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CHAPTER 7

Introduction to Economic Growth and Instability

143

1. Economic growth may be defined as either (a) an increase

of real GDP over time or (b) an increase in real GDP per

capita over time. Growth lessens the burden of scarcity

and provides increases in real GDP that can be used to

resolve socioeconomic problems. Since 1950, real GDP

growth in the United States has been about 3.5 percent

annually; real GDP per capita has grown at about a 2.3 per-

cent annual rate.

2. The United States and other industrial economies have gone

through periods of fluctuations in real GDP, employment,

and the price level. Although they have certain phases in

common—peak, recession, trough, expansion—business

cycles vary greatly in duration and intensity.

3. Although economists explain the business cycle in terms of

such causal factors as major innovations, political events,

and money creation, they generally agree that changes in

the level of total spending are the immediate causes of fluc-

tuating real output and employment.

4. The business cycle affects all sectors of the economy, though

in varying ways and degrees. The cycle has greater effects

on output and employment in the capital goods and durable

consumer goods industries than in the services and

nondurable goods industries.

5. Economists distinguish between frictional, structural, and

cyclical unemployment. The full-employment or natural

rate of unemployment, which is made up of frictional and

structural unemployment, is currently between 4 and

5 percent. The presence of part-time and discouraged work-

ers makes it difficult to measure unemployment accurately.

6. The GDP gap, which can be either a positive or a negative

value, is found by subtracting potential GDP from actual

GDP. The economic cost of unemployment, as measured by

the GDP gap, consists of the goods and services forgone by

society when its resources are involuntarily idle. Okun’s law

suggests that every 1-percentage-point increase in unem-

ployment above the natural rate causes an additional

2 percent negative GDP gap.

7. Inflation is a rise in the general price level and is measured

in the United States by the Consumer Price Index (CPI).

When inflation occurs, each dollar of income will buy fewer

goods and services than before. That is, inflation reduces

the purchasing power of money.

8. Unemployment rates and inflation rates vary widely glo-

bally. Unemployment rates differ because nations have differ-

ent natural rates of unemployment and often are in different

phases of their business cycles. Inflation and unemployment

rates in the United States recently have been in the middle to

low range compared with rates in other industrial nations.

9. Economists discern both demand-pull and cost-push

(supply-side) inflation. Demand-pull inflation results from

an excess of total spending relative to the economy’s capac-

ity to produce. The main source of cost-push inflation is

abrupt and rapid increases in the prices of key resources.

These supply shocks push up per-unit production costs and

ultimately raise the prices of consumer goods.

10. Unanticipated inflation arbitrarily redistributes real income

at the expense of fixed-income receivers, creditors, and

savers. If inflation is anticipated, individuals and businesses

may be able to take steps to lessen or eliminate adverse

redistribution effects.

11. When inflation is anticipated, lenders add an inflation

premium to the interest rate charged on loans. The nominal

interest rate thus reflects the real interest rate plus the

inflation premium (the expected rate of inflation).

12. Cost-push inflation reduces real output and employment.

Proponents of zero inflation argue that even mild demand-

pull inflation (1 to 3 percent) reduces the economy’s real

output. Other economists say that mild inflation may be a

necessary by-product of the high and growing spending that

produces high levels of output, full employment, and

economic growth.

13. Hyperinflation, caused by highly imprudent expansions of

the money supply, may undermine the monetary system and

cause severe declines in real output.

Summary

CHAPTER 7

Introduction to Economic Growth and Instability

143

Terms and Concepts

economic growth

real GDP per capita

rule of 70

productivity

business cycles

peak

recession

trough

expansion

labor force

unemployment rate

discouraged workers

frictional unemployment

structural unemployment

cyclical unemployment

full-employment rate of unemployment

natural rate of unemployment (NRU)

potential output

GDP gap

Okun’s law

inflation

Consumer Price Index (CPI)

demand-pull inflation

cost-push inflation

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144

Study Questions

1. Why is economic growth important? Why could the

difference between a 2.5 percent and a 3 percent annual

growth rate be of great significance over several decades?

KEY QUESTION Suppose an economy’s real GDP is $30,000

in year 1 and $31,200 in year 2. What is the growth rate of

its real GDP? Assume that population is 100 in year 1 and

102 in year 2. What is the growth rate of GDP per capita?

3. Briefly describe the growth record of the United States.

Compare the rates of growth of real GDP and real GDP

per capita, explaining any differences. Compare the average

growth rates of Japan and the United States between 1997

and 2005. To what extent might growth rates understate or

overstate economic well-being?

KEY QUESTION What are the four phases of the business

cycle? How long do business cycles last? How do seasonal

variations and long-run trends complicate measurement of

the business cycle? Why does the business cycle affect out-

put and employment in capital goods industries and con-

sumer durable goods industries more severely than in

industries producing consumer nondurables?

5. What factors make it difficult to determine the unemploy-

ment rate? Why is it difficult to distinguish between frictional,

structural, and cyclical unemployment? Why is unemploy-

ment an economic problem? What are the consequences of

a negative GDP gap? What are the noneconomic effects of

unemployment?

KEY QUESTION Use the following data to calculate (a) the

size of the labor force and (b) the official unemployment rate:

total population, 500; population under 16 years of age or

institutionalized, 120; not in labor force, 150; unemployed,

23; part-time workers looking for full-time jobs, 10.

7. Since the United States has an unemployment compensa-

tion program that provides income for those out of work,

why should we worry about unemployment?

KEY QUESTION Assume that in a particular year the

natural rate of unemployment is 5 percent and the actual

rate of unemployment is 9 percent. Use Okun’s law to

determine the size of the GDP gap in percentage-point

terms. If the potential GDP is $500 billion in that year,

how much output is being forgone because of cyclical

unemployment?

9. Explain how an increase in your nominal income and a

decrease in your real income might occur simultaneously.

Who loses from inflation? Who loses from unemployment?

If you had to choose between (a) full employment with a

6 percent annual rate of inflation and (b) price stability with

an 8 percent unemployment rate, which would you choose?

Why?

10. What is the Consumer Price Index (CPI) and how is it

determined each month? How does the Bureau of Labor

Statistics calculate the rate of inflation from one year to the

next? What effect does inflation have on the purchasing

power of a dollar? How does it explain differences between

nominal and real interest rates? How does deflation differ

from inflation?

11.

KEY QUESTION If the CPI was 110 last year and is 121 this

year, what is this year’s rate of inflation? What is the “rule of

70”? How long would it take for the price level to double if

inflation persisted at (a) 2, (b) 5, and (c) 10 percent per

year?

12. Distinguish between demand-pull inflation and cost-push

inflation. Which of the two types is most likely to be associ-

ated with a negative GDP gap? Which with a positive GDP

gap, in which actual GDP exceeds potential GDP?

13. Explain how hyperinflation might lead to a severe decline in

total output.

14. Evaluate as accurately as you can how each of the following

individuals would be affected by unanticipated inflation of

10 percent per year:

a. A pensioned railroad worker.

b. A department-store clerk.

c. A unionized automobile assembly-line worker.

d. A heavily indebted farmer.

e. A retired business executive whose current income

comes entirely from interest on government bonds.

f. The owner of an independent small-town department

store.

15.

LAST WORD Suppose that stock prices were to fall by 10

percent in the stock market. All else equal, would the lower

stock prices be likely to cause a decrease in real GDP? How

might they predict a decline in real GDP?

PART TWO

Macroeconomic Measurement and Basic Concepts

144

per-unit production costs

nominal income

real income

anticipated inflation

unanticipated inflation

cost-of-living adjustments (COLAs)

real interest rate

nominal interest rate

deflation

hyperinflation

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CHAPTER 7

Introduction to Economic Growth and Instability

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Web-Based Questions

1. WHAT IS THE CURRENT U.S. UNEMPLOYMENT RATE?

Visit the Bureau of Labor Statistics Web Site, www.bls.

gov/news.release/empsit.toc.htm, and select Employ-

ment Situation Summary. What month (and year) is

summarized? What was the unemployment rate for that

month? How does that rate compare with the rate in the

previous month? What were the unemployment rates for

adult men, adult women, teenagers, blacks, Hispanics, and

whites? How did these rates compare with those a month

earlier?

WHAT IS THE CURRENT U.S. INFLATION RATE? Visit

the Bureau of Labor Statistics Web Site, www.bls.gov/

news.release/cpi.toc.htm, and select Consumer Price In-

dex Summary. What month (and year) is summarized? What

was the CPI-U for the month? What was the rate of infla-

tion (change in the CPI-U) for the month? How does that

rate of inflation compare with the rate for the previous

month? Which two categories of goods or services had

the greatest price increases for the month? Which two

had the lowest price increases (or greatest price decreases)

for the month?

CHAPTER 7

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IN THIS CHAPTER YOU WILL LEARN:

• How changes in income affect consumption

(and saving).

• About factors other than income that can affect

consumption.

• How changes in real interest rates affect

investment.

• About factors other than the real interest rate that

can affect investment.

• Why changes in investment increase or decrease

real GDP by a multiple amount.

Basic Macroeconomic Relationships *

In Chapter 7 we described economic growth, the business cycle, recession, and inflation. Our even-

tual goal is to build economic models to explain those occurrences and assess the current status of the

economy. This chapter begins that process by examining basic relationships between several eco-

nomic aggregates. (Recall that to economists “aggregate” means “total” or “combined.”) Specifically,

this chapter looks at the relationships between:

• income and consumption (and income and saving).

• the interest rate and investment.

• changes in spending and changes in output.

*Note to the Instructor: If you wish to bypass the aggregate expenditures model covered in full in Chapter 9, assigning the present

chapter will provide a seamless transition to the AD-AS model of Chapter 10 and the chapters beyond. If you want to cover the aggregate

expenditure model, this present chapter provides the necessary building blocks.

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CHAPTER 8

Basic Macroeconomic Relationships

147

The Income-Consumption and

Income-Saving Relationships

The other-things-equal relationship between an economy’s

income and consumption is one of the best-established re-

lationships in macroeconomics. In examining that rela-

tionship, we are also exploring the relationship between

income and saving. Recall that economists define personal

saving as “not spending” or “that part of disposable (after-

tax) income not consumed.” Saving ( S ) equals disposable

income (DI) minus consumption ( C) .

Many factors determine the nation’s levels of con-

sumption and saving, but the most significant is disposable

income. Consider some recent historical data for the

United States. In Figure 8.1 each dot represents consump-

tion and disposable income for 1 year since 1983. The line

C that is loosely fitted to these points shows that consump-

tion is directly (positively) related to disposable income;

moreover, households spend most of their income.

But we can say more. The 45ⴗ (degree) line is a ref-

erence line. Because it bisects the 90 angle formed by

the two axes of the graph, each point on it is equidistant

from the two axes. At each point on the 45 line, con-

sumption would equal disposable income, or C  DI.

Therefore, the vertical distance between the 45 line and

any point on the horizontal axis measures either con-

sumption or disposable income. If we let it measure dis-

posable income, the vertical distance between it and the

consumption line labeled C represents the amount of sav-

ing ( S ) in that year. Saving is the amount by which actual

0 2000 3000 4000 5000 6000 7000 8000 9000 10,000

Consumption (billions of dollars)

Dis

osable income

(

billions of dollars

)

3000

2000

4000

5000

6000

7000

8000

9000

10,000

45ⴗ reference line

C ⴝ DI

Saving in

1992

Consumption

in 1992

45ⴗ

FIGURE 8.1 Consumption and disposable income, 1983–2005. Each dot in this figure shows consumption

and disposable income in a specific year. The line C, which generalizes the relationship between consumption and disposable income,

indicates a direct relationship and shows that households consume most of their incomes. In the unusual year 2005, they consumed

more than their income.

What explains the trends in consumption (consumer spending) and saving reported in the news?

How do changes in interest rates affect investment? How can initial changes in spending ultimately

produce multiplied changes in GDP?

147

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148

consumption in any year falls short of the 45 line—( S 

DI  C ). For example, in 1992 disposable income was

$4751 billion and consumption was $4385 billion, so sav-

ing was $366 billion. Observe that the vertical distance

between the 45 line and line C increases as we move

rightward along the horizontal axis and decreases as we

move leftward. Like consumption, saving typically varies

directly with the level of disposable income. That his-

torical pattern, however, has temporarily broken down in

recent years.

The Consumption Schedule

The dots in Figure 8.1 represent historical data—the ac-

tual amounts of DI, C , and S in the United States over a

period of years. But, for analytical pur-

poses, we need a schedule showing the

various amounts that households would

plan to consume at each of the various lev-

els of disposable income that might prevail

at some specific time. Columns 1 and 2 of

Table 8.1 , represented in Figure 8.2 a (Key

Graph), show the hypothetical consump-

tion schedule that we require. This con-

sumption schedule (or “consumption

function”) reflects the direct consumption– disposable in-

come relationship suggested by the data in Figure 8.1 , and

it is consistent with many household budget studies. In the

aggregate, households increase their spending as their

disposable income rises and spend a larger proportion

of a small disposable income than of a large disposable

income.

The Saving Schedule

It is relatively easy to derive a saving schedule (or “saving

function”). Because saving equals disposable income less

consumption ( S  DI  C ), we need only subtract con-

sumption ( Table 8.1 , column 2) from disposable income

(column 1) to find the amount saved (column 3) at each

DI. Thus, columns 1 and 3 in Table 8.1 are the saving

schedule, represented in Figure 8.2 b. The graph shows

that there is a direct relationship between saving and DI

but that saving is a smaller proportion of a small DI than

of a large DI. If households consume a smaller and smaller

proportion of DI as DI increases, then they must be saving

a larger and larger proportion.

Remembering that at each point on the 45 line con-

sumption equals DI, we see that dissaving (consuming in

excess of after-tax income) will occur at relatively low

DIs. For example, at $370 billion (row 1, Table 8.1 ), con-

sumption is $375 billion. Households can consume more

than their incomes by liquidating (selling for cash) accu-

mulated wealth or by borrowing. Graphically, dissaving is

shown as the vertical distance of the consumption sched-

ule above the 45° line or as the vertical distance of the

saving schedule below the horizontal axis. We have

marked the dissaving at the $370 billion level of income

in Figure 8.2 a and 8.2 b. Both vertical distances measure

the $5 billion of dissaving that occurs at $370 billion of

income.

In our example, the break-even income is $390 bil-

lion (row 2). This is the income level at which households

plan to consume their entire incomes ( C  DI). Graphi-

cally, the consumption schedule cuts the 45° line, and the

O 8.1

Income-

consumption

relationship

TABLE 8.1 Consumption and Saving Schedules (in Billions) and Propensities to Consume and Save

*The Greek letter , delta, means “the change in.”

(1) (4) (5) (6) (7)

Level of Average Average Marginal Marginal

Output Propensity Propensity Propensity Propensity

and (2) (3) to Consume to Save to Consume to Save

Income Consumption Saving (S), (APC), (APS), (MPC), (MPS),

(GDP ⴝ D1) (C) (1) ⴚ (2) (2)

Ⲑ

(1) (3)

Ⲑ

(1) (2)

Ⲑ

(1)* (3)

Ⲑ

(1)*

(1)$370 $375 $ⴚ5 1.01 ⴚ.01

.75 .25

(2) 390 390 0 1.00 .00

.75 .25

(3) 410 405 5 .99 .01

.75 .25

(4) 430 420 10 .98 .02

.75 .25

(5) 450 435 15 .97 .03

.75 .25

(6) 470 450 20 .96 .04

.75 .25

(7) 490 465 25 .95 .05

.75 .25

(8) 510 480 30 .94 .06

.75 .25

(9) 530 495 35 .93 .07

.75 .25

(10) 550 510 40 .93 .07

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FIGURE 8.2 (a) Consumption and

(b) saving schedules. The two parts of this

figure show the income-consumption and income-

saving relationships in Table 8.1 graphically. The saving

schedule in (b) is found by subtracting the consumption

schedule in (a) vertically from the 45° line.

Consumption equals disposable income (and saving

thus equals zero) at $390 billion for these hypothetical

data.

1. The slope of the consumption schedule in this figure is .75.

Thus the:

a. slope of the saving schedule is 1.33.

b. marginal propensity to consume is .75.

c. average propensity to consume is .25.

d. slope of the saving schedule is also .75.

2. In this figure, when consumption is a positive amount,

saving:

a. must be a negative amount.

b. must also be a positive amount.

c. can be either a positive or a negative amount.

d. is zero.

500

475

450

425

400

375

370 410 430 450 470 490 510 530

550

45ⴗ

Disposable income (billions of dollars)

(a)

Consumption schedule

Consumption (billions of dollars)

Saving (billions of dollars)

Disposable income (billions of dollars)

(b)

Saving schedule

550

Dissaving $5 billion

Saving $5 billion

Saving schedule

Consumption

schedule

530

510490470450430410390

Saving $5 billion

390

QUICK QUIZ 8.2

3. In this figure:

a. the marginal propensity to consume is constant at all levels

of income.

b. the marginal propensity to save rises as disposable income rises.

c. consumption is inversely (negatively) related to disposable

income.

d. saving is inversely (negatively) related to disposable income.

4. When consumption equals disposable income:

a. the marginal propensity to consume is zero.

b. the average propensity to consume is zero.

c. consumption and saving must be equal.

d. saving must be zero.

key

graph

149

Answers: 1. b; 2. c; 3. a; 4. d

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Macroeconomic Measurement and Basic Concepts

150

saving schedule cuts the horizontal axis (saving is zero) at

the break-even income level.

At all higher incomes, households plan to save part

of their incomes. Graphically, the vertical distance be-

tween the consumption schedule and the 45 line mea-

sures this saving (see Figure 8.2 a), as does the vertical

distance between the saving schedule and the horizontal

axis (see Figure 8.2 b). For example, at the $410 billion

level of income (row 3), both these distances indicate $5

billion of saving.

Average and Marginal

Propensities

Columns 4 to 7 in Table 8.1 show additional characteris-

tics of the consumption and saving schedules.

APC and APS The fraction, or percentage, of total

income that is consumed is the average propensity

to consume (APC). The fraction of total income that

is saved is the average propensity to save (APS). That is,

APC 

consumption

____________

income

and

APS



saving

_______

income

For example, at $470 billion of income (row 6) in Table 8.1 ,

the APC is

450

___

470



or about 96 percent, while the APS

___

470



, or about 4 percent. Columns 4 and 5 in Table 8.1

show the APC and APS at each of the 10 levels of DI; note

in the table that the APC falls and the APS rises as DI in-

creases, as was implied in our previous comments.

Because disposable income is either consumed or

saved, the fraction of any DI consumed plus the fraction

saved (not consumed) must exhaust that income. Mathe-

matically, APC  APS  1 at any level of disposable in-

come, as columns 4 and 5 in Table 8.1 illustrate.

Global Perspective 8.1 shows APCs for several

countries.

MPC and MPS The fact that households consume a

certain proportion of a particular total income, for exam-

ple,

of a $470 billion disposable income, does not guar-

antee they will consume the same proportion of any change

in income they might receive. The proportion, or frac-

tion, of any change in income consumed is called the

marginal propensity to consume (MPC) , “marginal”

meaning “extra” or “a change in.” Equivalently, the MPC

is the ratio of a change in consumption to a change in the

income that caused the consumption change:

MPC 

change in consumption

____________________

change in income

Similarly, the fraction of any change in income saved is

the marginal propensity to save (MPS) . The MPS is

the ratio of a change in saving to the change in income

that brought it about:

MPS 

change in saving

________________

change in income

If disposable income is $470 billion (row 6 horizontally in

Table 8.1 ) and household income rises by $20 billion to

$490 billion (row 7), households will consume

, or

, and

save

, or

, of that increase in income. In other words, the

MPC is

or .75, and the MPS is

or .25, as shown in col-

umns 6 and 7.

The sum of the MPC and the MPS for any change in

disposable income must always be 1. Consuming or saving

out of extra income is an either-or proposition; the frac-

tion of any change in income not consumed is, by defini-

tion, saved. Therefore, the fraction consumed (MPC) plus

the fraction saved (MPS) must exhaust the whole change

in income:

MPC  MPS  1

In our example, .75 plus .25 equals 1.

GLOBAL PERSPECTIVE 8.1

Average Propensities to Consume,

Selected Nations

There are surprisingly large differences in average propensities to

consume (APCs) among nations. The United States, Canada, and

the United Kingdom in particular have substantially higher APCs,

and thus lower APSs, than other advanced economies.

France

Average Propensity

to Consume

.80 .85 .90

.95 1.0

Italy

Canada

United States

Netherlands

United Kingdom

Germany

Japan

Source: Statistical Abstract of the United States 2006, p. 875, and authors’

calculations. Latest data.

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151

MPC and MPS as Slopes The MPC is the nu-

merical value of the slope of the consumption schedule,

and the MPS is the numerical value of the

slope of the saving schedule. We know

from the appendix to Chapter 1 that the

slope of any line is the ratio of the vertical

change to the horizontal change occasioned

in moving from one point to another on

that line.

Figure 8.3 measures the slopes of the

consumption and saving lines, using

enlarged portions of Figure 8.2 a and 8.2 b. Observe that

consumption changes by $15 billion (the vertical change)

for each $20 billion change in disposable income (the

horizontal change). The slope of the consumption line is

thus .75 ( $15Ⲑ$20), which is the value of the MPC.

Saving changes by $5 billion (shown as the vertical

change) for every $20 billion change in disposable in-

come (shown as the horizontal change). The slope of the

saving line therefore is .25 ( $5Ⲑ$20), which is the value

of the MPS. (Key Question 5)

Nonincome Determinants of

Consumption and Saving

The amount of disposable income is the basic determi-

nant of the amounts households will consume and save.

But certain determinants other than income might

prompt households to consume more or less at each pos-

sible level of income and thereby change the locations of

the consumption and saving schedules. Those other de-

terminants are wealth, expectations, interest rates, and

indebtedness.

Wealth The amount that households spend and save

from current income depends partly on the value of the

existing wealth they have already accumulated. By “wealth”

we mean the value of both real assets (for example, houses,

land) and financial assets (for example, cash, savings ac-

counts, stocks, bonds, pensions) that households own.

Households save to accumulate wealth. When events boost

the value of existing wealth, households increase their

spending and reduce their saving. This so-called wealth

effect shifts the consumption schedule upward and the

saving schedule downward. Examples: In the late 1990s,

skyrocketing U.S. stock values expanded the value of

household wealth. Predictably, households spent more and

saved less. In contrast, a modest “reverse wealth effect” oc-

curred in 2000 and 2001, when stock prices sharply fell.

Expectations Household expectations about future

prices and income may affect current spending and saving.

For example, expectations of rising prices tomorrow may

trigger more spending and less saving today. Thus, the

current consumption schedule shifts up and the current

saving schedule shifts down. Or expectations of a reces-

sion and thus lower income in the future may lead house-

holds to reduce consumption and save more today. If so,

the consumption schedule will shift down and the saving

schedule will shift up.

Real Interest Rates When real interest rates (those

adjusted for inflation) fall, households tend to borrow

more, consume more, and save less. A lower interest rate,

for example, induces consumers to purchase automobiles

and other goods bought on credit. A lower interest rate

also diminishes the incentive to save because of the re-

duced interest “payment” to the saver. These effects on

consumption and saving, however, are very modest. They

mainly shift consumption toward some products (those

Consumption

Disposable income

Saving

Disposable income

MPC = = .75

⌬DI ($20)

⌬C ($15)

MPS = = .25

⌬S ($5)

⌬DI ($20)

FIGURE 8.3 The marginal propensity to consume

and the marginal propensity to save. The MPC is the slope

(CⲐDI) of the consumption schedule, and the MPS is the slope (SⲐDI)

of the saving schedule. The Greek letter delta () means “the change in.”

W 8.1

Consumption and

saving

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PART TWO

Macroeconomic Measurement and Basic Concepts

152

bought on credit) and away from others. At best, lower

interest rates shift the consumption schedule slightly

upward and the saving schedule slightly downward. Higher

interest rates do the opposite.

Household Debt In drawing a particular consump-

tion schedule, household debt as a percentage of DI is held

constant. But when consumers as a group increase their

household debt, they can increase current consumption at

each level of DI. Increased borrowing shifts the consump-

tion schedule upward. In contrast, reduced borrowing

shifts the consumption schedule downward.

Other Important Considerations

There are several additional important points regarding

the consumption and saving schedules:

• Switch to real GDP When developing macroeco-

nomic models, economists change their focus from the

relationship between consumption (and saving) and

disposable income to the relationship between consump-

tion (and saving) and real domestic output (real GDP).

This modification is reflected in Figure 8.4 a and 8.4 b,

where the horizontal axes measure real GDP.

• Changes along schedules The movement from one

point to another on a consumption schedule (for

example, from a to b on C

in Figure 8.4 a) is a change

in the amount consumed and is solely caused by a

change in real GDP. On the other hand, an upward

or downward shift of the entire schedule, for exam-

ple, a shift from C

to C

or C

in Figure 8.4 a, is

caused by changes in any one or more of the nonin-

come determinants of consumption just discussed.

A similar distinction in terminology applies to the

saving schedule in Figure 8.4 b.

• Schedule shifts Changes in wealth, expectations,

interest rates, and household debt will shift the

consumption schedule in one direction and the saving

schedule in the opposite direction. If households

decide to consume more at each possible level of real

GDP, they want to save less, and vice versa. (Even

when they spend more by borrowing, they are, in

effect, reducing their current saving by the amount

borrowed.) Graphically, if the consumption schedule

shifts upward from C

to C

in Figure 8.4 a, the saving

schedule shifts downward, from S

to S

in Figure 8-

4b. Similarly, a downward shift of the consumption

schedule from C

to C

means an upward shift of the

saving schedule from S

to S

• Taxation In contrast, a change in taxes shifts the con-

sumption and saving schedules in the same direction.

Taxes are paid partly at the expense of consumption

and partly at the expense of saving. So an increase in

taxes will reduce both consumption and saving, shift-

ing the consumption schedule in Figure 8.4 a and the

saving schedule in Figure 8.4 b downward. Con-

versely, households will partly consume and partly

save any decrease in taxes. Both the consumption

schedule and saving schedule will shift upward.

• Stability The consumption and saving schedules usually

are relatively stable unless altered by major tax increases

or decreases. Their stability may be because

consumption-saving decisions are strongly

influenced by long-term considerations

such as saving to meet emergencies or sav-

ing for retirement. It may also be because

changes in the nonincome determinants

frequently work in opposite directions and

therefore may be self-canceling.

FIGURE 8.4 Shifts in the (a) consumption and

(b) saving schedules. Normally, if households consume more at each level

of real GDP, they are necessarily saving less. Graphically this means that an upward

shift of the consumption schedule (C

to C

) entails a downward shift of the saving

schedule (S

to S

). If households consume less at each level of real GDP, they are

saving more. A downward shift of the consumption schedule (C

to C

) is reflected

in an upward shift of the saving schedule (S

to S

). This pattern breaks down,

however, when taxes change; then the consumption and saving schedules move in

the same direction—opposite to the direction of the tax change.

Consumption

(billions of dollars)

45ⴗ

Real GDP (billions of dollars)

(a)

Consumption schedule

Saving

(billions of dollars)

Real GDP (billions of dollars)

(b)

Saving schedule





G 8.1

Consumption and

saving schedules

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