Basic Macroeconomic Relationships

Introduction

This chapter explores the fundamental relationships between key macroeconomic aggregates: income, consumption, saving, investment, and GDP. Understanding these relationships helps explain trends in consumer behavior, the impact of interest rates on investment, and how changes in spending affect overall economic output.

Income-Consumption and Income-Saving Relationships

Disposable Income, Consumption, and Saving

• Disposable income (DI) is the primary determinant of both consumption and saving in the economy.

• The consumption function describes how consumers increase their spending as DI rises, but spend a larger proportion of a small DI than of a large DI.

• The savings function shows a direct relationship between saving and DI, but saving is a smaller proportion of a small DI than of a large DI.

Average and Marginal Propensities

• Average Propensity to Consume (APC): The fraction or percentage of total income that is consumed.

• Average Propensity to Save (APS): The fraction or percentage of total income that is saved.

• Since all disposable income is either consumed or saved:

• Marginal Propensity to Consume (MPC): The proportion of any change in income that is consumed.

• Marginal Propensity to Save (MPS): The proportion of any change in income that is saved.

• The sum of MPC and MPS for any change in DI is always 1:

Non-Income Determinants of Consumption and Saving

Factors other than income can shift the consumption and saving schedules:

• Wealth: Increases in household wealth boost consumption and reduce saving.

• Borrowing (Household Debt): More borrowing can temporarily increase consumption.

• Expectations: Optimism about future income or prices can increase current consumption.

• Real Interest Rates: Lower real interest rates can encourage consumption and discourage saving.

• Taxes: Changes in taxes shift both consumption and saving schedules in the same direction, as taxes are paid partly at the expense of both.

The Interest-Rate–Investment Relationship

Determinants of Investment

• Expected Rate of Return (Profit): The anticipated profit from an investment project.

• Real Interest Rate: The cost of borrowing funds for investment. Investment increases when the expected rate of return exceeds the real interest rate.

The Investment Demand Curve

The investment demand curve arranges all potential investment projects in descending order of their expected rates of return. It slopes downward, indicating an inverse relationship between the real interest rate and the quantity of investment demanded.

Shifts of the Investment Demand Curve

Non-interest-rate determinants can shift the investment demand curve:

• Acquisition, Maintenance, and Operating Costs: Higher costs reduce investment demand.

• Business Taxes: Higher taxes lower profitability and shift the curve left.

• Technological Change: Innovations stimulate investment and shift the curve right.

• Stock of Capital on Hand: Excess capacity reduces investment demand.

• Planned Inventory Changes: Plans to increase inventories shift the curve right.

• Expectations: Optimism about future sales, costs, and profits shifts the curve right.

Instability of Investments

• Investment is much more volatile than consumption and is the most unstable component of total spending.

• Fluctuations in investment are a major cause of business cycles, affecting output and employment.

Factors Explaining Investment Volatility

• Durability of Capital: Optimism leads to replacement and modernization, increasing investment; pessimism leads to maintenance, reducing investment.

• Irregularity of Innovation: Technological progress occurs irregularly, causing waves of investment followed by slowdowns.

• Variability of Profits: Fluctuating profits affect both the incentive and the means to invest.

• Variability of Expectations: Business expectations can change rapidly due to economic, political, or market events, influencing investment decisions.

The Multiplier Effect

Definition and Rationale

• The multiplier effect describes how an initial change in spending leads to a larger change in real GDP.

• More spending results in a higher GDP; less spending results in a lower GDP.

• The multiplier quantifies how much larger the change in GDP will be compared to the initial change in spending.

• Formula:

Multiplier Formulas

• The multiplier can be calculated using the marginal propensities:

• Where MPC is the marginal propensity to consume and MPS is the marginal propensity to save.

Rationale for the Multiplier

• The economy supports continuous flows of expenditures and income; dollars spent by one person become income for another, creating a chain reaction.

• Each round of spending is smaller than the previous, but the cumulative effect is a multiple change in GDP.

• Initial changes in spending produce magnified changes in output and income.

Additional info: The multiplier effect is a central concept in Keynesian economics, explaining why fiscal policy can have a significant impact on national income and output.