CHAPTER 10 Basic Macroeconomic Relationships* Flashcards
What is the relationship between income and consumption?
Income and consumption are directly (positively) related, meaning as income increases, consumption generally increases.
How is personal saving defined?
Personal saving is “not spending” or the portion of disposable income (DI) not consumed. It is calculated as:
𝑆 =𝐷𝐼 − 𝐶
where S is spending, DI is Disposable income and C is Consumption
What is the significance of the 45° line in the income-consumption graph?
The 45° line represents points where consumption equals disposable income (C=DI). The vertical distance between the 45° line and the consumption line (C) represents saving.
What unusual trend occurred during the COVID-19 pandemic regarding consumption and income?
Between 2019 and 2020, disposable income increased due to government stimulus, but consumption fell as people saved more due to uncertainty.
What is the consumption schedule?
The consumption schedule shows planned consumption at different levels of disposable income. It typically indicates that households consume more as DI increases but a smaller proportion of large incomes.
How do the saving and consumption schedules relate?
The saving schedule is derived by subtracting consumption from disposable income. As DI increases, saving increases, while dissaving occurs when consumption exceeds DI.
What is the break-even income?
Break-even income is the level of DI where households consume their entire income (C=DI), resulting in zero saving.
What is the average propensity to consume (APC)?
APC is the fraction of total income spent on consumption:
APC= (Consumption)/(Income)
What is the average propensity to save (APS)?
APS is the fraction of total income saved:
𝐴𝑃𝑆 = Saving / Income
Key relationship:
APC+APS=1
What is the marginal propensity to consume (MPC)?
MPC is the fraction of any change in income consumed:
MPC= ΔConsumption/ΔIncome
What is the marginal propensity to save (MPS)?
MPS is the fraction of any change in income saved:
MPS= ΔSaving/ΔIncome
Key relationship:
MPC+MPS=1
How are MPC and MPS related to the consumption and saving schedules?
The slope of the consumption schedule represents MPC, while the slope of the saving schedule represents MPS.
What happens to APC and APS as disposable income increases?
APC decreases, while APS increases, as a smaller proportion of income is consumed and a larger proportion is saved.
What is dissaving?
Dissaving occurs when households consume more than their disposable income, using savings or borrowing to finance the excess.
How did savings change during the COVID-19 pandemic?
The personal savings rate increased significantly, reaching 33.8% in spring 2020 due to increased uncertainty and stimulus payments.
What does MPC+MPS = 1 signify?
It shows that all changes in disposable income are either consumed (MPC) or saved (MPS).
What are the nonincome determinants of consumption and saving?
Wealth, borrowing, expectations, and real interest rates.
How does an increase in household wealth affect consumption and saving?
It increases consumption (shifts consumption schedule upward) and decreases saving (shifts saving schedule downward).
What is the wealth effect?
The tendency for households to consume more and save less when their wealth increases unexpectedly
How does borrowing impact current and future consumption?
Borrowing increases current consumption but reduces future consumption due to debt repayment, which lowers wealth.
How do expectations about future prices and income affect current consumption and saving?
Higher Future Prices: Increase current consumption and decrease saving.
Recession Expectations: Decrease current consumption and increase saving.
What is the effect of lower real interest rates on consumption and saving?
Lower real interest rates encourage borrowing and consumption and discourage saving.
What happens when real GDP changes versus when nonincome determinants change?
Changes in real GDP cause movement along the consumption and saving schedules.
Changes in nonincome determinants cause shifts in the schedules.
How do tax changes affect the consumption and saving schedules?
Higher Taxes: Shift both schedules downward.
Lower Taxes: Shift both schedules upward.
Why are consumption and saving schedules typically stable?
Long-term goals like retirement savings and emergency funds stabilize these schedules unless disrupted by major events.
What is the paradox of thrift?
Definition: Increased saving during a recession reduces spending, worsening the recession.
Irony: Individual households aim to save more, but collectively save less due to income declines.
How did the Pandemic Recession of 2020 illustrate the paradox of thrift?
Households saved more and consumed less, shifting the consumption schedule downward and saving schedule upward, which worsened the economic downturn.
What happens to the saving schedule when the consumption schedule shifts upward?
The saving schedule shifts downward.
What happens when taxes decrease?
Both the consumption schedule and saving schedule shift upward.
What is the framework for investment decisions?
Investment decisions balance the expected rate of return (r) against the real interest rate (i). Firms invest where r > i.
What does the expected rate of return (r) represent?
The anticipated profit percentage from an investment relative to its cost.
How is the expected rate of return calculated?
r = ExpectedProfit / CostofInvestment
Example: $1,000 machine with $1,100 net revenue yields r = 10%.
Why does investment involve risk?
Returns are not guaranteed, and actual profits may differ from expected profits.
What is the real interest rate (i)?
The inflation-adjusted cost of borrowing, calculated as:
Realinterestrate = Nominalinterestrate − Inflationrate
What is the rule for making investment decisions?
- Invest in all projects where r > i.
- Continue until r = i.
What is the investment demand curve?
A curve showing the total monetary amount of investment demanded at various real interest rates.
Why does the investment demand curve slope downward?
There is an inverse relationship between the real interest rate and the quantity of investment demanded. Lower i encourages more investment.
How does inflation affect the real interest rate?
Inflation reduces the purchasing power of repaid dollars, effectively lowering the real interest rate and making investments more attractive.
How do shifts in consumer factors affect the investment demand curve?
Changes in consumer wealth, expectations, household debt, or taxes can shift the curve.
What is the relationship between the real interest rate and investment in the law of demand?
Lower i (borrowing cost) increases investment demand.
What is the practical rule for businesses to decide on investment projects?
Analyze opportunities using the marginal-benefit–marginal-cost rule, and invest until
r = i.
What happens to the investment demand curve when acquisition, maintenance, or operating costs increase?
Expected returns decrease → curve shifts left.
How do lower business taxes affect the investment demand curve?
After-tax profitability increases → curve shifts right.
How does technological change affect the investment demand curve?
Advances in technology increase productivity and profitability → curve shifts right.
What happens when the economy is overstocked with capital goods?
Expected returns decrease → curve shifts left.
How do planned inventory changes affect the investment demand curve?
- Planned inventory increase (expecting higher sales): Curve shifts right.
- Planned inventory decrease (expecting lower sales): Curve shifts left.
How do optimistic business expectations impact the investment demand curve?
Expected returns increase → curve shifts right.
Why is investment considered unstable?
It is highly volatile and fluctuates due to:
- Variability of expectations.
- Durability of capital goods.
- Irregularity of innovation.
- Variability of profits.
How does the durability of capital goods contribute to investment instability?
Firms can delay replacing equipment, making investment discretionary.
How do high current profits influence investment?
High profits generate optimism and funds for investment → increased investment.
What role does innovation play in investment instability?
Major innovations trigger waves of investment but occur irregularly.
What is the main component of economic fluctuations in output and employment?
Investment demand shocks caused by volatility in investment.
What is the multiplier effect?
It is the phenomenon where an initial change in spending leads to a larger change in GDP.
What is the formula for the multiplier?
Multiplier= ChangeinRealGDP / InitialChangeinSpending
How can the change in real GDP be calculated using the multiplier?
ChangeinRealGDP=Multiplier × Initial
If investment increases by $30 billion and GDP increases by $90 billion, what is the multiplier?
Multiplier = 90/30 = 3
What types of spending can trigger the multiplier effect?
Investment, consumption, net exports, and government purchases.
How does the multiplier work in both directions?
Increase in spending → multiplied GDP increase.
Decrease in spending → multiplied GDP decrease.
What are MPC and MPS, and how are they related?
- Marginal Propensity to Consume (MPC): Fraction of additional income spent.
- Marginal Propensity to Save (MPS): Fraction of additional income saved.
- Relationship: MPC + MPS = 1
What is the multiplier formula based on MPC?
Multiplier= 1 / (1−MPC)
What is the multiplier formula based on MPS?
Multiplier = 1 / MPS
What is the relationship between MPS and the multiplier?
Inverse relationship:
Higher MPS → smaller multiplier.
Lower MPS → larger multiplier.
In an example with MPC = 0.75 and MPS = 0.25, how does a $5 billion investment affect GDP?
Total GDP change = $20 billion.
Multiplier: 20 / 5 = 4
How does a higher MPC affect the multiplier?
A higher MPC results in a larger multiplier because more income is spent at each round.
How do taxes and imports affect the multiplier?
They reduce the multiplier effect by diverting spending away from domestic goods and services.
What happens to the multiplier when inflation occurs?
Inflation reduces the impact of the multiplier on real GDP as higher prices decrease the real output purchased.
What is the range of estimated multipliers in the U.S. economy?
Estimates range from 0 to 2.5 due to factors like taxes, imports, and inflation.
Why does a smaller MPS lead to a larger multiplier?
A smaller MPS means more income is re-spent in each round, amplifying the GDP change.
If the MPS is 0.2, what is the multiplier?
Multiplier = 1 / 0.2 = 5
If the MPS is 0.33, what is the multiplier?
Multiplier = 1 / 0.33 = 3
What does a large MPC imply for GDP growth?
A large MPC causes GDP to grow more significantly as spending decreases slowly in successive rounds.
