8.1 Graphing Exercise: Consumption and Saving Schedules

Although many other factors help to determine the amount of consumption and saving, disposable income is easily the most important. Furthermore, any determinant of consumption must also be a determinant of saving: By definition, any amount of disposable income that is not spent must be saved. Likewise, any fraction of a change in disposable income that is not spent must be saved. That is, C + S = DI and MPC + MPS = 1.

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Exploration: How are disposable income, consumption, and saving related?

The consumption schedule graphically illustrates the relationship between consumption and disposable income. (Listed as C and Y, respectively, in the table.) While the fraction of disposable income that is spent typically declines as income increases, it is usually assumed that consumers spend a constant fraction of any change in income. That is, the consumption schedule is linear with a slope less than one.

The graph shows a typical consumption schedule and its corresponding saving schedule. Initially, consumers are assumed to spend $1250 when disposable income is zero ("autonomous consumption.") The MPC is set to .75, indicating that consumers spend 75% of any change in their disposable income (and save 25%). Combined, these two imply that consumers will spend all of their disposable income when the latter is at $5000, as shown in the graph. At this level of income, saving must be zero.

To use the graph, click and drag the blue diamond to change the level of disposable income; the corresponding values for consumption and saving will be updated in the chart. Drag any of the scroll buttons to change the values of the MPC, MPS, or autonomous consumption.

1. If the MPC is .75, by how much will consumption increase if disposable income increases by $1000? By how much will saving increase?
   See answer here
2. If the MPC rises to .85, what happens to the MPS?
   See answer here
3. Reset the curves to their initial positions by clicking the Reset button. Suppose an increase in the values of their stock and bond portfolios causes consumers to increase desired consumption by $100 at every level of income. How will this affect saving? With this new consumption schedule, at what level of income is saving zero? At this level of income, how much is being consumed?
   See answer here
4. Suppose an increase in taxes reduces disposable income by $500. With an MPC of .75, how much will consumption change? How much will saving change?
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5. Generalize the relationships between the consumption and saving schedules: Any factor which raises the MPC must _____. Any factor which raises the MPC must _____.
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8.2 Graphing Exercise: Investment Demand Curve

A profit-maximizing firm will undertake any investment project that adds to its profits. Under what conditions will a particular investment be profitable? By comparing the additional sales revenue generated by the project over time to the project's anticipated costs, we can find the project's expected rate of return, r. The investment project will be profitable if this expected rate of return exceeds the opportunity cost of the funds-the interest rate, i-used to finance the project. For the economy as a whole, all investment projects whose real rate of return exceeds the real rate of interest will be undertaken. That is, investment is undertaken up to the point where r = i.

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Exploration: How is the demand for investment goods related to the real rate of interest?

The graph illustrates the total dollar amount of investment projects (measured in billions of dollars on the horizontal axis) whose expected rate of return is at least r (measured in percent on the vertical axis.) For example, the graph shows that there are currently no investment projects whose expected rate of return is at least 12%, but $15 billion worth of investment projects whose rate of return is at least 6%. To use the graph, click and drag on the blue diamond to adjust the real rate of interest; click and drag on the ID label to shift the investment demand curve.

1. What is the total dollar value of investment projects whose rate of return is at least 8%? How much total investment will take place if the interest rate is 8%?
   See answer here
2. If the interest rate falls from 8% to 4%, what happens to total investment spending?
   See answer here
3. Suppose a projected improvement in the economy increases the expected rate of return on every possible investment project by 2%. If the interest rate is 6%, what will happen to total investment?
   See answer here
4. Explore on your own. What is the general relationship between the rate of interest, the rate of return on investment, and total investment spending?
   See answer here