Basic Macroeconomic Relationships

The business cycle is driven largely by changes in total spending. To understand why spending rises and falls, we need to look at the decisions behind it: how households split their income between consuming and saving, how businesses decide how much to invest, and how an initial change in spending ripples through the economy. These behavioral relationships are the building blocks of the aggregate demand model.

Consumption and Saving

The largest part of total spending is household consumption. Income that is not consumed is saved, so consumption and saving are two sides of the same decision. The most important determinant of both is disposable income — income after taxes.

The consumption schedule shows the planned level of consumption at each level of disposable income; the saving schedule shows planned saving. As income rises, households both consume and save more, but how they divide each additional dollar is captured by two key concepts:

• The marginal propensity to consume (MPC) is the fraction of an additional dollar of income that is spent.
• The marginal propensity to save (MPS) is the fraction that is saved.

Because every extra dollar is either spent or saved, MPC + MPS = 1.

Other Influences on Consumption

Income is the main driver, but other factors shift the entire consumption schedule:

• Wealth — A rise in the value of households' assets, such as homes or stocks, encourages more consumption. This is the wealth effect.
• Expectations — Optimism about future income or prices encourages spending today.
• Household debt — Higher debt levels can restrain current consumption.
• Taxes — Higher taxes reduce disposable income and thus both consumption and saving.

Investment

Investment — business spending on capital goods, new structures, and inventories — is the most volatile component of spending and a major source of business cycles. Firms invest when they expect the return to exceed the cost.

The two central determinants are:

• The expected rate of return — How profitable the investment is anticipated to be.
• The real interest rate — The cost of borrowing (or the opportunity cost of using one's own funds). When the interest rate falls below the expected return, the investment is worth making.

The investment demand curve ranks potential projects by their expected return and shows that, as the interest rate falls, more projects become profitable and investment rises. Investment is volatile because expectations about the future can change quickly and dramatically, and because durable capital can be postponed when conditions look uncertain.

The Multiplier Effect

A change in spending does not affect the economy only by its initial amount. When a firm builds a new plant, the construction workers it pays then spend part of their new income, which becomes income for others, who spend part of it in turn, and so on. This chain reaction is the multiplier effect: an initial change in spending produces a larger total change in output and income.

The size of the multiplier depends on the MPC. The larger the fraction of each new dollar that gets re-spent, the longer and stronger the chain. Formally:

Multiplier = 1 / (1 − MPC) = 1 / MPS

If the MPC is 0.75, the multiplier is 4, so an initial $10 billion increase in spending could eventually raise total output by $40 billion. The multiplier works in both directions: a drop in spending shrinks output by a multiple of the initial decline, which is why a relatively small shock can tip the economy into recession.

Putting It Together

Consumption, investment, and the multiplier explain how and why total spending changes — and why those changes are amplified. These relationships feed directly into the aggregate demand curve of the next chapter, where we combine all sources of spending to determine the economy's output and price level.

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Next chapter: we assemble these pieces into the central model of macroeconomics — aggregate demand and aggregate supply.