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The Three Basic Macroeconomics Relationship The Income-Consumption and Income-Saving Relationships

The relationship between income and spending (or saving) is closely monitored. In general, spending is most strongly affected by a persons disposable income, or the money they have left over after taxes. If you were to graph the relationship between disposable income and spending, you could draw a 45 degree line at which spending = disposable income. Historically, both spending and disposable income have increased. The Consumption Schedule The consumption schedule or consumption function (or aggregate expenditures curve) shows what percentage of their money people spend based on different levels of disposable income. In general, as income increase the percentage spent decreases. The Saving Schedule The saving schedule is the same thing as the consumption schedule, but measures savings. Savings are the difference between disposable income and spending. However, sometimes households will dissave, or spend more than they earn by running up debt or selling assets. In general, households earning less than the break-even level of income dissave. As income increases above that level they begin saving a larger and larger percentage of their earnings. Average and Marginal Propensities o APC and APS The average propensity to consume (APC) and average propensity to spend (APS) relate savings and spending to income. APC + APS must always equal 1. APC = (consumption) / (income) o MPC and MPS Marginal versions of the two quantities we discussed show how changes in income impact spending and saving.

APS = (saving) / (income)

Marginal propensity to consume (MPC) = (change in consumption) / (change in income) Marginal propensity to save (MPS) = (change in saving) / (change in income)

o MPC and MPS as Slopes If you were to draw a line relating disposable income to consumption, the MPC would be the slope of the line. The same would be true with a graph relating disposable income to saving, except the slope would be the MPS.

Non-income Determinants of Consumption and Saving Although disposable income is very important in determining how much households spend, other factors also play a role. o Wealth Wealth is a households assets minus its liabilities. Households with more wealth spend more. In addition, a sudden increase in wealth often causes people to spend a greater percentage of their income. This is called the wealth effect.

o Borrowing Households can borrow money to increase current consumption, but doing so reduces future consumption and wealth.

o Expectations If people expect inflation they will spend more today to beat the price increases. If, on the other hand, a recession is expected, people will be afraid of losing their jobs and will reduce spending.

o Real Interest Rates Lower real interest rates encourage households to spend more. The incentive to save is also reduced because households will earn less interest on their money. However, these effects are relatively small.

Other Important Considerations When discussing the macro economy, economists talk about the relationship between spending and real GDP, not disposable income. Changes in GDP cause movement along the consumption schedule. Changes in any of the factors we discussed (wealth, debt, interest rates and so forth) cause schedule shifts, moving the entire curve. Higher taxes reduce both spending and saving. Finally, it is important to note that spending and saving patterns are relatively stable, possibly because people save for long-term events and arent as interested in the short term.

The Interest Rate Investment Relationship

As with any economic decision, businesses decide which projects to invest in based on marginal costs (interest rates) and marginal benefits (the expected return). Expected Rate of Return Businesses invest to make a profit above the cost of the investment. Businesses measure the expected rate of return, which is the expected profit divided by the expenditure required. If the expected rate of return is 5% no businessperson would borrow money at 6% to implement the project he or she is considering. The Real Interest Rate The real interest rate is the other side of the equation. The real interest rate is the nominal interest rate (what banks charge) minus inflation. Investment Demand Curve The investment demand curve shows how much money will be invested at different interest rates. If the real interest rate is 10%, only projects with an expected rate of return of more than 10% are economically viable. As the real interest rate falls more projects become sound investments. For this reason the investment demand curve is downward sloping. Shifts in the Investment Demand Curve Any change that would make businesses expect to earn a higher rate of return will shift the investment demand curve to the right (and vice-versa).

o Acquisition, Maintenance and Operating Costs If the cost of acquiring or maintaining capital goods falls, then firms will earn a higher return on their investment.

o Business Taxes Since businesses are looking at after-tax rates of return, lower takes increase investment demand.

o Technological Change Technological innovation can increase investment demand by lowering production costs or leading to the development of new goods or services that businesses buy (invest in) to stay competitive.

o Stock of Capital Goods on Hand Firms with idle production facilities are less likely to invest. This, in turn, depends on the strength of demand. If the economy is expanding and inventories are low, there will be more demand to invest in new capital goods.

o Planned Inventory Changes If firms decide to increase their inventories, that is technically and investment and shifts the investment demand curve to the right. Firms will increase the number of goods they keep in inventory if they expect demand to rise in the future.

o Expectations Businesses also base their expected rate of return calculations on other factors such as the life of the investment, demographic factors such as population growth, the political climate and so forth. Optimistic expectations increase investment demand.

Instability of Investment It turns out that investment is one of the most volatile components of GDP. Investment spending can fluctuate widely because of: o Durability

Capital goods are durable, meaning that they last a long time. If the economy falls into a recession firms can delay buying replacement equipment, reducing investment demand.

o Irregularity of Innovation Breakthrough technological innovations are released almost randomly. If a significantly invention is unveiled it can cause a brief surge of investment spending.

o Variability of Profits Profits effect investment in a number of ways. When firms make more money they may not have to take out loans to finance investment. In addition, the profits made by firms who have made similar investments can be used to predict expected returns.

o Variability of Expectations Unfolding events can quickly change expectations about the future. Political, environmental, social, international relational (is that a word?) and other factors can all make businesses much more optimistic or pessimistic in the blink of an eye.

The Multiplier Effect

An increase in one component of expenditures is multiplied in the aggregate economy. Let's pretend that the government expenditures increase:

Businesses sell more goods. They increase investment and hire more workers. Aggregate expenditures rise. Since more people have jobs, they consume more goods. Aggregate expenditure rise. In addition, since more people have jobs, businesses sell more, which means that they have to hire more worker, which means that more people have jobs...it's a virtuous cycle. (Note, however, that this doesnt go on forever).