Chapter 10 – Basic Macroeconomic Relationships
CHAPTER TEN
BASIC MACROECONOMIC RELATIONSHIPS
CHAPTER OVERVIEW
The central purpose of this chapter is to introduce three basic macroeconomic relationships that will help
us organize our thinking about macroeconomic theories and controversies: First, the focus is on the
income-consumption and income-saving relationships. Second, the relationship between the interest rate
and investment is examined. Finally, the multiplier concept is developed, relating changes in spending to
changes in output. All of this is done outside the formal framework of the Aggregate Expenditures model,
which is developed in Chapter 11.
WHAT’S NEW
There are no major changes in content for this chapter.
The relevant tables and data have been updated.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. Describe the income-consumption and income-saving relationships.
2. Recognize, construct, and explain the consumption and saving schedules.
3. Identify the determinants of the location of the consumption and saving schedules.
4. Calculate and differentiate between the average and marginal propensities to consume (and save).
5. Describe the relationship between the interest rate, expected rate of return, and investment.
6. Identify the determinants of investment and construct an investment demand curve.
7. Identify the factors that may cause a shift in the investment-demand curve.
8. Describe the reasons for the instability in investment spending.
9. Provide an intuitive explanation of the multiplier effect.
10. Calculate the multiplier and changes in real GDP given information about changes in spending and
the marginal propensities.
11. Discuss why the actual multiplier may differ from the theoretical examples.
12. Define and identify terms and concepts at the end of the chapter.
COMMENTS AND TEACHING SUGGESTIONS
1. Regardless of whether you develop the multiplier theoretically or more intuitively, if you require
students to calculate multiplier effects, expect to give them lots of practice. As part of that, you
may want to give them “detective” work – “If we know that real GDP changed by $100 billion and
spending changed by $25 billion, what can we conclude about the multiplier and MPC?”
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Chapter 10 – Basic Macroeconomic Relationships
2. The multiplier concept can be demonstrated effectively by a role-playing exercise in which you
have students pretend that one row (group) of students are construction workers who benefit from a
$1 million increase in investment spending. (Some instructors use an oversized paper $1-million
bill.) If their MPC is .9, then they will spend $900,000 of this at stores “owned” by a second row
(group) of students, who will in turn spend $810,000 or .9 x $900,000. At the end of the exercise,
each row can add up its new income and it will be well in excess of the initial $1 million. In fact, if
played out to its conclusion, the final change in GDP should approximate $10 million, given that
the MPS is .1 in this example.
If you decide to use an oversized paper $1-million bill, then students will have to clip off one-tenth of it at
every stage to represent saving. By the end of the process, each row (group) of students has seen
its income increase by nine-tenths of what the previous group received. Adding up all of these
increases illustrates the idea that the original $1 million increase in spending has resulted in many
times that amount in terms of the students’ increased incomes. Obviously, you won’t be able to
illustrate the final multiplier, but it should give them a good idea of how the final multiplier could
be equal to 10 in this example. In other words, if the process were carried to its conclusion, the
original $1 million of new investment would result in a $10 million increase in student incomes
and $10 million of new saving.
If you don’t want to use the prop, students are good at imagining that this could happen if you’ll simply
ask them to imagine that a new $1 million injection of investment spending (or government or
export sales) occurs, and then go through the chain of events described above.
3. Note that the multiplier effect can work in reverse as well as the forward direction. The closing of
a military base or a factory shutting down has a multiplied negative impact on the local community,
reducing retail sales and placing a hardship on other businesses. Ask students to offer examples of
the multiplier effect that they have witnessed. They enjoy making up their own versions of
Buchwald’s Last Word for this chapter.
4. Data to update Figure 10.1 may be found in the most recent issue of Survey of Current Business or
Economic Indicators. Web-based questions at the end of the chapter also point to sources.
5. Investment expenditures are the most volatile segment of aggregate expenditures. Ask students to
research a particular industry to find out what factors are most likely to influence investment
decisions for that industry, or have students interview a local business manager or owner about
their decision to add capital equipment. Make a list of the factors that they consider when making
their decisions. Are they similar to the reasons given in the text? How were they different?
STUDENT STUMBLING BLOCKS
1. If your class is filled with struggling students consider using only one “macro model.” It is very
difficult for beginning students to switch from one set of assumptions to another. The concept of
equilibrium can be presented using Aggregate Expenditures or the AD-AS model presented in
Chapter 12. The model in this chapter uses income as the main determinant. AD-AS emphasizes
the price level. An emphasis on only one model may help students understand the macro economy
better. This chapter may help you gauge whether or not to skip Chapter 11.
2. Students sometimes get so caught up in the theory that they forget the basic relationships. To help
them remember even simple things like MPC+MPS=1, remind them that there are two things they
can do with their disposable income – spend it or save it. Invariably someone will ask, “What
about paying off credit cards (or other forms of debt)? Isn’t that spending?” You can either
respond then or attempt to preempt the question by explaining that repayment of debt is merely
saving “after the fact.” It is also an opportunity to review past material. If someone suggests that
they can also pay taxes, you can remind them that disposable income is after-tax income.
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Chapter 10 – Basic Macroeconomic Relationships
3. The discussion of the income and consumption relationship is a good opportunity to remind
students about the “fallacy of composition.” Unfortunately it is also a potential stumbling block.
When you discuss the marginal propensities, for example, it is on the one hand helpful to
individualize the experience – “If you received an extra dollar, how much of it would you spend?”
On the other hand, how students answer such questions may cloud their ability to reason through
what to expect in the aggregate. You will need to remind students at times that they’re examining
aggregate behavior and that they can’t necessarily generalize from their individual experience.
LECTURE NOTES
I. Introduction—What Are the Basic Macro Relationships?
A. Learning objectives – After reading this chapter, students should be able to:
1. Describe how changes in income affect consumption and saving.
2. List and explain factors other than income that can affect consumption.
3. Explain how changes in real interest rates affect investment.
4. Identify and explain factors other than the real interest rate that can affect investment.
5. Illustrate how changes in investment (or one of the other components of total spending)
can increase or decrease real GDP by a multiple amount.
B. Previously we identified macroeconomic issues of growth, business cycles, recession, and
inflation. Here we begin to develop tools to explain these events.
C. This chapter focuses on the three basic macroeconomic relationships.
1. Income and consumption, and income and saving.
2. The interest rate and investment.
3. Changes in spending and changes in output.
II. The Income-Consumption and Income-Saving Relationships
A. Disposable income is the most important determinant of consumer spending.
B. What is not spent is called saving.
C. Figure 10.1 represents graphically the recent historical relationship between disposable
income (DI), consumption (C), and saving (S) in the United States.
1. A 45-degree line represents all points where consumer spending is equal to disposable
income; other points represent actual C, DI relationships for each year from
1983-2012.
2. If the actual graph of the relationship between consumption and income is below the 45-
degree line, then the difference must represent the amount of income that is saved.
3. In 1998 consumption was $6157.5 billion and disposable income was $6498.9 billion.
Hence, saving was $344 billion. Notice that in 2005, consumption ($9072.1 billion)
exceeded disposable income ($9038.6 billion) – personal saving was a negative $33.5
billion!
4. Since the Great Recession, savings has increased as shown by the larger difference
between the 45-degree line and consumption.
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Chapter 10 – Basic Macroeconomic Relationships
5. Some conclusions can be drawn:
a. Households consume a large portion of their disposable income.
b. Both consumption and saving are directly related to the level of income.
D. The Consumption Schedule
1. A hypothetical consumption schedule (Table 10.1 and Key Graph 10.2a) shows that
households spend a larger proportion of a small income than of a large income.
2. Consumption varies directly with DI.
E. The Saving Schedule
1. A hypothetical saving schedule (Table 10.1, column 3) is illustrated in Key Graph 10.2b.
2. Note that “dissaving” occurs at low levels of disposable income, where consumption
exceeds income and households must borrow or use up some of their wealth.
F. Average and marginal propensities to consume and save:
1. Define average propensity to consume (APC) as the fraction or % of income consumed
(APC = consumption/income). See Column 4 in Table 10.1.
2. Define average propensity to save (APS) as the fraction or % of income saved (APS =
saving/income). See Column 5 in Table 10.1.
3. Global Perspective 10.1 shows the APCs for several nations in 2011. Note the high APCs
for the U.S., Canada, and Australia.
4. Marginal propensity to consume (MPC) is the fraction or proportion of any change in
income that is consumed. (MPC = change in consumption/change in income.) See
Column 6 in Table 10.1.
5. Marginal propensity to save (MPS) is the fraction or proportion of any change in income
that is saved. (MPS = change in saving/change in income.) See Column 7 in Table 10.1.
6. Note that APC + APS = 1 and MPC + MPS = 1.
7. Note that Figure 10.3 illustrates that MPC is the slope of the consumption schedule, and
MPS is the slope of the saving schedule.
8. Test Yourself: Try the Self-Quiz below Key Graph 10.2.
G. Nonincome Determinants of Consumption and Saving
1. They cause people to spend or save more or less at all income levels, although the level
of income is the basic determinant
2. 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 strong “reverse wealth effect” occurred in 2008, when
stock and real estate prices fell dramatically, erasing $11.2 trillion in wealth.
3. Expectations: Changes in expected future prices or wealth can affect consumption
spending today.
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Chapter 10 – Basic Macroeconomic Relationships
4. Real interest rates: Declining interest rates increase the incentive to borrow and
consume, and reduce the incentive to save. Because many household expenditures are
not interest sensitive – the light bill, groceries, etc. – the effect of interest rate changes on
spending are modest.
5. Household borrowing: Lower levels of borrowing shift the consumption schedule up and
saving schedule down.
H. Other important considerations: See Figure 10.4.
1. Macroeconomic models focus on real domestic output (real GDP) more than on
disposable income. Figure 10.4 reflects this change in the labeling of the horizontal axis.
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
consumption schedule, and is caused by nonincome determinants of consumption.
3. Simultaneous shifts: Consumption and saving schedules will always shift in opposite
directions unless a shift is caused by a tax change.
4. Taxation: Lower taxes will shift both schedules up since taxation affects both spending
and saving, and vice versa for higher taxes.
5. Stability: Economists believe that consumption and saving schedules are generally stable
unless deliberately shifted by government action.
I. Consider This…The Great Recession and the Paradox of Thrift. In response to the Great
Recession, households decreased consumption and increased savings. The paradox occurs
because an increase in savings during a recession can make the recession worse even though
increased savings is better in the long run. At the same time the collective decrease in
consumption can actually force households to save less as the reduction in consumption
creates an increase in job losses.
III. The Interest Rate – Investment Relationship
A. Investment consists of spending on new plants, capital equipment, machinery, inventories,
construction, etc.
1. The investment decision weighs marginal benefits and marginal costs.
2. The expected rate of return is the marginal benefit and the interest rate – the cost of
borrowing funds – represents the marginal cost.
B. Expected rate of return is found by comparing the expected economic profit (total revenue
minus total cost) to cost of investment to get expected rate of return. The text’s example
gives $100 expected profit on a $1000 investment, for a 10% expected rate of return. Thus,
the business would not want to pay more than 10% interest rate on investment. Remember
that the expected rate of return is not a guaranteed rate of return. Investment carries risk.
C. The real interest rate, i (nominal rate corrected for expected inflation), determines the cost of
investment.
1. The interest rate represents either the cost of borrowed funds or the opportunity cost of
investing your own funds, which is income forgone.
2. If real interest rate exceeds the expected rate of return, the investment should not be
made.
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Chapter 10 – Basic Macroeconomic Relationships
D. Investment demand schedule, or curve, shows an inverse relationship between the interest rate
and amount of investment.
1. As long as the expected return exceeds interest rate, the investment is expected to be
profitable (see the table in Figure 10.5).
2. Key Graph 10.5 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. Test yourself with Quick Quiz 10.5.
E. Shifts in investment demand (Figure 10.6) occur when any determinant apart from the
interest rate changes.
1. Greater expected returns create more investment demand; shift curve to right. The
reverse causes a leftward shift.
2. Consider This … The Great Recession and the Investment Riddle
a. During the Great Recession the FED lowered interest rates, so there should have
been an increase in investment demand. However, investment demand actually fell in
this period.
b. The reason is that the investment demand schedule shifted to the left during this
period as well.
3. Changes in expected returns result because:
a. Acquisition, maintenance, and operating costs of capital goods may change. Higher
costs lower the expected return.
b. Business taxes may change. Increased taxes lower the expected return.
c. Technology may change. Technological change often involves lower costs, which
would increase expected returns.
d. Stock of capital goods on hand will affect new investment. If there is abundant idle
capital on hand because of weak demand or recent investment, new investments
would be less profitable.
e. Expectations about future economic and political conditions, both in the aggregate
and in certain specific markets, can change the view of expected profits.
F. Investment is a very unstable type of spending; Ig is more volatile than GDP (See Figure 10.8).
1. Expectations can be easily changed.
2. Capital goods are durable, so spending can be postponed or not. This is unpredictable.
3. Innovation occurs irregularly.
4. Profits vary considerably.
IV. The Multiplier Effect
A. Changes in spending ripple through the economy to generate event larger changes in real
GDP. This is called the multiplier effect.
1. Multiplier = change in real GDP / initial change in spending. Alternatively, it can be
rearranged to read Change in real GDP = initial change in spending x multiplier.
2. Three points to remember about the multiplier:
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
government purchases also are subject to the multiplier effect.
b. The initial change refers to an upshift or downshift in the aggregate expenditures
schedule due to a change in one of its components, like investment.
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Chapter 10 – Basic Macroeconomic Relationships
c. The multiplier works in both directions (up or down).
B. The multiplier is based on two facts.
1. The economy has continuous flows of expenditures and income—a ripple effect—in
which income received by Grant comes from money spent by Battaglia. Battaglia’s
income, in turn, came from money spent by Mendoza, and so forth.
2. Any change in income will cause both consumption and saving to vary in the same
direction as the initial change in income, and by a fraction of that change.
a. The fraction of the change in income that is spent is called the marginal propensity to
consume (MPC).
b. The fraction of the change in income that is saved is called the marginal propensity to
save (MPS).
c. This is illustrated in the table in figure 10.8.
C. The size of the MPC and the multiplier are directly related; the size of the
MPS and the multiplier are inversely related. See Figure 10.9 for an illustration of this
point. In equation form Multiplier = 1 / MPS or 1 / (1-MPC).
D. The significance of the multiplier is that a small change in investment plans or consumption-
saving plans can trigger a much larger change in the equilibrium level of GDP.
E. The simple multiplier given above can be generalized to include other “leakages” from the spending
flow besides savings. For example, the actual multiplier is derived by including taxes and imports as
well as savings in the equation. In other words, the denominator is the fraction of a change in income
not spent on domestic output.
V. LAST WORD: Squaring the Economic Circle
A. Humorist Art Buchwald illustrates the concept of the multiplier with this funny essay.
B. Hofberger, a Ford salesman in Tomcat, Va., called up Littleton of Littleton Menswear &
Haberdashery, and told him that a new Ford had been set aside for Littleton and his wife.
C. Littleton said he was sorry, but he couldn’t buy a car because he and Mrs. Littleton were
getting a divorce.
D. Soon afterward, Bedcheck the painter called Hofberger to ask when to begin painting the
Hofbergers’ home. Hofberger said he couldn’t, because Littleton was getting a divorce, not
buying a new car, and, therefore, Hofberger could not afford to paint his house.
E. When Bedcheck went home that evening, he told his wife to return their new television set to
Gladstone’s TV store. When she returned it the next day, Gladstone immediately called his
travel agent and canceled his trip. He said he couldn’t go because Bedcheck returned the TV
set because Hofberger didn’t sell a car to Littleton because Littletons are divorcing.
F. Sandstorm, the travel agent, tore up Gladstone’s plane tickets, and immediately called his
banker, Gripsholm, to tell him that he couldn’t pay back his loan that month.
G. When Rudemaker came to the bank to borrow money for a new kitchen for his restaurant, the
banker told him that he had no money to lend because Sandstorm had not repaid his loan yet.
H. Rudemaker called his contractor, Eagleton, who had to lay off eight men.
I. Meanwhile, Ford announced it would give a rebate on its new models. Hofberger called
Littleton to tell him that he could probably afford a car even with the divorce. Littleton said
that he and his wife had made up and were not divorcing. However, his business was so
lousy that he couldn’t afford a car now. His regular customers, Bedcheck, Gladstone,
Sandstorm, Gripsholm, Rudemaker, and Eagleton had not been in for over a month!
QUIZ
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Chapter 10 – Basic Macroeconomic Relationships
1. The size of the MPC is assumed to be:
A. less than zero.
B. greater than one.
C. greater than zero, but less than one.
D. two or more.
2. Suppose that a new machine tool having a useful life of only one year costs $80,000. Suppose,
also, that the net additional revenue resulting from buying this tool is expected to be $96,000. The
expected rate of return on this tool is:
A. 80 percent.
B. 8 percent.
C. 2 percent.
D. 20 percent.
3. If business taxes are reduced and the real interest rate increases:
A. consumption and saving will necessarily increase.
B. the level of investment spending might either increase or decrease.
C. the level of investment spending will necessarily increase.
D. the level of investment spending will necessarily decrease.
4. The multiplier effect means that:
A. consumption is typically several times as large as saving.
B. a change in consumption can cause a larger increase in investment.
C. an increase in investment can cause GDP to change by a larger amount.
D. a decline in the MPC can cause GDP to rise by several times that amount.
5. As disposable income decreases, consumption:
A. And saving both increase
B. And saving both decrease
C. Increases and saving decreases
D. Decreases and saving increases
6. If the consumption schedule shifts downward, and the shift was not caused by a tax change, then
the saving schedule:
A. May shift either upward or downward
B. Will shift downward
C. Will shift upward
D. Will not shift
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Chapter 10 – Basic Macroeconomic Relationships
7. Which would shift the consumption schedule upward?
A. A decrease in wealth
B. An increase in wealth
C. Consumer expectations of falling prices
D. Consumer expectations of product surpluses
8. An inverse relationship between the rate of interest and the level of:
A. Income is suggested by the consumption function
B. Prices is suggested by the aggregate supply curve
C. Employment is suggested by the aggregate demand curve
D. Investment spending is suggested by the investment-demand curve
9. Which would decrease investment demand?
A. A decrease in business taxes
B. An increase in the cost of acquiring capital goods
C. An increase in the rate of technological change
D. A decrease in the stock of capital goods on hand
10. Generally speaking, the greater the MPS, the:
A. Smaller would be the increase in income which results from an increase in consumption
spending
B. Larger would be the increase in income which results from an increase in consumption
spending
C. Larger would be the increase in income which results from a decrease in consumption
spending
D. Smaller would be the increase in income which results from a decrease in consumption
spending
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