and saving schedules,theseslopes donot changeas thelevelofincomechangestheslopesandthusthe MPCandMPSremainconstant. 86 Whatarethebasicdeterminantsofinvestment?Explaintherelationshipbetweentherealinterest rate and the level of investment. Why is investment spending unstable? How is it possible for investmentspendingtoincreaseeveninaperiodinwhichtherealinterestraterises? The basic determinants of investment are the expected rate of return (net profit) that businesses hopetorealizefrominvestmentspending,andtherealrateofinterest. When the real interest rate rises, investment decreases and when the real interest rate drops, investment increasesotherthings equalinbothcases.Thereasonforthisrelationshipisthatit makessensetoborrowmoneyat,say,10percent,iftheexpectedrateofnetprofitishigherthan10 percent,forthenonemakesaprofitontheborrowedmoney.Butiftheexpectedrateofnetprofit is less than 10 percent, borrowing the money would be expected to result in a negative rate of returnontheborrowedmoney.Evenifthefirmhasmoneyofitsowntoinvest,theprinciplestill holds: The firm would not be maximizing profit if it used its own money to carry out an investmentreturning,say,9percentwhenitcouldlendthemoneyataninterestrateof10percent. Investment is unstable because, unlike most consumption,it canbeput off.Ingoodtimes,with demandstrongandrising,businesseswillbringinmoremachinesandreplaceoldones.Intimesof economicdownturn,nonewmachineswillbeordered.Afirmcancontinueforyearswith,say,a tenth of the investment it was carrying out in the boom. Very few families could cut their consumptionsodrastically. Newbusinessideasandtheinnovationsthatspringfromthemdonotcomeataconstantrate.This is another reason for the irregularity of investment. Profits and the expectations of profits also vary.Sinceprofits,intheabsenceofeasyaccesstoborrowedmoney,areessentialforinvestment andsince,moreover,theobjectofinvestmentistomakeaprofit,investment,too,mustvary. As long as expected rates of return rise faster than real interest rates, investment spending may increase.Thisismostlikelytooccurduringperiodsofeconomicexpansion. 87 (KeyQuestion)Supposeahandbillpublishercanbuyanewduplicatingmachinefor$500andthe duplicatorhasa1yearlife.Themachineisexpectedtocontribute$550totheyearsnetrevenue. What is the expected rate of return? If the real interest rate at whichfunds canbeborrowedto purchasethemachineis8percent,willthe publisherchoosetoinvestinthemachine?Explain. Theexpectedrateofreturnis10%($50expectedprofit/$500costofmachine).The$50expected profitcomesfromthenetrevenueof$550lessthe$500costofthemachine. If the real interest rate is 8%, the publisher will invest in the machine as the expected profit (marginalbenefit)fromtheinvestmentexceedsthecostofborrowingthefunds(marginalcost). 88 (KeyQuestion)Assumetherearenoinvestmentprojectsintheeconomywhichyieldanexpected rate of return of 25 percent or more. But suppose there are $10 billion of investment projects yieldingexpectedrateofreturnofbetween20and25percentanother$10billionyieldingbetween 15and20percentanother$10billionbetween10and15percentandsoforth.Cumulatethese dataandpresent themgraphically,puttingtheexpectedrateofnetreturnontheverticalaxisand theamount ofinvestment onthehorizontalaxis.Whatwillbetheequilibriumlevelofaggregate investmentiftherealinterestrateis(a)15percent,(b)10percent,and(c)5percent?Explainwhy thiscurveistheinvestmentdemandcurve.

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Seethegraphbelow.Aggregateinvestment:(a)$20billion(b)$30billion(c)$40billion.This istheinvestmentdemandcurvebecausewehaveappliedtheruleofundertakingallinvestmentup tothepointwheretheexpectedrateofreturn,r,equalstheinterestrate,i.

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(KeyQuestion)Whatisthemultipliereffect?WhatrelationshipdoestheMPCbeartothesizeof themultiplier?TheMPS?WhatwillthemultiplierbewhentheMPSis0,.4,.6,and1?What willitbewhentheMPCis1,.9,.67,.5,and0?HowmuchofachangeinGDPwillresultiffirms increasetheirlevelofinvestmentby$8billionand theMPCis.80?IftheMPCis.67? The multiplier effect describes how an initialchangeinspendingripples throughtheeconomyto generatealargerchangeinrealGDP.Itoccursbecauseoftheinterconnectednessoftheeconomy, where a change in Lassletts spending will generate more income for Gavidia, who will in turn spendmore,generatingadditionalincomeforGrimes. The MPC is directly (positively) related to the size of the multiplier. The MPS is inversely (negatively)relatedtothesizeofthemultiplier. ThemultipliervaluesfortheMPSvalues:undefined,2.5,1.67,0. ThemultipliervaluesfortheMPCvalues:undefined,10,3(approx.actually3.03),2,0. IfMPCis.80,changeinGDPis$40billion(5x$8=$40) IfMPCis.67,changeinGDPis$24billion(approximately)(3x$8=$24)

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WhyistheactualmultiplierfortheU.S.economylessthanthemultiplierinthischapterssimple examples? Theactualmultiplier(estimatedtobeabout2)issmallerbecauseitincludesotherleakagesfrom the spending and income cycle besides just saving.Importsandtaxes reducetheflowofmoney backintospendingondomesticallyproducedoutput,reducingthemultipliereffect.

811

Advancedanalysis:Linearequations(seeappendixtoChapter1)fortheconsumptionandsaving schedules take the general form C = a + bY and S = a + (1 b)Y, where C, S, and Y are consumption, saving, and national income respectively. The constant a represents the vertical intercept,and brepresentstheslopeoftheconsumptionschedule. a. Usethefollowingdatatosubstitutespecificnumericalvaluesintotheconsumptionandsaving equations.

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NationalIncome(Y) $0 100 200 300 400

Consumption(C) $80 140 200 260 320

b. Whatistheeconomicmeaningofb?Of(1b)? c. Suppose the amount of saving that occurs at each level ofnationalincomefalls by$20,but that the values for b and (1 b) remain unchanged. Restate the saving and consumption equationsforthenewnumericalvaluesandciteafactorthatmighthavecausedthechange. (a) C=$80+0.6Y S=$80+0.4Y

(b) Sincebistheslopeoftheconsumptionfunction,itisthevalueoftheMPC.(Inthiscasethe slope is 6/10, which means for every $10 increase in income (movement to the right on the horizontal axis of the graph), consumption will increase by $6 (movement upwards on the verticalaxisofthegraph).(1b)wouldbe1.6=.4,whichistheMPS. Since(1b)istheslopeofthesavingfunction,itisthevalueoftheMPS.Withtheslopeof the MPC being 6/10, the MPS will be 4/10. This means for every $10 increase in income (movement to the right on the horizontal axis of the graph), saving will increase by $4 (movementupwardontheverticalaxisofthegraph). (c) C =100 + 06 . Y
S =-$100+ 04 . Y

A factor that might have caused the decrease in savingthe increased consumptionis the beliefthatinflationwillaccelerate.Consumerswishtostockupbeforepricesincrease.Other factorsmightincludeasuddenincreaseinwealthordecreaseinindebtedness,oradecreasein personaltaxes. 812 Advancedanalysis:Supposethatthelinearequationforconsumptioninahypotheticaleconomyis C=$40+.8Y.Alsosupposethatincome(Y)is$400.Determine(a)themarginalpropensityto consume, (b) the marginal propensity to save, (c) the level of consumption, (d) the average propensitytoconsume,(e)thelevelofsaving,and(f)theaveragepropensitytosave. (a) MPCis. 8

) 2 (b) MPS is(1-8 = .

(c) C=$40+ . ($ )= $ + $ = $ 8 400 40 320 360 (d) APC =$ /$ = . 360 400 9 (e) S =Y - C= $400- $ = $ 360 40 (f) APS =$ /$ = . or1- APC 40 400 1

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(Last Word) What is thecentraleconomicideahumorouslyillustratedinArt Buchwalds piece, SquaringtheEconomicCircle?Howdoesthecentralidearelatetorecessions,ontheonehand, andvigorousexpansions,ontheother?

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The central ideaillustratedis themultipliereffect that exists inamarket economicsystem.One independentlydeterminedchangeinspendinghasaneffectonanothersincome,whichthensetsin motionachainofeventswherebyspendingchangesdirectlywiththeincomechanges.Adeclinein spendingbeginsachainofdeclines,or,inotherwords,theinitialdecreaseinspendingismultiplied intermsofthefinaleffectofthissingledecision.Thisoccursbecauseoftheobservationthatany changeinincomecausesachangeinspendingthatisdirectlyproportionaltoit. Themultipliereffecthelpsusunderstandwhythereisabusinesscycleasopposedtoastablelevel ofoutputgrowthfromyeartoyear.IntheBuchwaldpiece,adownturnforonepersonbecamea downturnforeveryoneinthatfictionaleconomy.Likewise,ifthestoryhadbegunwithaburstof optimism andanincreaseinspending,itmighthaverippledthroughtoexpandeveryonesfortunes. Themultiplierintensifiestheeffectofaspendingchange,whetheritisanincreaseordecrease.

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