Transcript Basic Macroeconomic Relationships Please

Basic
Macroeconomic
Relationships
Please listen to the audio as you work
through the slides.
Learning objectives
Students should be able to thoroughly and
completely explain:
1. The relationships between Income,
Consumptions, Saving, and GDP.
2. The relationships between Interest rates,
Expected Rates of Return, and Investment
spending.
3. The Multiplier, (including the 3 types
discussed in the notes), and how the
Multiplier works.
Topics
Household sector:
Income – consumption & saving relationship
Business sector:
Interest rate – Rate of return – investment
Magnification of changes:
The multiplier – very important concept!
U.S. Income Relationships 2007
Gross Domestic Product (GDP)
Less: Consumption of Fixed Capital
Equals: Net Domestic Product (NDP)
Less: Statistical Discrepancy
Plus: Net Foreign Factor Income
Equals: National Income (NI)
Less: Taxes on Production and Imports
Less: Social Security Contributions
Less: Corporate Income Taxes
Less: Undistributed Corporate Profits
Plus: Transfer Payments
Equals: Personal Income (PI)
Less: Personal Taxes
Equals: Disposable Income (DI)
$ 13,841
1687
$ 12,154
29
96
$ 12,221
1009
979
467
344
2237
$ 11,659
1482
$ 10,177
Income – Consumption Relationship and
Income – Saving Relationship
Definition of some terms:
• Disposable Income (DI)
• DI = C+S
• Personal Saving (S) – “not spending”
• Consumption (C) – Consumption spending
• The Consumption Schedule (consumption function)
•A schedule showing the various amounts that households would plan to
consume at each of the various levels of DI that might prevail at some point in
time
• The Saving Schedule (saving function)
•A schedule showing the various amounts that households would plan to save
at each of the various levels of DI that might prevail as some point in time
• Break-even Income – the level of income at which households
plan to consume their entire incomes C=DI
Graphic representation of the income,
consumption, saving relationship
Consumption (billions of dollars)
500
C
475
450
425
Saving $5 BillionConsumption
Schedule
Any point on the 45 degree
Reference line is equidistant
From each axis (DI = C)
Saving and consumption
Both are directly related to
Disposable income
400
375
Dissaving $5 Billion
Saving
(billions of dollars)
45°
370 390 410 430 450 470 490 510 530 550
50
25
0
Disposable Income (billions of dollars)
Dissaving
Saving Schedule
$5 Billion
S
Saving $5 Billion
370 390 410 430 450 470 490 510 530 550
Consumption and Saving Terminology
APC – average propensity to consume – fraction of income that is
spent on consumption.
Consumption / Income
APS – average propensity to save – fraction of income that is saved.
Saving / Income
APS+APC=1
MPC – marginal propensity to consume – the fraction of any change in
Income that will be consumed. Change in Consumption / Change in Income
MPS – marginal propensity to save – the fraction of any change in
Income that will be saved. change in Saving / change in Income
MPS+MPC=1
Average Propensity to Consume
Selected Nations, with respect to GDP, 2006
.80
.85
.90
.95
1.00
United States
Canada
United Kingdom
Japan
Germany
Netherlands
Italy
France
Source: Statistical Abstract of the United States, 2006
Non Income Determinants of
Consumption and Saving (curve shifters)
•Wealth – value of real (houses and land) and financial
assets (cash, bank accounts, securities, pensions)
•Wealth Effects – causes consumption and saving to
increase or decrease
•Expectations – about inflation, recession, etc
•Real Interest Rates (adjusted for inflation (nominal interest
rate minus rate of inflation))
•Household Debt – more debt enables more consumption
•Taxation –
•Consumption & saving move in same direction –
taxes affect both
Consumer Debt 1999 to 2010
TERMINOLOGY, SHIFTS, & STABILITY
• Terminology
•Movement along a curve (change in
amount consumed) vs. shift of a curve
• Schedule Shifters
•Wealth,
•expectations,
•interest rates,
•household debt
•Taxes – affect both C and S
• Stability – consumption & savings
functions relatively stable
Saving
(billions of dollars) Consumption (billions of dollars)
Consumption and Saving
C1
C0
C2
45°
Disposable Income (billions of dollars)
S
S20
S1
The Interest Rate – Investment Relationship
Listen to the audio for more info.
Relationship between real interest rates, expected rate of return,
and investment.
Investment – expenditures on new plants, capital equipment,
machinery, inventories, etc.
Investment decision – a MB MC decision.
1. MB is the expected rate of return businesses hope to realize.
2. MC is the interest rate that must be paid for borrowed funds.
Business will invest in all projects where expected rate of return exceed the interest rate.
The two basic determinants of investment spending!
Interest Rate – Investment
Relationship
Expected Rate of Return, r
Real Interest Rate:
i is the nominal rate adjusted for inflation.
Inverse relationship between Investment demand
and the real interest rate. Please explain.
Graphically presented...
Investment Demand Curve
16%
14%
12%
10%
8%
6%
4%
2%
0%
$
0
5
10
15
20
25
30
35
40
16
14
r and i (percent)
Expected
Rate of
Return (r)
Cumulative
Amount of
Investment
Having This
Rate of
Return or Higher
(I)
12
10
8
6
4
2
ID
0
5
10
15
20
25
30
35
Investment (billions of dollars)
40
Investment Demand Curve
r and i (percent)
Increase in
Investment Demand
Decrease in
Investment Demand
0
ID
IDID
1
0
2
Investment (billions of dollars)
Non-Interest Rate Determinants of Investment Demand
These affect Investment Demand
by way of the Expected Rate of Return
What would have to happen to each of these factors to
cause a change in the Expected Rate of Return on a
project?
•
•
•
•
•
•
Acquisition, Maintenance, and Operating Costs
Business Taxes
Technological Change
Stock of Capital Goods on Hand
Planned inventory changes
Expectations
Gross Investment Expenditure
Percent of GDP, Selected Nations, 2006
0
10
20
30
South Korea
Japan
Canada
Mexico
France
United States
Sweden
Germany
United Kingdom
Source: International Monetary Fund
Causes of Instability of Investment
•Durability of capital goods
•Irregularity of Innovation
•Variability of Profits
•Variability of Expectations
Multipliers
• February 2009
– $800 Billion stimulus bill signed
• Why $800 Billion?
The Multiplier Effect
• More spending results in higher GDP
• Initial change in spending changes
GDP by a multiplied amount
Multiplier =
Change in Real GDP
Initial Change in Spending
The Multiplier Effect
• Some causes of the initial change in
spending
– Changes in investment
– Other changes –
• such as: changes in Consumption,
Government, or Net Export spending.
• Rationale
– Dollars spent are received as income
– Income received is spent (MPC)
– Initial changes in spending cause a spending
chain
The Multipliers – make sure you know these
1. Spending Multiplier = 1/MPS
– An autonomous change in spending results in a change in
aggregate production in the same direction.
2. Tax Multiplier = (MPC/MPS)
– If, for example, the MPC is 0.75 (and the MPS is 0.25), then
an autonomous $1 trillion change in taxes results in an
opposite change in aggregate production of $3 trillion
3. Balanced Budget Multiplier = 1
– The balanced-budget multiplier measures the combined
impact on aggregate production of equal changes in
government purchases and taxes. The simple balancedbudget multiplier has a value equal to one
http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=tax+multiplier
The Multiplier Spending Effect
Multiplier
Change in Real GDP
= Initial Change in Spending
The big picture:
We know we need to increase or
decrease our GDP, but we don’t
know by how much we need to
change spending to get the desired
result. How do we figure that out?
Change
in GDP
= Multiplier x
initial change
in spending
For Example…
The Multiplier Effect
The following slide shows you
how the Multiplier operates.
The Multiplier Effect
(1)
• Business Sector
Increase in Investment of $5
Second Round
Third Round
Fourth Round
Fifth Round
All other rounds
Total
$20.00
15.25
13.67
11.56
8.75
5.00
ΔI=
$5 billion
(3)
(2)
Change in Change in Change in
Income Consumption Saving
(MPC = .75) (MPS = .25)
$ 5.00
$ 3.75 $ 1.25
3.75
2.81
.94
2.81
2.11
.70
2.11
1.58
.53
1.58
1.19
.39
4.75
3.56
1.19
$ 20.00
$ 15.00
$ 5.00
$4.75
$1.58
$2.11
$2.81
$3.75
$5.00
1
2
3
4
Rounds of Spending
5
All
The Spending Multiplier Effect
Multiplier Effect and the
Marginal Propensities
Inverse relationship between:
Multiplier & MPS
Multiplier
Change in
GDP
=
1
1
or 1 - MPC
MPS
= Multiplier x
initial change
in spending
The Multiplier Effect
MPC and the Multiplier
Rules of thumb
MPC
Multiplier
.9
10
.8
5
.75
4
.67
.5
3
2
The Tax Multiplier
• (- MPC/MPS)
• You are the chief economic adviser to the president. You
are instructed to devise a plan to reduce unemployment
to an acceptable level without increasing the level of
government spending.
• You decide to cut taxes and maintain the spending level.
• A tax cut increases disposable income which leads to
increases in consumption.
• Would the decrease in taxes affect aggregate output in
the same way as an increase in government spending?
The Tax Multiplier
•
•
•
•
•
A tax decrease causes an income increase.
Consumption increases
Inventories decrease
Output increases in response.
Employment and income increase and lead to
subsequent rounds of spending.
• GDP will increase by a multiple of the decrease in taxes.
• The multiplier for a change in taxes is not the same as
the multiplier for an change in government spending.