Chapter 27 Basic Macroeconomic Relationships

Chapter 27 - Basic Macroeconomic Relationships

Chapter 27 Basic Macroeconomic Relationships

QUESTIONS

1. What are the variables (the items measured on the axes) in a graph of the (a) consumption schedule and (b) saving schedule? Are the variables inversely (negatively) related or are they directly (positively) related? What is the fundamental reason that the levels of consumption and saving in the United States are each higher today than they were a decade ago? LO1

Answer: (a) Consumption schedule: The variable on the vertical axis (y-axis) is consumption and the variable on the horizontal axis (x-axis) is disposable income (see Figure 27.2a).

These variables are directly (positively) related because they move in the same direction.

(b) Saving schedule: The variable on the vertical axis (y-axis) is saving and the variable on the horizontal axis (x-axis) is disposable income (see Figure 27.2b).

These variables are directly (positively) related because they move in the same direction.

The level of consumption and saving in the United States is higher today than a decade ago because real GDP and income are higher.

2. Precisely how do the MPC and the APC differ? How does the MPC differ from the MPS? Why must the sum of MPC and the MPS equal 1? LO1

Answer: MPC refers to changes in spending and income at the margin. Here we compare a change in consumer spending to a change in income: MPC = change in C / change in Y. APC is an average whereby total spending on consumption (C) is compared to total income (Y): APC = C/Y.

When your income changes there are only two possible options regarding what to do with it: You either spend it or you save it. MPC is the fraction of the change in income spent; therefore, the fraction not spent must be saved and this is the MPS. The change in the dollars spent or saved will appear in the numerator and together they must add to the total change in income. Since the denominator is the total change in income, the sum of the MPC and MPS is one.

3. In what direction will each of the following occurrences shift the consumption and saving schedules, other things equal? LO2

a. A large decrease in real estate values, including private homes.

b. A sharp, sustained increase in stock prices.

c. A 5-year increase in the minimum age for collecting Social Security benefits.

d. An economy-wide expectation that a recession is over and that a robust expansion will occur.

e. A substantial increase in household borrowing to finance auto purchases.

Answer: (a) The consumption schedule will shift downward and the saving schedule will shift upward given the decrease in wealth.

(b) The consumption schedule will shift upward and the saving schedule will shift downward given the increase in wealth.

(c) The consumption schedule will likely shift upward and the saving schedule will likely shift downward given that individuals will need to work 5 more years before retiring. There is less need to save for retirement.

(d) The consumption schedule will shift upward and the saving schedule will shift downward because individuals expect to be earning higher income in the future.

(e) The consumption schedule will shift upward and the saving schedule will shift downward as individuals borrow (decrease saving) and purchase the automobiles (increase consumption).

4. Why does a downshift of the consumption schedule typically involve an equal upshift of the saving schedule? What is the exception to this relationship? LO2

Answer: If, by definition, all that you can do with your income is use it for consumption or saving, then if you consume less out of any given income, you will necessarily save more. This being so, when your consumption schedule shifts downward (meaning you are consuming less out of any given income), your saving schedule shifts upward (meaning you are saving more out of any given income).

The exception is a change in personal taxes. When these change, your disposable income changes, and, therefore, your consumption and saving both change in the same direction and opposite to the change in taxes. If your MPC, say, is 0.9, then your MPS is 0.1. Now, if your taxes increase by $100, your consumption will decrease by $90 and your saving will decrease by $10.

5. Why will a reduction in the real interest rate increase investment spending, other things equal? LO3

Answer: Firms will only make an investment purchase if the expected return is greater than or equal to real interest rate at which it can borrow.

The logic is as follows. If you borrow a $100 at an interest rate of 10%, then at the end of the year you will owe $110.

Now, if you can earn a rate of return of 20% on the borrowed $100, then you will have $120 from your investment at the end of the year. You pay off the $110 loan and keep $10. This is a good investment.

However, if you can earn a rate of return of 5% on the borrowed $100, then you will have $105 from your investment at the end of the year. You pay off the $110 loan and lose $5. This is a bad investment.

Using this logic, a reduction in the real interest rate will make previously unprofitable investments profitable. Thus, other things equal, this will increase investment.

For example, if the real interest rate fell from 10% to 3% it would be a good investment to borrow at 5% and now, where it wasn't before when the real interest rate was 10%.

6. In what direction will each of the following occurrences shift the investment demand curve, other things equal? LO4

a. An increase in unused production capacity occurs.

b. Business taxes decline.

c. The costs of acquiring equipment fall.

d. Widespread pessimism arises about future business conditions and sales revenues.

e. A major new technological breakthrough creates prospects for a wide range of profitable new products.

Answer: (a) This will decrease investment demand causing the investment curve to shift to the left. The increase in unused capacity reduces the need (expected return) for capital.

(b) This will increase investment demand causing the investment curve to shift to the right. The decrease in business taxes increase after-tax expected returns (which determines investment decisions).

(c) This will increase investment demand causing the investment curve to shift to the right. The expected return increases due to the declining cost.

(d) This will decrease investment demand causing the investment curve to shift to the left. Widespread pessimism about future business conditions and sales revenues reduces expected returns.

(e) This will increase investment demand causing the investment curve to shift to the right. The major new technological breakthrough increases expected returns.

7. How is it possible for investment spending to increase even in a period in which the real interest rate rises? LO4

Answer: As long as expected rates of return rise faster than real interest rates, investment spending may increase. This is most likely to occur during periods of economic expansion.

8. Why is investment spending unstable? LO4

Answer: Investment is unstable because, unlike most consumption, it can be put off. In good times, with demand strong and rising, businesses will bring in more machines and replace old ones. In times of economic downturn, no new machines will be ordered. A firm can continue for years with, say, a tenth of the investment it was carrying out in the boom. Very few families could cut their consumption so drastically.

Also, new business ideas and the innovations that spring from them do not come at a constant rate. This is another reason for the irregularity of investment. Profits and the expectations of profits vary. Since profits, in the absence of easy access to borrowed money, are essential for investment and since, moreover, the object of investment is to make a profit, investment, too, must vary.

9. Is the relationship between changes in spending and changes in real GDP in the multiplier effect a direct (positive) relationship or is it an inverse (negative) relationship? How does the size of the multiplier relate to the size of the MPC? The MPS? What is the logic of the multiplier-MPC relationship? LO5

Answer: The key relationship is as follows:

Change in Real GDP = multiplier x change in spending

From this equation we can see that there is direct relationship between changes in spending and changes in real GDP. When spending increases real GDP increases and when spending decreases real GDP decreases. They both move in the same direction.

To answer the next part of the question we use the following relationships.

MPC + MPS = 1

and

Multiplier = 1/ (1-MPC)

or

Multiplier = 1/ MPS.

From above, we see that an increase in the MPC increases the multiplier and a decrease in the MPC reduces the multiplier. For the MPS, we see that an increase in the MPS decreases the multiplier and an increase in the MPS reduces the multiplier.

The reason we see an increase in the multiplier when the MPC increases is because the initial change in spending results in greater consumption spending at each stage of the expansion process. Thus, the higher the MPC the greater the change in real GDP following an increase in spending. The same logic applies to a decrease in spending.

10. Why is the actual multiplier in the U.S. economy less than the multiplier in this chapter’s example? LO5

Answer: The actual multiplier (estimated to be about 2) is smaller because it includes other leakages from the spending and income cycle besides just saving. Imports and taxes reduce the flow of money back into spending on domestically produced output, reducing the multiplier effect.

11. LAST WORD What is the central economic idea humorously illustrated in Art Buchwald’s piece, “Squaring the Economic Circle”? How does the central idea relate to economic recessions, on the one hand, and vigorous economic expansions, on the other?

Answer: The central idea illustrated is the multiplier effect that exists in a market economic system. One independently determined change in spending has an effect on another’s income, which then sets in motion a chain of events whereby spending changes directly with the income changes. A decline in spending begins a chain of declines, or, in other words, the initial decrease in spending is multiplied in terms of the final effect of this single decision. This occurs because of the observation that any change in income causes a change in spending that is directly proportional to it.

The multiplier effect helps us understand why there is a business cycle as opposed to a stable level of output growth from year to year. In the Buchwald piece, a “downturn” for one person became a downturn for everyone in that fictional economy. Likewise, if the story had begun with a burst of optimism and an increase in spending, it might have rippled through to expand everyone’s fortunes. The multiplier intensifies the effect of a spending change, whether it is an increase or decrease.

PROBLEMS

1. Refer to the incomplete table below. LO1

a. Fill in the missing numbers in the table.

b. What is the break-even level of income in the table? What is the term that economists use for the saving situation shown at the $240 level of income?

c. For each of the following items indicate whether the value in the table is either constant or variable as income changes: the MPS, the APC, the MPC, the APS.

Answers: (a) data in the completed table; (b) $260, dissaving; (c) constant, variable, constant, variable.

Feedback: Consider the following example. Refer to the nearby incomplete table.

Part a:

Fill in the missing numbers in the table.

Level of Output and Income (GDP=DI) / Consumption / Saving / APC / APS / MPC / MPS
$240 / $244 / -$4 / 1.0167 / -0.0167 / 0.8 / 0.2
260 / $260 / 0 / 1 / 0 / 0.8 / 0.2
280 / $276 / 4 / 0.9857 / 0.0143 / 0.8 / 0.2
300 / $292 / 8 / 0.9733 / 0.0267 / 0.8 / 0.2
320 / $308 / 12 / 0.9625 / 0.0375 / 0.8 / 0.2
340 / $324 / 16 / 0.9529 / 0.0471 / 0.8 / 0.2
360 / $340 / 20 / 0.9444 / 0.0556 / 0.8 / 0.2
380 / $356 / 24 / 0.9368 / 0.0632 / 0.8 / 0.2
400 / $372 / 28 / 0.93 / 0.07 / 0.8 / 0.2

To find the level of consumption (column 2):

Consumption = Income - Saving

Example: at Income $300 Consumption = $300 - $8 = $292

To find the Average Propensity to Consume (APC) (column 4):

APC = Consumption/Income

Example: at Income $300 APC = $292/$300 = 0.9733

To find the Average Propensity to Save (APS) (column 5):

APS = Saving/Income

Example: at Income $300 APS = $8/$300 = 0.0267

To find the Marginal Propensity to Consume (MPC) (column 6):

MPC = Δ Consumption/Δ Income

Example: at Income $300 (from $280) MPC = $16/$20 = 0.8

To find the Marginal Propensity to Save (MPS) (column 7):

MPS= Δ Saving/Δ Income

Example: at Income $300 (from $280) MPS = $4/$20 = 0.2

Part b:

What is the break-even level of income in the table? What is the term that economists use for the saving situation shown at the $240 level of income?

Break-even level of income is where saving equals zero (consumption equals income). Thus, the break-even level of income is $260.

At the level of income $240 saving is negative. Economists refer to this as dissaving.

Part c:

For each of the following items indicate whether the value in the table is either constant or variable as income changes: the MPS, the APC, the MPC, the APS.