Basic Macroeconomic Relationships

Basic Macroeconomic Relationships This chapter examines the basic relationships between three different pairs of economic aggregates. o (Recall that “aggregate” means “total” or “combined.”)  Specifically, this chapter looks at the relationship between: 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 The other-things-equal relationship between income and consumption is one of the best-established relationships in macroeconomics. o In examining that relationship, we are also exploring the relationship between income and saving.  Recall that economists define personal saving as “not spending” or as “that part of disposable (after-tax) income not consumed.” Saving (S) equals disposable income (DI) minus consumption ( C ). Many factors determine a nation’s levels of consumption and saving, but the most significant is disposable income. o Consider some recent historical data for the United States.  In Figure 30.1 each dot represents consumption and disposable income for one year since 1993. The line C that loosely fits these points shows that consumption is directly (positively) related to disposable income. o Moreover, households spend most of their income. The 45 degree line is a reference line. o Because it bisects the 90 degree angle formed by the two axes of the graph, each point on it is equidistant from the two axes.  At each point on the 45 degree line, consumption equals disposable income, or C = DI. Therefore, the vertical distance between the 45 degree line and any point on the horizontal axis measures either consumption or disposable income. o If we use it to measure disposable income, then the vertical distance between it and the consumption line labeled C represents the amount of saving (S) in that year.  Saving is the amount by which actual consumption in any year falls short of the 45 degree line – (S = DI – C). For example, in 2008 disposable income was $10,935 billion and consumption was $10,390 billion, so saving was $545 billion. o Observe that the vertical distance between the 45 degree line and line C increases as we move rightward along the horizontal axis and decreases as we move leftward.  Like consumption, saving typically varies directly with disposable income. The Consumption Schedule The dots in Figure 30.1 represent historical data – the actual amounts of DI, C, and S in the United States over a period of years. o But because we want to understand how the economy would behave under different possible scenarios, we need a hypothetical schedule showing the various amounts that households plan to consume at each level of disposable income that might prevail at some specific time.  Columns 1 and 3 of Table 30.1, represented in Figures 30.2a, show the hypothetical consumption schedule. This consumption schedule ( or “consumption function”) reflects the direct consumption-disposable income relationship suggested by the data in Figure 30.1. It is consistent with many household budget studies. o In the aggregate, households increase their spending as their disposable income rises, and they spend a larger proportion of a small disposable income than of a large disposable income. The Saving Schedule It is relatively easy to derive a saving schedule (or “saving function”). o Because saving equals disposable income less consumption (S = DI – C), we need only subtract consumption from disposable income to find the amount saved at each DI.  If households consume a smaller and smaller proportion of DI as DI increases, then they must be saving a larger and larger proportion of DI. Remembering that at each point on the 45 degree line consumption equals. o DI, we see that dissaving (consuming in excess of after-tax income) will occur at relatively low DIs.  For example, at $370 billion, consumption is $375 billion. Households can consume more than their current incomes by liquidating (selling for cash) accumulated wealth of by borrowing. Average and Marginal Propensities APC and APS o The fraction, or percentage, of total income that is consumed is the average propensity to consume (APC). The fraction of total income that is saved is the average propensity to save (APS).  APC = Consumption/income  APS = Saving/income  MPC and MPS The fact that households consume a certain proportion of a particular total income, for example 45/47 of a $470 billion disposable income, does not guarantee they will consume the same proportion, or fraction of any change in income consumed is called the marginal propensity to consume (MPC), “marginal” meaning “extra” or “a change in.” o Equivalently, the MPC is the ratio of a change in consumption to a change in the income that caused the consumption change:  MPC = change in consumption/ change in income  The fraction of any change in income saved is the marginal propensity to save (MPS). o The MPS is the ratio of a change in saving to the change in income that brough it about:  MPS = change in saving/ change in income  The sum of the MPC and the MPS for any change in disposable income must always be 1. o Consuming or saving out of extra income is an either-or proposition; the fraction of any change in income not consumed is, by definition, saved.  If 0.75 of extra disposable income is consumed, 0.25 must be saved. The fraction consumed (MPC) plus the fraction saved (MPS) must exhaust the whole change in income: o MPC + MPS = 1  MPC and MPS as Slopes o The MPC is the numerical value of the slope of the consumption schedule, and the MPS is the numerical value of the slope of the saving schedule.  We know from the appendix to Chapter 1 that the slope of any line is the ratio of the vertical change to the horizontal change occasioned in moving from one point to another on that line. Nonincome Determinants of Consumption and Saving  Disposable income is the primary determinant of the amounts households will consume and save. o But other determinants might prompt households to consume more or less at each possible income level of income.  Those other determinants are wealth, borrowing, expectations, and interest rates.  Wealth o A household’s wealth is the dollar amount of all the assets that it owns minus the dollar amount of its liabilities (its total debt).  Households build wealth by saving money out of current income. The point of building wealth is to increase consumption possibilities.    o The larger a household’s stock of wealth, the larger its present and future consumption possibilities. o When events suddenly boost the value of existing wealth, households tend to increase their spending and reduce their saving.  This wealth effect shifts the consumption schedules upward and the saving schedule downward. The schedules move in response to households taking advantage of the increased consumption possibilities granted by the sudden wealth increase. Borrowing o When a household borrows, it can increase current consumption beyond its disposable income.  By allowing households to spend more, borrowing shifts the current consumption schedule upward. o But note that there is no “free lunch”.  While borrowing in the present allows for higher consumption now, it necessitates lower consumption in the future when the debt must be repaid. Stated differently, increased borrowing increases debt (liabilities), which in turn reduces household wealth (because wealth = assets – liabilities). o This reduction in wealth reduces future consumption possibilities. Expectations o Household expectations about future prices and income may affect current spending and saving.  For example, the expectation of higher prices tomorrow may cause households to buy more today while prices are still low. Thus, the current consumption schedule shifts up and the current saving schedule shifts down. o In contrast, expectations of a recession and thus lower income in the future may lead households to reduce consumption and save more today.  Greater present saving will help households build wealth that will help them ride out the expected bad times. The consumption schedule therefore shifts down and the saving schedule shifts up. Real Interest Rates o When real interest rates (those adjusted for inflation) fall, households tend to borrow more, consume more, and save less.  A lower interest rate, for example, decreases monthly loan payments and induces consumers to purchase automobiles and other goods bought on credit.  A lower interest rate also diminishes the incentive to save because of the reduced interest “payment” to the saver. These effects on consumption and saving, however, are very modest. o They mainly shift consumption toward some products (those bought on credit) and away from others, at best, lower interest rates shift the consumption schedule slightly upward and the saving schedule slightly downward.  Higher interest rates do the opposite. Other Important Considerations  We must make several additional important points regarding the consumption and saving schedules: o Switching to real GDP  When developing macroeconomic models, economists change their focus from the relationship between consumption (and saving) and disposable income to relationship between consumption (and saving) and real domestic output (real GDP). o Changes along schedules  The movement from one point to another on a consumption schedule is a change in the amount consumed and is caused solely by a change in real GDP. On the other hand, an upward or downward shift of the entire schedule is a shift of the consumption schedule and is caused by changes in any one or more of the nonincome determinants of consumption just discussed. o Simultaneous shifts  Changes in wealth, expectations, interest rates, and household debt shift the consumption schedule in one direction and the saving schedule in the opposite direction. If households decide to consume more at each possible level of real GDP, they must save less, and vice versa. o (Even when they spend more by borrowing, they are, in effect, reducing their current saving by the amount borrowed because borrowing is, effectively, “negative saving.”) o Taxation  A change in taxes shifts the consumption and saving schedules in the same direction. Taxes are paid partly at the expense of consumption and partly at the expense of saving. o So an increase in taxes reduces both consumption and saving, shifting the consumption schedule downward and the saving schedule downward.  Conversely, households partly consume and partly save any decrease in taxes. Both the consumption schedule and saving schedule shift upward. o Stability  The consumption and saving schedules usually are relatively stable unless altered by major tax increases or decreases. Their stability may be come from the fact that consumption-saving decisions are strongly influenced by long-term considerations such as saving to meet emergencies or saving for retirement. o In addition, changes in the nonincome determinants frequently work in opposite directions and therefore may be self-canceling. The Interest-Rate-Investment Relationship  Recall that investment consists of expenditures on new plants, capital equipment, machinery, inventories, and so on. o The investment decision is a marginal-benefit-marginal-cost decision:  The marginal benefit from investment is the expected rate of return businesses hope to realize.  The marginal cost is the interest rate that businesses must pay to borrow money.  Businesses will invest in all projects for which the expected rate of return exceeds the interest rate.  Expected returns (profits) and the interest rate therefore determine investment spending. Expected Rate of Return  Investment spending is guided by the profit motive; businesses buy capital goods only when they think such purchases will be profitable. o Dividing the profit by the cost of the object, you will find the object’s expected rate of return, r.  It is important to note that this rate of return is expected, not guaranteed. The investment may or may not generate as much revenue or as much profit as anticipated. o Investment involves risk. The Real Interest Rate  The firm should undertake every investment project that it expects to be profitable. o In other words, the firms should array its prospective investment projects from the highest expected rate of return, r, downward and then invest in all projects for which r exceeds i.   The firm should invest to the point where r = i because then it will have undertaken all investments for which r is greater than i. The real interest rate, rather than the nominal rate, is crucial in making investment decisions. o Recall from Chapter 29 that the nominal interest rate is expressed in dollars of current value, while the real interest rate is stated in constant or inflation-adjusted dollars.  Also recall that the real interest rate is the nominal rate minus the inflation rate. Investment Demand Curve  We now move from a single firm’s investment decision to total demand for investment goods by the entire business sector. Assume that every firm has estimated the expected rates of return from all investment projects and has recorded those data. We can sum these data by asking: How many dollars’ worth of investment projects have an expected rate of return of, say, 16 percent or more? How many have 14 percent or more? How many have 12 percent or more? And so on.  Suppose no prospective investments yield an expected return of 16 percent or more. But there are $5 billion of investment opportunities with expected rates of return between 14 and 16 percent; an additional $5 billion yielding between 12 and 14 percent; and additional $5 billion yielding between the 10 and 12 percent; and an additional $5 billion in each successive 2-percent range of yield down to and including the 0 to 2 percent range.  By applying the marginal-benefit-marginal-cost rule that firms should undertake investment projects up to the point where r = i, we see that we can add the real interest rate to the vertical axis. o That is, the curve not only shows rates of return; it also shows the quantity of investment demanded at each “price” i (interest rate) of investment.  The vertical axis shows the various possible real interest rates, and the horizontal axis shows the corresponding quantities of investment demanded.  The inverse (downward sloping) relationship between the interest rate (price) and the dollar quantity of investment demanded conforms to the law of demand discussed in Chapter 3. o The investment demand curve shows the amount of investment at each real interest rate.  The level of investment depends on the expected rate or return and the real interest rate.